The basics of designing a bad bank

A solution to Indian banks’ bad loan problem calls for a creative and pragmatic approach, RBI Governor Urjit Patel said some time back. The latest talk about formation of a “bad bank” to take over the bad loans and administering/selling them into the private markets seems to be part of the creative and pragmatic approach to this issue. New RBI Deputy Governor Viral Acharya, a globally acclaimed scholar on credit risk/systemic risk in banking, has also offered his first views on the subject. “I don’t think a bad bank just by itself will necessarily work, I think it has to be designed right,” Viral Acharya has indicated. He has pointed out that key to the whole concept is getting right the price at which the bank can sell off the assets to private investors. If designed properly, the bad bank idea might work, the Deputy Governor has said.

In this backdrop, this article seeks to identify some fundamental principles that should apply in the determination of the “right” price at which bad assets can be taken off Indian banks’ — particularly public sector banks’ — books.

Identification of the fundamental principles seems critical for the following reasons:

a. Too often, the public debate on such matters focuses on the arcane and for a “sophisticated” audience, ignoring the bottom-line implications.

b. But, it is the bottom-line implications that are critical for the well-being of the common man. However sophisticated the financial engineering, there will ultimately be significant financial implications for the common man arising from the “resolution” of latest India’s bad loans crisis.

c. Highlighting the bottom-line implications for the common man also serves an important purpose – they help form public opinion so that at least in future, the chances of such financial blow-outs are minimised or at least their severity is mitigated.

d. The public needs to know who is responsible for permitting, or not permitting a problem situation to develop.

Economic Survey 2017 states that the total level of stressed assets (NPA + restructured + unrecognised) in public sector banks will be as much as 20 per cent of their loan book. The bad bank idea is primarily with respect to this loan stock.

Public sector banks account for 70 per cent of total banking assets. With total scheduled commercial banks credit at ₹74,00,000 crore, we take public sector banks’ share at ₹50,00,000 crore.

Of this, ₹10,00,000 crore is the level of stressed assets.

This is the quantum of bad assets that have to be taken off their books at a “right” price for all stakeholders — the banks themselves, the buyer and last but not the least, the general public.

Banking regulation is fundamentally founded on the idea that a regulated institution at all times should be “safe” and “sound”. Safety and soundness in regulation is termed as solvency regulation in the jargon.

Solvency regulation seeks to ensure that at least all small fixed amount creditors (that is, small depositors) do not suffer any loss when a financial institution goes insolvent.

At least, theoretically, the idea is that large creditors can suffer losses. (Of course, as we all know even large creditors do not suffer any losses as the “too big to fail” syndrome illustrates).

Leaving aside that, the core idea is that small fixed amount depositors should not suffer any losses when there is a serious deterioration in the value of a bank’s assets vis-à-vis its liabilities.

In other words, solvency regulation should ensure that overall asset values should at all times be higher than liability values. (Going by the Economic Survey, it seems probable that at the aggregate level for public sector banks, asset values may be perilously close to falling below liabilities. Hence the need for a disaggregated approach to marshalling assets and selling them).

Given the foregoing, we can judge how well India’s banking regulator — the RBI — has performed its task over the past many years.

The total stock of deposits held by individuals (considered as small fixed creditors) in total public sector banks’ deposits is roughly ₹35,00,000 crore. Other key deposit holders are the government sector and private corporate sector at ₹10 lakh crore and ₹14 lakh crore respectively. The household sector (excluding individuals) and foreign sector hold the balance.

One can say that the bad assets may be squarely written off against the deposit holdings of the government sector. They should be “priced” in such a manner that prospective buyers (such as asset reconstruction companies / other private investors) see enough upside to participate in the exercise. Here, one should note that unless the underlying macroeconomic environment improves, the haircut demanded by private investors would be higher. In any case, only the government sector would be capable, at the primary level, of absorbing large losses on its deposit holdings. To be sure, second-order effects of the government sector absorbing large deposit losses would be felt in the government’s fiscal position going forward. That, in turn, would be passed off either in the form of higher taxes or higher (inflationary) deficits. But, that will be a lesser evil relative to delivering a shock for individual depositors. There’s no easy trade-off here.

The writer is a Chennai-based financial consultant