1. NPAs woes: Bad bank idea will promote risky loan culture; here’s why

NPAs woes: Bad bank idea will promote risky loan culture; here’s why

The issue of resolution of NPAs (non-performing assets) is back on the discussion board given its magnitude. In fact the problem was always there, but we have tended to push things under a cover of camouflage.

By: | Published: February 28, 2017 4:39 AM
non-performing assets, NPAs, Bank, Demonetisation, RBI, ARCs, public financial institutions, Budget, Public sector bankers, PSUs, NPA resolution The issue of resolution of NPAs (non-performing assets) is back on the discussion board given its magnitude. In fact the problem was always there, but we have tended to push things under a cover of camouflage. (Source: Reuters)

The issue of resolution of NPAs (non-performing assets) is back on the discussion board given its magnitude. In fact the problem was always there, but we have tended to push things under a cover of camouflage for quite some time now, under what was euphemistically called restructured assets. One fine day it was decided that we must come clean and banks have started recognising these in a uniform manner. They also made provisions thereof leading to drop in profits which coexist with high NPA ratios. The banks are supposed to cleanse their books by March 2017; but one cannot be too sure as a large number of them had given assurances that this would be done by March 2016, which was not the case.

Now, there are talks of having a bad bank which can resolve the problem of NPAs. Simply put, the bad bank buys up all the bad assets of banks and pays them partly in cash with the rest in securities, and then takes on the job of collecting and resolving the same, analogous to what a recovery agent does for retail loans. The bank is freed of such assets and continues with business, while the bad bank resolves and pays back the bank based on the success of the recovery.

As we are seriously talking of such a bad bank being created, there are ten questions that should be kept in mind which cover all aspects of this grand design and simultaneously highlight what can go wrong, so that we are better prepared.

First, how many such bad banks (BB) should there be? Is a single entity effective or should there be multiple BBs so as to make it more manageable? After all we are talking of a potential number of R7 lakh crore of loans which are classified as bad assets which have to be taken over. On the face of it, a single entity could get bogged down by the number and having regional BBs could be a better idea.

Second, what should be the ownership pattern of a BB? As the ARCs which have operated so far have had limited success, the onus of creating such a platform is on the government, and ideally the centre has to form such an institution. But a government owned BB tackling issues of NPA resolution, of probably PSBs, can run into bureaucratic speed breakers or interference making it a non-starter. Asking the private sector to do so will not be different from the ARCs, and hence a combination can be considered, though the possibility of falling back cannot be ruled out.

Third, whether the BB buys bad assets of only public sector banks or all banks? Ideally, it should be the latter as the idea is to cleanse the toxic assets which afflict the system though the magnitude is assuredly smaller for private banks. But they must be treated on par with public sector banks when the purchases are being made.

Fourth, which assets should be bought by the BB? NPAs are well spread across sectors and a call has to be taken whether it should be looking at only industry or cover retail, services and agriculture. This is important because farm loans, too, are important and susceptible to weather conditions that affect ability to service debt. By taking them off the books, the issue of loan waivers can be addressed. Hence, there is need to have a formal pecking order that forms a priority list of the sectors to be sequentially cleaned up.

Linked to the sectors to be covered, the fifth question pertains to the size of loans that have to be bought. While prima facie, taking off the larger loans makes sense, from the point of view of resolution, the smaller tickets could be the low hanging fruits. Therefore, it may make sense to have allocations across the loan size segments so that the BB ends up with an eclectic mix of bad assets.

The sixth question for the BB is funding. At the end of the day, the BB requires money to pay upfront to the selling bank and administer the recovery process. If we are talking of large numbers, then it is essential for them to be well capitalised. The BB would also have to borrow funds in the market (hopefully not from banks!) to ensure that they have funds to expand their operations. The latter can be difficult; and would be possible only after a minimum level of maturity is achieved in their operations. If this is so then then the government has to allocate funds from the Budget or get the public financial institutions to contribute to the capital.

Seventh, at what price should the loans be bought? This has been a sticky point in terms of valuation. Public sector bankers, in particular, would be petrified to sell at a low price, and hence there has to be a standardised way of determining this value so that bankers come forward. There have been many instances of bankers being pursued well after their tenure for loan failures, and unless the formula is fixed from above, there would be little enthusiasm shown by banks.

The eighth question that has to be answered in advance is whether or not we are sure that such assets can be sold. For example, a loan asset may be secured by a steel mill. Can the BB be sure of selling this mill? Also, while often the BB would be getting in fresh investors who could be looking at only the better layers of assets. This will also be the problem with the securities that are to be issued where the market has to be deep.

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The ninth issue to be sorted out pertains to regulation where banks which sell their assets would also have to make the accompanying changes in their accounts to consider the possibility of under-recovery. There are no fixed templates here, and the recovery can range from 10-60% for BBs when they finally manage to resolve the cases.
The last question that the BB has to pose for its sustenance is whether we are creating a new moral hazard? The moment banks know that there is a BB which will take over bad loans there will be an incentive to go in for more risky loans knowing fully well that they can be handed over if things go wrong. The lure for higher returns through interest rates may be a temptation, with the BB providing a hedge for adverse selection.

The creation of a BB, howsoever tempting it may be, should be thought through well. Or else it could meet the same challenges which all our other attempts at NPA resolution have encountered in the past. This should not be the case this time.

The author is chief economist, CARE Ratings. Views are personal

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