Could Bad Banks be Good?
“Bad banks are not only necessary but unavoidable.” What? How? Read on.
“Bad banks are not only necessary but unavoidable.”
- D. Subbarao (former RBI Governor).
Hain? Bad banks are necessary? What?
And, why are veteran bankers professing this?
Well, let’s set some context first, and then dive deeper into what Bad Banks are.
On the asset side of the balance sheet of a bank, we have loans that have been lent out by the bank.
Let’s say a bank gives a car loan of Rs.10 lakhs to you. This particular amount is an asset for the bank (it can recover the money from you) and a liability for you (you owe them the money).
Banks expect to recover these loans from time to time.
But, obviously, you can’t expect full recovery (unless you lend only to Harishchandra’s of the world).
So, are you saying that banks know in advance that some people would pull a Vijay Mallya?
Yes.
They know some money won’t come back - they don’t know who will not pay back.
So, these loans, when not timely paid, turn into NPAs (Non-Performing Assets).
The loans that the bank extends are expected to be repaid by the borrower. When these borrowers fail to repay (or stop performing as per expectations), they become non-performing assets. Clear?
Now, to ease the pain of borrowers, RBI gave a moratorium (an option for the borrowers to defer the payment of a loan for a specified period) till 31 August 2020.
This was done keeping in mind the massive layoffs, and virtually no economic activity in the country. Cash was not flowing in for businesses and individuals alike.
However, no one could predict the extent to which this pandemic is going to hurt our economy. Latest GDP numbers showed that our economy has contracted by 23.9%!
Businesses have been shut, jobs lost, and the future of the economy looks bleak.
Every day, bankers are losing their sleep over the NPA problem.
To take away the pain of these bankers, some veterans are suggesting that the Government establishes a Bad Bank.
Wouldn’t it be great if there was a Super Bank that would solve all the problems for our banks? After all, who doesn’t want to live tension free?
Now, as the non-performing “assets” of a bank are still assets - why not sell them at a low price to someone and save time, effort and money wasted on catching hold of the Mallya’s of the world?
Plus, vasooli is not the core job of a bank, is it?
Decoding Bad Banks
A bad bank is an institution that buys the bad loans of banks at a discounted price so as to help the banks focus on fresh lending.
Wait a second! Isn’t this what Asset Reconstruction Companies (ARCs) do?
Bang on. You are absolutely correct. The only difference is that ARCs are not backed by the Central Government. ARCs use private money to buy these loans.
Bad Banks use public money.
Taxpayers money.
Our money.
So, what does a bad bank do with the bad loans it buys?
Well, the bad bank hires “recovery agents” and tries to vasoolofy the amount of loan from the borrowers.
If their recovery amount is higher than what they paid for the loan, they make money. Also, there are some businesses that need just a touch of expertise and professional problem solving to revive.
Bad banks try to make the fallen warriors stand back on their feet.
Not so bad after all, eh?
One of the most famous Bad Banks is Danaharta Bank of Malaysia, which was formed during the 1997 Asian currency crisis and was funded by the Malaysian Government.
It was able to recover a handsome 58.7% of the bad loans by the end of 2005.
Talking about the Indian scenario, IDBI Ltd., in 2014, was converted to a bank and the government had set up a fund called the SASF to transfer assets worth Rs. 9,000 crores off IDBI Ltd’s Balance sheet. These assets were taken over by SASF before IDBI was converted into a bank.
According to a 2014 audit report by the CAG (Comptroller and Auditor General of India), SASF was able to recover only about Rs.4,000 crores.
Also, we do have twenty-nine Asset Reconstruction Companies(ARCs) in India that buy bad loans in exchange for bonds/securities, but their performance has also been… eh.
The recovery rate of loans bought by these ARCs has varied from 2.4% to 21.5% (of the book value of loans) between 2004-2019, where the 20% barrier was crossed only once in 2010.
One could argue that if the private sector has failed, how can we expect a government entity to outperform? To this, we have no counter-argument.
While a Bad Bank could solve our perennial NPA problem, there is a larger issue to address: setting up of a Bad Bank that is backed by the Government may make the banking sector a bit more risk-friendly.
They may get too comfortable.
Here’s what Prof. Raghuram Rajan had to say on this issue -
“I just see this as shifting loans from one government pocket (the public sector banks) to another (the bad bank) and do not see how it would improve matters. Indeed, if the bad bank were in the public sector, the reluctance to act would merely be shifted to the bad bank. Why not instead infuse the capital that would be given to the bad bank directly into the public sector banks? Alternatively, if the bad bank were to be in the private sector, the reluctance of public sector banks to sell loans to the bad bank at a significant haircut would still prevail. Once again, it would solve nothing.”
So, could Bad Banks really be our saviour? Or is the root cause of the NPA problem something else altogether?
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The author of this piece, Vedant, is passionately curious. When he’s not reading about economics and finance (which are his first love), he likes to mimic us. A lot. And he’s good at it too :P