The concept of bad bank has come to limelight as our Finance Minister announced in the Union Budget recently that an Asset Reconstruction Company (ARC) and Asset Management Company (AMC) would be established to address stressed debt of ₹2.25 lakh crore in the banking sector.

The main objectives of creation of the bad bank are (a) to clean the balance sheets of banks in India, (b) to enable the banks to reach the required level of capital adequacy by mobilising fresh capital from the market, and (c) to focus on credit growth to boost investment and ultimately economic growth. Essentially a bad bank would help the Indian banks to trim losses and concentrate on their core business of lending. Let us discuss the same in detail.

Bad loans at a glance

Risk is inherent in every business, more so in banking. Stressed assets of Indian banks have been mounting due to a slew of factors such as persistent global economic slowdown exacerbated by Covid-19, stalled infrastructure projects coupled with cost overruns, inordinate delay in obtaining various clearances, land acquisition issues, etc.

According to Reserve Bank of India’s Trends and Progress Report 2020 , gross non-performing assets (GNPAs) of Indian banks reached 8.2 per cent (equivalent to ₹9 lakh crore) at the end of March 2020 as against 9.1 per cent (equivalent to ₹9.36 lakh crore) at the end of March 31, 2019. In fact, GNPAs of public sector banks (PSBs) stood at 10.3 per cent (equivalent to ₹6.78 lakh crore) as on March 31, 2020.

The rapid credit growth during 2005-12, coupled with absence of robust credit appraisal and sound monitoring standards and wilful defaults are the primary reasons for the huge amount of bad loans in the later period. Though the absolute volume of GNPAs of Indian banks marginally reduced mainly due to massive write-offs to the extent of ₹2.38 lakh crore during 2019-20, total restructured standard advances increased from 0.36 per cent to 0.43 per cent as of March 2020 reflecting incipient stress in the sector.

The accretion to GNPAs would have been even higher in the absence of the asset quality standstill provided by the RBI as a Covid-19 relief measure. The RBI predicted in its report that the asset quality of the Indian banking system may deteriorate sharply in the near future. To address this, the Economic Survey suggested recapitalisation of banks along with cleaning of their balance sheets.

The proposed bad bank is better than the existing Asset Reconstruction Companies as it will be owned by the government. Once the NPAs are transferred to the bad bank, PSBs need not resort to higher provisioning and would be better placed to mobilise capital from the market. Since there has been a steep rise in discount rates from 30 to 60 per cent of the book value of bad loans due to regulatory norm of upfront cash payment of 15 per cent by ARCs, the timing of bad bank is apt.

Banks in India have been very slow in selling assets to the existing ARCs as neither the ARCs nor the banks were ready to bear the losses which prolonged the process of recovery.

The way forward

Over a period of time, a vicious cycle has emerged in the Indian banking sector: rising NPA level calls for higher provisioning resulting in lower capital adequacy and subdued profitability levels. This further leads to muted growth in lending capacity which in turn increases NPAs. Banks are specialised in lending but not in resolving the mammoth stressed assets; they neither possess the required level of legal expertise nor the conducive environment to recover the NPAs.

Besides, banks have to focus on capacity building and re-skilling of their in-house personnel in loan recovery, risk management, etc., in order to stay ahead of the learning curve.

Though the government is willing to privatise PSBs, it may amount to a sell-off at unattractive valuations. In this scenario, a bad bank appears to be a good idea among the available options. If the bad bank is designed with a good business model, it may address the twin balance sheet problem in India and capital adequacy concern too.

To make bad bank successful, valuation of the NPAs should be undertaken by recognised, professional, and independent institutions. However, it is not that easy to establish the bad bank given the off-balance sheet exposure of the government of India and other legal hurdles.

Srikanth is Associate Professor, National Institute of Rural Development and Panchayati Raj, Hyderabad, and Saravanan is Professor of Finance and Accounting, Indian Institute of Management Tiruchirappalli