Is there a case for a bad bank?

The economic uncertainties from the Covid -19 pandemic has once again re-opened the debate on the need for setting up a bad bank to take care of the fresh wave of bad loans and also free up resources for lending.

While the Finance Ministry is understood to be examining such a proposal, Reserve Bank of India Governor Shaktikanta Das also recently said the central bank is open to look at such a plan.

Significantly, the Economic Survey 2020-21 has been silent on the issue of a bad bank but has pointed out the need for an asset quality review after the current forbearance ends and a re-capitalisation of banks to spur lending.

All eyes are now on whether Finance Minister Nirmala Sitharaman will announce such a plan in the Union Budget 2021-22 or will look at other ways to resolve the challenges in the banking sector.

The RBI in its latest Financial Stability Report has estimated that the gross NPAs of banks may increase from 8.5 per cent in March 2020 to 12.5 per cent by March 2021 under the baseline scenario and the ratio may escalate to 14.7 per cent under a very severely stressed scenario.

This is already becoming evident in the third quarter results of banks that reflect increased stress and lenders are gearing up to meet a fresh wave of NPAs.

HDFC Bank had said if it had classified accounts as NPA after August 31, 2020, the proforma gross NPA ratio would have been 1.38 per cent as on December 31, 2020 as against reported 0.81 per cent.

For Yes Bank, the proforma gross NPA would be nearly at 20 per cent as against the reported 15.36 per cent for the third quarter this fiscal.

In their pre-Budget interactions, setting up of a bad bank has been a key wish list for many stakeholders and experts. Industry chamber CII had urged the Finance Minister to consider such a proposal and allow multiple bad banks.

Explaining the rationale, veteran banker and CII President Uday Kotak had said, “In the aftermath of Covid-19 it is important to find a resolution mechanism through a market determined price discovery. With huge liquidity both globally and domestically multiple bad banks, can address this issue in a transparent manner and get the credit cycle back in action.”

Prashant Kumar, Managing Director and CEO, Yes Bank, also said it would be good for the economy. “We are the first ones to support the idea of a bad bank and we are working on our own ARC. I think a bad bank coming in any form would be really good for the economy,” he had recently told BusinessLine .

Analysts point out that a bad bank would lower the re-capitalisation need for public sector banks in the new fiscal year and boost incremental lending by banks.

Banks could become more cautious on lending if bad loans rise. The Survey highlighted that credit growth slowed down to 6.7 per cent as on January 1, 2021 from 14.8 per cent in February 2019.

Not a new idea

The idea of a bad bank is not a new proposal but has been revisited a couple of times in the last few years.

As the name suggests, a bad bank will buy the bad loans of financial sector entities so that they can clean up their balance sheets and move ahead with lending.

One such entity was set up in 1988 for US based Mellon Bank and other such agencies have been set up in countries including Ireland.

The proposal of setting up a bad bank in India had previously come up in the Economic Survey 2016-17, which had suggested setting up of a centralised Public Sector Asset Rehabilitation Agency (PARA) to take charge of the largest, most difficult cases, and make politically tough decisions to reduce debt.

In June 2018, then Finance Minister Piyush Goyal had set up a committee to examine whether transferring NPAs of PSBs to an ARC or a bad bank was a suitable proposal.

Many not in favour

But, there have also been many arguments against a bad bank, with reservations within the government and RBI at various points of time.

Funding could be an issue in a year when the government is hard pressed for resources. In its proposal submitted in May last year, Indian Banks’ Association had suggested an initial outlay of ₹10,000 crore.

But the main issue is that banks would have to sell the bad loans and take a haircut, which would impact its P&L. Until this issue is addressed, creating a new structure may not be as potent in addressing the problem.

A recent note by Kotak Institutional Equities had also said bad bank is perhaps well served in the initial leg of the recognition cycle.

“Today, the banking system is relatively more solid with slippages declining in the corporate segment for the past two years and high NPL coverage ratios, which enable faster resolution,” it said, adding that setting up such an agency today would aggregate but not serve the purpose observed in other markets.

As of now, the problem of NPAs are held at bay as the Supreme Court verdict is pending. Setting out a strategy to tackle the looming issue is critical – if not a bad bank, then via other options.