The key to the proper functioning of a failing bank is that it should never be viewed as a financing institution where bad debts are routinely transferred.
Banks should bear the cost of bad loans. Image courtesy of CNBC-TV18
The concept of bad bank is not new in global financial jargon or here in India. A similar concept was launched in the 2016-17 economic study and was called the Public Sector Asset Rehabilitation Agency (PARA). It was also one of the few times the concept was discussed but ultimately was not implemented. In this year’s budget, the creation of a failing bank was again proposed.
Every bank makes a profit from its lending activities through the difference in interest it charges between its deposits and loans. Thus, any loan is an asset for a bank, because it generates income. However, sometimes the person who made use of the loan from a bank may not be able to repay the loan due to various reasons ranging from financial inability to repay to fraudulent siphoning of money. In this way, an asset for the bank that was supposed to generate income has in fact become a liability, as the bank may also not be able to recover even the original amount of money that it lent. Therefore, this loan becomes “bad” for the bank and is qualified as “non-performing asset” (NPA).
A logical indicator of a bank’s financial health is the percentage of its loans that have become NPA. It is not possible for a bank to have no NPAs, but it is important to contain them. A high percentage of APM is problematic because the bank’s balance sheet is stressed and the bank may become overly suspicious of loans. A decrease in the total number of loans granted by a bank is then a bigger problem for the economy because there will be a shortage of capital for the companies and they will be forced to reduce their spending, which will have a negative impact on the economy. economy. .
According to RBI data, as of September 2020, the APM percentage of public sector banks was around 9.7%, which is considerably high because any healthy bank should contain APMs below 4%. The solution is to pay off bad loans or simply cover them with bank profits. In India, the usual course is that loans go badly in the banking system and since the majority of the banking sector is government owned, from time to time they receive new capitalization from the government. It breaks one of the most basic rules of economics, where there is private gain at the expense of public risk. This is because the individual who takes out a loan does not repay it, but the government repays it with taxpayer money. This is obviously a situation that must be remedied.
The proposed bad bank is not a bank in itself. It is an entity that will specialize in the resolution of bad debts. This is done by providing the institution with staff who specialize in appraisals and appraisals and who can quickly tap into the legal framework to recover all possible capital from a loan that has gone bad. This function cannot be performed routinely by the staff of a commercial bank.
The bad bank can in theory get more money back on a bad loan, just because it is only doing that and not the usual functions of the bank. Thus, a commercial bank can put all of its energies into banking services and not just credit collection. In addition, the simple removal of NPAs from bank balance sheets in itself offers a good outlook for the bank and its valuation by the market is not hindered. Considering this, one might think that why has it not materialized yet, given its benefits. This is so because there are also major challenges for the functioning of a failing bank.
The main challenge is the financing of the institution itself, that is to say the money that the bad bank would need to pay the banks while buying its NPAs. If the government decides to fund it, the initial problem of private gain at public expense is not resolved. Yet the governments of many countries are known to do so, especially in the aftermath of the 2008 financial crisis. All major economies, including the US and the EU, have funded bad debts with cash. public. This model is not desirable for India because the government is already fiscally constrained to do the same, and it has no significant monetary advantages compared to their direct recapitalization. Public funding also encourages reckless lending, as there would be less incentive for banks to do due diligence for a loan as, in the end, the government will bear the risk of their decision. Fortunately, the government has ruled out funding the bad bank for the moment.
The other alternative is to keep the bad bank a private entity. In this case, if the bad bank itself does not generate any profit, few private parties will be interested in the idea. It is therefore important to find an effective mechanism to maintain the leverage of the bad bank. This is possible if they are able to make sufficient recoveries through auctions, securitization (converting them into salable securities) and strategic investment (where the bad asset may be most relevant). It is also important that the lending bank is held accountable for a percentage of the NPA and that there are clear guidelines on the demarcation of risk-taking between the lending bank and the failing bank.
The most critical aspect of any bad bank is quick decision making because the nature of debt is that it keeps increasing over time. It is statistically established that faster debt resolution leads to higher collections. Therefore, it is important that the transfer mechanism between banks, especially the PSUs and the failed bank, also occurs quickly. Public sector banks are not known for their fast operation, which can be difficult for the bad bank.
The key to the effective functioning of a failing bank is that it should never be viewed as a financing institution, where bad debts are routinely transferred, rather it is an institution that can be approached by banks to resolve their NPAs. and they have to pay a fee for it from their provisions. Ultimately, banks should not be able to escape the cost that has been incurred by the system as a result of the loan default.
The author is Assistant Professor of Law at the Maharashtra National Law University, Mumbai.