In its annual budget in February, the Indian government announced the formation of a ‘national bad bank’ to tackle the decade-long non-performing loan (NPL) crisis that has undermined India’s banking sector. But what will this bad bank look like?
First, it will not be funded by the government, but by a consortium of public sector banks with approximately Rs150bn ($2bn) of capital.
Second, both private and public banks will transfer the bad assets above Rs5bn to the bad bank in lieu of security receipts and cash.
These transactions, however, will happen without active price discovery and at book value net of provisions.
In turn, the bad bank will make all or part of these assets open to bidding to existing asset reconstruction companies (ARCs). The set-up is similar to the bad bank implemented in Ireland after the global financial crisis.
It is important to note that private ARCs, which are often sponsored by bank consortiums, are already managing more than Rs1tn of bad assets.
What then is the value created by one more bad bank?
A crucial element is the government guarantee on security receipts issued by the national bad bank. It means that bad assets purchased from Indian banks which will be much safer than the receipts issued by the private ARCs, which often require additional provisioning.
All cash deals
The excess provisioning has prompted the commercial banks to negotiate all-cash deals, instead of the standard 15:85 model used in recent years, with the cash component shooting up to 91% in 2020 compared to 15% in 2016, according to the Indian subsidiary of S&P Global.
In turn, the thinly-capitalised private ARCs are quoting steeper discounts on the bad assets with the average haircut rising from 61% in 2018 to 65% in 2020, according to the Reserve Bank of India (RBI).
Public banks, however, have been extremely averse to selling the loans at discount, fearing scrutiny by regulators. With the national bad bank in place, the burden of justifying the price for bad assets is off the shoulders of the bank management.
With the bad bank in place, the burden of justifying the price for bad assets is off the shoulders of bank management
This separation, industry experts say, is likely to boost the willingness of the public banks to use the bad bank and help them clean up their balance sheets. Another advantage of new bad bank is that it can handle larger loans than the ARCs, which have a leverage ratio of up to seven times.
Moreover, higher ‘skin in the game’ regulations have decreased asset sales to existing ARCs.
Private banks sold only 15% of the newly recognised bad assets to ARCs in the 2019–2020 financial year. This compares with 70% two years earlier, while public banks sold less than 10% of the bad assets to ARCs, making a strong case for the bad bank.
Banking reforms
The government’s bad bank announcement follows a raft of banking reforms over the past five years which have sought to force banks to recognise bad assets and encourage government-funded recapitalisation of state lenders.
The implementation of the Insolvency and Bankruptcy Code in 2016 sought to force time limits on the recovery of non-performing assets. The recovery rates under the insolvency code’s mechanisms stands at 45.5% this year, compared with 26% previously. The reforms have led to a roughly 300 basis points drop in Indian bank’s gross NPLs from 10.5% in 2018 to 7.5% in 2020.
However, almost 50% of the 4,008 cases submitted under the insolvency code’s mechanism since 2016 remain pending, with many exceeding the code’s 270-day time limit. Moreover, once the moratorium on the Insolvency and Bankruptcy Code implemented during the Covid-19 pandemic is lifted this month, NPLs are expected to shoot up to 13.5%, according to the RBI.
It all makes a making a compelling case for a bad bank to find a market solution to India’s NPL problem. Nonetheless, the success of bad bank depends upon a few considerations.
A study by the Bank for International Settlements found that that segregation of bad assets improves future bank lending and limits NPLs when implemented with recapitalisation. Therefore, effective implementation of the insolvency code will be crucial going forward if private investors are to be convinced to invest in the bad assets. Independence, especially by the management of the public banks, is crucial for the bad bank’s success.
It remains to be seen whether the bad bank can transform the Indian banking sector to usher new era of productive lending.
Apoorva Javadekar is a professor of finance at the Indian School of Business in Hyderabad.
