Why in News: –
In the early days of pandemic, banks expected of an exponential jump in non-performing assets. This worry continued well into the third quarter of the year.
GS 3: Monetary Policy/ Banking Sector & NBFCs/ Capital Market
- Indian banks were written off in the early days of the pandemic when there were expectations of an exponential jump in non-performing assets.
- This worry continued well into the third quarter of the year. It was, however, only after the banks, in their forward guidance, consistently talked about the lower number of restructuring requests, and the higher provision coverage ratios that the markets began to get convinced.
What is a bad bank?
- A ‘bad bank’ is a bank that buys the bad loans of other lenders and financial institutions to help clear their balance sheets.
- The bad bank then resolves these bad assets over a period of time.
- When the banks are freed of the NPA burden, they can take a more positive look at the new loans.
- Ideally, such a bank should be owned by the banks which have the most of NPAs.
Positive impact on the banking system?
- First, banks in India and globally were much better capitalised prior to the pandemic.
- Second, Indian banks had built up a sizeable buffer to provide for bad assets negating any surprise on balance sheets during and even after the pandemic.
- Third, independent research shows that as the size of the middle class grows to about two-thirds of Asian households, on the back of a steady rise in disposable income, personal financial assets in Asia will reach about $69 trillion by 2025 — approximately three-quarters of the global total.
- This trend will be the main driver of demand for financial services in Asia, specifically in India. Banks in Asia, including in India, have begun to adjust for this steady growth in the size of pie by experimenting with new business models, rationalising costs and providing faster and superior customer digital experience, as was clear during pandemic.
- Fourth, Indian banks and the RBI brought about financial discipline much before the pandemic to make borrowers realise that timely payments of interest and instalments were necessary and that any breach would affect their ratings and the pricing of loans.
Asset Reconstruction Company (ARC) and Bad Banks: –
- The creation of a bad bank under an Asset Reconstruction Company (ARC)-Asset Management Company (AMC) structure, wherein the ARC will aggregate the debt, while the AMC will act as a resolution manager.
- The proposed structure envisages setting up of a National Asset Reconstruction Company (NARC) to acquire stressed assets in an aggregated manner from lenders, which will be resolved by the National Asset Management Company (NAMC).
- A skilled and professional set-up dedicated for Stressed Asset Resolution will be ably supported by attracting institutional funding in stressed assets through strategic investors, AIFs, special situation funds, stressed asset funds, etc for participation in the resolution process.
- The net effect of this approach would be to build an open architecture and a vibrant market for stressed assets.
- The benefits of this process include the recovered value, and significant lending leverage because of three factors:
- One, capital being freed up from less than fully provisioned bad assets;
- two, capital freed up from security receipts because of a sovereign guarantee, and three, cash receipts that come back to the banks and can be leveraged for lending, also freeing up provisions from the balance sheet.
What Steps are needed?
- There have been no quantifiable estimates in the public domain of the supposed benefits of setting up such a structure.
- As we understand currently from several news reports, banks may first transfer those assets to the proposed bad bank with a 100 per cent provision on its book and then based on the experience they will decide on transferring assets with less than 100 per cent provisioning at a later date.
- It is also being speculated that of the total amounts recovered, a specified percentage say 85 per cent will be in the form of security receipts that will reside in the bank balance sheets, but will carry a zero-risk weight, with full government guarantees for a specified period of time.
Assumptions put Forward: –
- For the sake of simplicity, assume Rs 400 of bad assets are transferred to the bad bank of which Rs 100 undertaken in the first tranche is fully provisioned for.
- In the remaining three tranches, we assume that provisions progressively decline to 90, 80, and 70 per cent (the average provision coverage ratio in September 2020 was close to 80 per cent).
- The recovery rate is pegged at a minimal 20 per cent. Standard rules of such recovery are 15 per cent in cash and 85 per cent in sovereign guaranteed security receipts.
What do the RBI governors say on bad bank Shaktikanta Das
“Bad banks have been under discussion for a long time, we are open to looking up any proposal on bad banks. It is for the government to come up with such a proposal, and if any, we will examine the proposal.”
Former governor Raghuram Rajan
Former RBI governor Raghuram Rajan has also suggested the government to privatise select public sector banks (PSBs) and set up a bad bank to deal with NPAs and dilute the role of department of financial services.
Way Forward: –
- The current Indian approach will drive consolidation of stressed assets under the AMC for better and faster decision making. This will free up management bandwidth of banks enabling them to focus on credit growth, leading to an enhancement in their valuations. Given that the governance of the AMC and its independence is central to its successful functioning, there are multiple suggestions to make. These include keeping majority ownership in the private sector, putting together a strong and independent board, a professional team, and linking AMC compensation to returns delivered to investors.
What are the bad banks? Discuss how the Asset Reconstruction Company (ARC) and Bad Banks will contribute in solving the problem of NPA’s in India?