Bad Banks to make Good Banks?

One solution propounded to deal with the burden of non-performing assets of banks is to create a special vehicle-a ‘bad bank’ to take over the bad loans at a discount, and deal with them appropriately. While this may clean up the books of the afflicted banks and make them look rosy, there are pitfalls too. The aim should be to nip the generation of bad loans in the first place…

There are some institutions whose names give positive feelings. One such name is that of ‘bank’. It indicates the existence of an institution that renders services to the people. People use banks to deposit their money to be kept in a safe custody while also earning interest. Money is withdrawn as per the need of the depositor. Cheques are issued on banks and transactions are done using the various services of the banks to do business. Banks become big tools in the business operations of people. Banks also give loans as per the requirements of a business. All these service profiles of a bank lead us to the conclusion that bank means good.

However, these days, a new name is emerging and that is of ‘bad bank’. How does a bank become bad? We will be wrong if we take the literal meaning, as bad bank is a concept for doing good work in the banking sector, and that it does not mean a bank which has become bad. The Finance Minister in the Budget-2021 propounded this concept and a few days back its road map has also been given.

Take over bad loans

What is a Bad Bank? A bad bank houses bad loans or non-performing assets (NPAs) of other banks, which are transferred under specified rules. This idea of the bad bank was earlier implemented in some countries like Sweden, Finland, France, Germany, Indonesia etc. Bad banks work on the only objective of liquidating NPAs under its specialised treatment. Some NPAs may be liquidated by the bad bank while some may be restructured. The original concept of a bad bank was pioneered at the Pittsburgh-headquartered Mellon Bank in 1988.

In India, prior to Budget-2021, the Indian Banking Association mooted the proposal for this. Bad Bank works on the following principles:

• Banks will identify and demarcate their assets into good and bad assets
• Good assets are those assets whose loans are being repaid as per schedule while bad assets are those where repayments are defaulted
• Bad assets can be removed from the books and transferred to a bad bank
• This way the lender banks present a cleaner picture
• The bad bank will absorb the NPAs of the lender banks at a price below the book value of the loans
• The need for a bad bank is to present lender banks in a good health so that more money comes in for giving more loans. If the NPAs are high then a bank loses its ability to borrow, lend or conduct banking operations.

The first-ever ‘bad bank’ in India has already been established through the National Asset Reconstruction Company Limited (NARCL). It will acquire NPAs worth about Rs.2 lakh crore from various commercial banks in different phases. Another entity, India Debt Resolution Company Ltd (IDRCL), which has also been set up will then try and sell the stressed assets in the market. The NARCL-IDRCL structure is the new concept of a bad bank. To make it work, the government has approved the use of Rs.30,000 crore to be used as a guarantee for five years.

Many pluses

There are many advantages attached to the creation of a bad bank. A bad bank helps recover whatever economic value can be salvaged from assets that are generally not contributing anything to the economy. Further, as these loans are already fully written off, the proceeds can be written back as profits, and thus, adding to the book value of banks. As banks hit by NPAs are mainly public sector banks (PSBs), the government is saved from putting more money, say, in the form of equities, into these banks.

Coordinated effort

The one big advantage is connected to the coordination in efforts for realisation from dead assets. There are always a large number of lenders to nearly all the defaulting companies and it becomes very difficult to coordinate the resolution of these loans. It normally prolongs the process and also brings down the amount recovered. Normally, lending consortiums have 25 to 30 lenders, thus, making it difficult to reach a consensus on steps to be taken.

Some pitfalls

The main argument against a bad bank is moral hazard. If banks transfer bad loans without a haircut, the lending institutions may repeat their mistakes in future as they escape from being penalised for the errors committed in the past. On the other hand, if the government insists on large haircuts before the transfer of bad loans, the process may get delayed as some banks may resist the direction of the government.

Further, another argument can be made that it will be easier for the unscrupulous defaulting companies to deal with one organisation if all the loans are with one entity and that they may get that one entity compromised. No doubt, there can always be some demerits of a scheme launched for betterment. Overall, the launching of a bad bank is for the good of the banking sector. Its success will ultimately depend upon its execution and its management.

The bad bank concept is needed due to the malaise of NPAs with which our banks, particularly public sector banks were suffering. Till recently, our NPAs had reached more than Rs.11 lakh crores and after serious efforts made in the last three years, it has now been brought down to Rs.8.50 lakh crore as of 1st April 2021. The health of banks is very important for the health of the country’s economy. Banks cannot go for the needed lending if they are burdened with NPAs.

"A new name is emerging and that is of ‘bad bank’. How does a bank become bad? We will be wrong if we take the literal meaning, as ‘bad bank’ is a concept for doing good work in the banking sector, and that it does not mean a bank that has become bad"

Why bad loans?

Now the question arises as to the causes for the rise of NPAs beyond the permissible realistic limits. There are many reasons. First, is the genuine reason, when the borrowers’ business health turns weak and as a result, the loans taken cannot be repaid as per the schedule. Say, the case of the telecom sector, which is not in a good health financially today, and as a result, borrowers in this sector are constrained to allow the debts in their hands to become bad debts.

Second, are the wilful frauds committed by borrowers. In this category, borrowers may try to siphon off the loan money, as their intention, to begin with, was not genuine. It has been seen that such borrowers open a large number of shell companies and rotate the loan money in such a manner that ultimately, the destination of the money is not visible.

Fraud and corruption

Third, it is corruption, even negligence on the part of the bankers that loan taken for a particular project as per the records, goes somewhere else and no action is taken. If the project is non-functional and no income is earned then the loan taken cannot be repaid. In this category, the loan records are manipulated with the collusion of bankers so that there is hardly any asset for realisation when the debt is finally seen as bad. I remember a case dealt by me when a public sector bank advanced a huge loan to an NRI, through its London branch for a project in Nigeria but the money was immediately diverted through a foreign bank in India for the purchase of shares in an Indian company. The bankers and the borrower were in collusion and ultimately the matter was handed over to the competent agency for investigation and prosecution.

Fourth, many PSBs have been caught in the mess due to high-level illegal political and bureaucratic instructions. In such a situation, loans were advanced to unscrupulous borrowers who never wanted to return the loans taken. Sometimes even a junior level official plans a fraud on his employer bank and that fraud becomes the cause of a big bad loan. The case of Nirav Modi, which originated due to fraud by a junior official of the Punjab National Bank, is a good illustration.

Nip them in the bud

The permanent solution for the problem in the banking sector is not the creation of bad banks but to nip instances of bad loans in the bud. Bad loans due to genuine reasons may keep arising but at least the generation of bad loans due to frauds, corruption and negligence should be stopped. The watchdog of banks is the Reserve Bank of India and it is desired that there should be more vigilance on its part. Exemplary punishments should be given to all those who are part of the collusion to harm banks. The proceedings under the Insolvency and Bankruptcy Code should be expedited so that the promoters with bad loans lose their companies. Such stern actions may have ripple effects in reducing the rise of bad loans at the very first instance.

Banks get in trouble for one reason: they make bad loans. A man under debt can soon become a disturbance if he is allowed to remain in this status-quo. A bad bank or even a network of bad banks will not make the losses disappear. The losses or NPAs are transferred to a bad bank which may contribute to exist with some relief. It is important that bad loans are controlled, to begin with.