Union Budget 2021: Banks should not escape cost incurred by system due to bad loans

The concept of a bad bank is not new either in the global financial parlance or here in India. A similar concept was floated in the Economic Survey of 2016-17 and was called Public Sector Asset Rehabilitation Agency (PARA). It was also one of the few times when the concept was discussed but ultimately not implemented. In this year’s budget, the establishment of a bad bank has been proposed again.

Any bank makes a profit by its lending activities through the difference of interest which it charges between its deposits and loans. Thus, any loan is an asset for a bank, because it generates revenues. However, sometimes the person who has availed the loan from a bank may not be able to repay the loan for a variety of reasons ranging from the financial inability to repay to fraudulently siphoning off the money. This way an asset for the bank which was supposed to generate revenue has actually become a liability because the bank may also not be able to recover even the original amount of money that was lent by it. Hence, this loan becomes ‘bad’ for the bank and is termed as a ‘Non-performing Asset’ (NPA).

A logical indicator of the financial health of any bank is the percentage of its loans that have become NPA. It is not possible that any bank has no NPAs at all, but it is important to contain them. A high percentage of NPAs is problematic because the bank’s balance sheet becomes stressed by them and the bank can become too wary of lending. A decline in the total number of loans handed by a bank is then a larger problem for the economy because there will be a shortage of capital for the businesses and they will be forced to cut down on expenditure which will have a negative impact on the economy.

As per the RBI data, in September 2020, the percentage of NPAs of public sector banks was around 9.7 percent, which is considerably high as any healthy bank is expected to contain the NPAs under 4 percent. The solution to this is resolving the loans which have become bad or simply providing for them through the profits of the banks. In India, the usual course is that the loans go bad in the banking system and since the majority of the banking sector is held by the government, they receive fresh capitalization from the government every now and then. This breaks one of the most fundamental rules of economics, where is there is private gain at the expense of public risk. It is so because the private person taking a loan doesn’t repay it but the government repays it from the taxpayer’s money. This is obviously a situation that needs to be remedied.

The proposed bad bank is not a bank per se. It is an entity that will specialise in resolving bad loans. This is done by equipping the institution with personnel who have specialization in valuations and appraisals and they can quickly tap into the legal framework to recover whatever capital that is possible from a loan that has gone bad. This function may not be performed by the personnel of a commercial bank in a routine manner.

The bad bank can in theory recover more money 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 in the banking services and not only on recovering loans. Moreover, the mere removal of NPAs from the balance sheets of the banks in itself provides good optics for the bank and its valuation by the market is not hampered. Considering this, one may think that why hasn’t it materialised yet, given its advantages. This is so because there are major challenges to the functioning of a bad bank as well.

The foremost challenge is the funding of the institution itself, that is the money that the bad bank would need to pay the banks while buying its NPAs. If the government decides to fund it then the original problem of private gain at the public expense is not resolved. Yet, governments in many countries have been known to do that, especially in the aftermath of the 2008 financial crisis. All major economies including the US and the EU funded the bad loans through public money. 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 over directly recapitalizing them. Government funding also encourages reckless lending, as the banks would have lesser incentive to do due diligence for a loan because ultimately the government will bear the risk of their decision. Thankfully, the government has ruled out that it will be funding the bad bank for now.

The other alternative is to keep the bad bank a private entity. In that case, if the bad bank itself doesn’t generate any profits, not many private parties will be interested in the idea. It is thus important to find an efficient mechanism to keep the bad bank leveraged. This is possible if they are able to make sufficient recoveries through auctions, securitization (converting them into sellable securities) and strategic placement (where the bad asset may be most relevant). It is also important that the lending bank should be made accountable for a percentage of the NPA and there should be clear guidelines on the demarcation of risk-bearing of the lending bank and the bad bank.

The most critical aspect of any bad bank is swift decision making as the nature of debt is that it keeps increasing with time. It is statistically established that a quicker resolution of debt leads to larger recoveries. Therefore, it is important that the transferring mechanism between the banks, especially the PSUs and the bad bank also happens swiftly. The public sector banks are not known for swift functioning, so that may prove to be challenging for the bad bank.

The key to the efficient functioning of a bad bank is that it should never be looked at as a funding institution, where bad loans are routinely transferred, it is instead an institution that can be approached by banks to resolve their NPAs and they have to pay a fee for that from their provisions. Ultimately, the banks shouldn’t be able to escape the cost that has been incurred by the system because of the loan going bad.

The writer is an Assistant Professor of Law at Maharashtra National Law University, Mumbai