To solve the problem of bad loans in India, the Reserve Bank of India (RBI) has introduced multiple schemes over the last few years: Flexible Refinancing of Infrastructure (5/25 scheme), Asset Reconstruction (ARC), Strategic Debt Restructuring (SDR), Asset Quality Review (AQR) and Sustainable Structuring of Stressed Assets (S4A).
On the banking side, stressed assets now stand at over 12% of the total loans in the banking system. Public sector banks, which own almost 70% of banking assets, have a stressed-loan ratio of almost 16%. Banks are unwilling to take on fresh risks, which has led to negative growth of real credit, the lowest in over two decades.
A new solution gaining popularity is the “bad bank”. The concept is simple: Divide a bank’s assets into two categories, good and bad. By separating the two, a bank can avoid the contamination of good assets by the bad. It also alleviates the concerns of investors and helps the bank focus on future lending by improving health and transparency.
However, while the concept of a bad bank is simple, the implementation can be quite complicated. A variety of organizational and financial choices are available while designing a bad bank. When RBI deputy governor Viral Acharya was asked if setting up a bad bank could be an effective solution to India’s problem of bad loans, he said that it could help “if designed properly”. So, how to design the bad bank of India?
A report by McKinsey & Co., “Understanding The Bad Bank”, proposes four organizational models for a bad bank based on two decision factors.
First is to decide whether or not to keep the bad assets on the bank’s balance sheet. Moving assets off the balance sheet is better for investors and counterparties and provides more transparency into the bank’s core operations. But it is more complex and expensive.
Second, is to decide whether the bad-bank assets will be housed and managed in a banking entity or a special purpose vehicle (SPV).
Depending on the choices, the four basic bad-bank models are: on-balance-sheet guarantee, internal restructuring unit, special-purpose entity and bad-bank spin-off.
In the on-balance-sheet guarantee structure, the bank gets a loss-guarantee from the government for a part of its portfolio. The model is simple, less expensive and can be implemented quickly. However, the transfer of risk is limited and bad assets continue to remain on the bank’s balance sheet, clouding its core performance. This approach is useful for stabilizing a bank in trouble.
Consider the case of the Indian Overseas Bank (IOB). As of the quarter ended December 2016, the bank reported gross non-performing assets (NPAs) of 22.42%, net NPAs of 14.32% and a net loss of Rs554 crore. Since May 2016, the stock price of IOB has dropped more than 20%. An on-balance-sheet guarantee by the government can quickly restore confidence in the bank.
Internal restructuring unit
An internal restructuring unit is like setting up an internal bad bank. The bank places bad assets in a separate internal unit, assigns a separate management team and gives them clear incentives. This works well as a signalling mechanism to the market and increases the bank’s transparency, if the results are reported separately.
It is clear that this model relies on the existing management team to restructure assets. However, if the existing management is looking to kick the can down the road, as is the case for many banks in India, this is not an effective solution.
In a special-purpose entity structure, bad assets are offloaded into a SPV, securitized and sold to a diverse set of investors. The model works best for a small, homogeneous set of assets. The bad loan problem in India is concentrated in a few sectors like infrastructure and basic metals. An effective solution would be to transfer bad loans from these distressed sectors into sector-specific SPVs, securitize them and sell them in an auction. If the pricing is determined by the market, PSU bankers will receive less blame for losses to the exchequer.
A bad-bank spin-off is the most familiar, thorough and effective bad-bank model. In a spin-off, the bank shifts bad assets into a separate banking entity, which ensures maximum risk transfer.
But the model is complex and expensive because it requires setting up a separate organization, equipped with a skilled management team, IT systems and a regulatory compliance set-up. Also, the problem related to asset valuation and pricing will be the most severe in this model.
The Public Sector Asset Rehabilitation Agency (PARA) proposed by the Economic Survey 2016-17 falls in this category. However, given the complexity and cost of the model, it is recommended to be used as a last resort, after all other initiatives fail.
Setting up a bad bank is a very complex process. It is not a silver bullet which will solve all the problems in the Indian banking sector. More importantly, a one-size-fits-all approach to designing a bad bank can be very expensive and less effective.
Just setting up one PARA will not be enough to get the banking sector back on track. The most efficient approach would be to design solutions tailor-made for different parts of India’s bad loan problem.