A bad bank for bad banks?


India’s public sector banks(PSBs) are in a big mess. As of September 30, 2016, the gross non-performing assets ratio of these banks stood at around 12 per cent. A gross non-performing assets ratio or a bad loans ratio of 12 per cent basically means that for every Rs 100 loaned out by the banks, the borrowers have
stopped paying interest on Rs 12.

One solution that has been advocated to solve this problem is that of a bad bank. To put it simplistically, the solution entails moving the bad loans of the public-sector banks to a newly created bank. This bank, referred to as the bad bank, will then go around recovering the loans that have been defaulted on by selling the assets offered as a collateral against the defaulted loans.

The PSBs will have to be recapitalised by the government and then they can simply concentrate on the lending business. The bad-bank strategy was successfully followed in the United States to sort out the Savings and Loans crisis of the 1980s. It was also used successfully in Sweden in the early 1990s.

The latest Economic Survey released on January 31, 2017, talks about setting up of the Public Sector Asset Rehabilitation Agency(PARA). This will be a bad bank which will buy the bad loans from the PSBs and “then work them out, either by converting debt to equity and selling the stakes in auctions or by granting debt reduction, depending on professional assessments of the value-maximizing strategy”. The bad bank strategy has also been recently recommended by Viral Acharya, a deputy governor of the Reserve Bank of India.

The thing is, this is not as simple as it sounds. In the past, PSBs have tried to sell their bad loans to private asset reconstruction companies. Like in case of bad banks, a bank sells its bad loans to an asset reconstruction company, which then goes about selling the assets held as collateral against bad loans.

The trouble is that the asset reconstruction companies haven’t really been able to do a good job of it. As the Economic Survey puts it: “Asset reconstruction companies have found it difficult to resolve the assets they have purchased, so they are only willing to purchase loans at low prices. As a result, banks have been unwilling to sell them loans on a large scale.

This is a problem that a bad bank will also face. At what price should it buy the bad loans from the public sector banks? Will those banks be ready to sell at that price, given the fear of courts, vigilance as well as the CAG?

Assuming the banks and the bad banks are able to get over this obstacle, they will run into another major obstacle. Many corporates to which banks have lent money have an interest coverage ratio of less than one. These companies are referred to as stressed companies in the Economic Survey. This basically means that the operating profit (earnings before interest and taxes) of these firms is lower than the interest that they need to pay on their outstanding debt, during a given period. They are simply not earning enough to be able to pay the interest that is due on their debt.

The stressed companies with an interest coverage ratio of less than one, owe a little more than 40 per cent of the loans given out by Indian banks. In fact, even within stressed companies the problem is concentrated among a few borrowers. A mere 50 companies account for 71 per cent of the loans owed by the stressed companies. On an average these companies owe Rs 20,000 crore each to the banking system. The top 10 companies on an average owe Rs 40,000 crore apiece.

These are some of the biggest business groups in the country. Going about selling their assets in order to recover the loans will not be easy for the bad bank. These groups have access to some of the best legal brains in the country. They are also close to the politicians. As Acharya put it: “I don’t think a bad bank just by itself will necessarily work, I think it has to be designed right.”

Political will allowing the bad bank to go after business groups which have defaulted on bank loans, must be a big part of that design. Does the Modi government have that will, is a question worth asking?

(The article was originally published in the Daily News and Analysis(DNA) on February 16, 2017).