Cutting loss. Why a bad bank is good for the economy

The pandemic has resulted in several big-ticket reforms in India, most of them geared towards improving productivity levels.

India’s total factor productivity growth in 2019 was 0.43 per cent while that of China was 2.8 per cent. If we look at labour productivity measured as output per hour per labour employed in the economy, China has roughly 1.5 times our productivity levels.

Therefore, there is significant scope to improve our productivity levels, which will enhamce growth. This is precisely why the present set of reforms initiated by the government are exciting as they can usher in a period of prolonged and sustained high levels of economic growth aided by strong macroeconomic fundamentals.

One of the recently announced reforms pertains to reducing frictions when it comes to allocation of capital across various sectors, especially when capital is stuck in inefficient firms or in unviable projects. More precisely, it is regarding the Cabinet approval for what is commonly referred to as a ‘NARCL’ — an idea that has been extensively discussed and debated.

The proposed Bad Bank is important for various reasons. First, it addresses a major bottleneck to India’s growth over the last few years due to heightened risk aversion in the banking sector. This risk aversion was largely an outcome of piling up of non-performing assets in the system due to excessive lending between 2008 to 2012.

The IBC initiative

A systematic clean-up of the banking sector was initiated with the introduction of the Insolvency & the Bankruptcy Code (IBC) which has been routinely updated and amended to bring it up to date with the evolving challenges that emerged while cleaning up of the sector.

However, the sheer quantum of bad loans, some of which were given due to political capital rather than viability of the project was bound to overwhelm any system. Think of it this way, the IBC achieves two things really well — first, it ensures that fresh insolvency cases can be resolved easily enabling promoters exit as and when necessary and secondly, it ensures a credible threat of promoters losing their wealth and control over their companies.

However, the quantum of bad loans had an adverse impact on the flow. Therefore, a one-time transfer of assets outside of the bank’s balance-sheets is essential as it will enable the banks to focus solely on lending activities while the bad bank deals with recovering dues via liquidation, restructuring of assets or any other means.

Therefore, on one hand banks can now focus on improving credit which is critical for spurring investments while on the other hand, the bad bank will unlock trapped capital in inefficient firms — both of which will be positive for the economy in the short to medium run.

It is also important to understand that movement of assets from the balance sheets of banks does not mean that the money owed will not be recovered — the mechanism is such that the bad bank will pay the banks and purchase these NPAs while it works on recovering the money that is owed to the banks.

In the past similar structures have been explored, and in most cases, the asset reconstruction companies (ARC) end up making money — in this case, since 51 per cent of ownership is with PSBs, even if they take a haircut on their balance-sheets, they can expect capital gains through their ownership of the ARC. Ultimately, it may well be the case that this may reduce overall haircuts further and improve the recovery process in the event of efficient functioning of the institution.

Given that criticality in terms of operational efficiency, the structure of the entity becomes important. While the National Asset Reconstruction Company Limited (NARCL) will acquire assets from various banks, the India Debt Resolution Company Ltd (IDRCL) will be responsible for management of these assets. 51 per cent of the ownership will be with public sector banks while rest will come from the private sector — and the contingency buffers offered by the government in the form of guarantee of ₹30,600 crore worth of Security Receipts (SR) issued by NARCL become important.

The guarantee is provided for five years, and it will reduce the need for upfront capitalisation of the new entity as the SR will cover for the gaps between the value of SR and the actual realisation. This will also improve liquidity in the market for SRs which is essential for proactive resolution of stressed assets.

The structure of the bad bank is conducive for providing a final solution to the banking sector stress and it builds on a series of other reforms that have been initiated since 2015. Hopefully, this will culminate the legacy issue of NPAs once and for all and in process it will create a far more resilient, modern and dynamic banking sector.

The writer is a New York-based economist