During her budget speech earlier this month, Finance Minister Nirmala Sitharaman announced plans for setting up asset restructuring companies and asset management companies (informally referred to as ‘Bad Banks’) that will take over bad loans from banks in the country. While the banking industry has welcomed this move, critics have raised some concerns on this. Let us dig into the details.
A bad loan is a non-performing asset (NPA). Several companies end up defaulting on loan payments, due to various reasons. These loans are clubbed together as non-performing assets, and the banks either write-off such loans or partially recover by selling the underlying collateral (such as physical assets including buildings and machinery of the companies).
As on 30 September 2020, the gross NPAs of scheduled commercial banks in India stood at a whopping ₹8,08,799 crore. Around 85% of these NPAs are in the hands of public sector banks. This puts a lot of stress on the banks, which utilize precious resources in tackling the NPA problem.
One of the ideas formulated to reduce this stress is to sell those NPAs to an Asset Restructuring Company (ARC), which will pay the bank based on the net book value of those assets (15% paid in cash and 85% in securitised receipts which will only be paid after cash recovery of underlying assets). These NPAs will be further transferred to an Asset Management Company (AMC), where dedicated experts will try to resolve the problem by selling to suitable investors. This ARC-AMC model of NPA resolution will let the banks focus on their lending business, instead of worrying about recovering the NPAs.
The government noted that the ARC-AMC model will be implemented by the banks themselves, and the government will not be infusing any equity for this purpose.
Setting up bad banks is a good idea:
Bringing all NPAs under one entity will enable better management of the recovery process. A dedicated and focused workforce on resolving NPAs will significantly improve the chances of resolution and recovery. It will also reduce the exposure of other assets of the banks to risks of failure.
Another merit in setting up bad banks is the opportunity to clean up the balance sheets of scheduled banks. When banks are stuck with NPAs, their ability to raise funds from the market to support their lending business diminishes. This leads to a situation where banks will slow down lending, affecting the economy adversely. By transferring NPAs to bad banks, the credibility of the banks will improve leading to better ratings by credit rating agencies and others.
Underlying all this is the confidence of the banker to lend money. If a banker feels that the NPAs are ballooning out of control, then the banker will take steps to minimize the exposure to new NPAs. This is again done by slowing down lending to existing and new customers. If bad banks take over the NPAs, the banker will regain confidence and start lending to those in need.
Setting up bad banks is a bad idea:
When banks know that there is someone else who will take care of their NPAs, then the banks may become less careful while lending. Due diligence before providing loans may take a back seat.
Issues in transfer pricing may become prominent. If the banks sell the NPAs to bad banks at a higher rate, then it becomes difficult for bad banks to recover the amount from the market. If the banks sell at a lower rate, then the market value of similar assets in other banks may reduce leading to a vicious cycle.
The costs of transferring NPAs to bad banks will be huge. These costs include the cost of running a bad bank, the cost of transferring NPAs from banks to bad banks, and the cost of restructuring and eventual sale of the NPAs. The impact of these costs will be immense.