Mumbai: Indian banks have accumulated ₹ 5.8 trillion in bad loans with the prospect of more to come. The fear is that this pile of defaults, sitting atop thinly capitalized bank balance sheets, can threaten an early economic recovery by stalling the flow of capital to critical sectors like infrastructure. It is this fear that has the government, the regulator and lenders scrambling to find a way to resolve bad loans. To be sure, the eventual resolution of these stressed assets will take years but the idea is to find a way to lessen the load on bank balance sheets more quickly.
One of the ideas being discussed is a provision to convert part of the unsustainable debt held by a firm to long-dated securities like convertible preference shares, which will be held by banks. Another likely solution is the setting up of a stressed debt fund which steps in to provide bridge financing to stressed firms where banks are not in a position to lend.
Solutions introduced so far such as the strategic debt restructuring (SDR) scheme have proved to be difficult to implement while court-driven resolution processes remain painfully slow.
As India searches for a solution to its bad loan problem, it may be worth looking around the world to see how some other economies are tackling similar problems. Some of these models are being suggested as possible solutions for the Indian bad loan problem as well.
The Italian way
The most recent example of a bad loan resolution plan of significant scale and size comes from Italy. Italian banks have been the weak spot in Europe ever since the financial crisis of 2008. After years of dithering, in February 2016, the Italian government announced a plan to strengthen the country’s banks.
There were two parts to the plan. The first part was a 5-6 billion euro bank stabilization fund dubbed ‘Atlas’. The fund was set up as a private alternative investment fund in which a number of Italian banks and financial institutions were investors. The fund is managed by an external agency and is set to invest in share issues by weak Italian banks while also buying non-performing loans from weak banks.
The second and more interesting part of the Italian bad loan resolution plan is a proposal to allow banks to securitize bad loans with the government coming in and guaranteeing the most senior tranche of these loans.
A senior tranche of a pool of loans is the one deemed least risky. By allowing this, the Italian government hoped that banks will be able to shed some of their bad loans.
China looks to securitization
The idea of securitizing bad loans is something that has been used in China in the past as well and is being tried again. In May, the Bank of China said it will sell bonds backed by non-performing loans for the first time since 2008. According to a 19 May Bloomberg report, the Chinese government intends to allow banks to issue up to 50 billion yuan worth of such asset-backed securities. Such securities have been issued by Chinese banks in the past but were stopped in the aftermath of the global financial crisis.
China is also experimenting with a debt-to-equity conversion plan, a tool similar to the SDR scheme being used in India. According to a May report from brokerage house CLSA, 15-19% of China’s bank loans are bad, necessitating a solution.
The bad bank experiments
Apart from the newer resolution mechanisms being attempted, the classic bad bank approach has been tried in a number of economies ranging from Spain to Ireland. Both countries set up large state-backed asset management companies which bought stressed assets at low valuations from banks and later pushed out these assets to those specializing in stressed asset investing and recovery.
Ireland had set up the National Asset Management Agency (NAMA) in 2009 for a period of 10 years. On 8 June, the agency predicted that it would make a profit of 2.3 billion euro by the time it winds down, according to a report by Reuters. The agency had taken over almost 74 billion euro in bad loans from Irish banks in the aftermath of the crisis.
The track record of Ireland’s bad bank has been better than that of Spain’s. According to a 31 March Reuters report, Spain’s bad bank reported its third year of losses in 2015, missing its forecast to turn profitable by the second year of operations. The Spanish bad bank, called Sareb, was set up in 2012 and took over €50 billion in bad loans and assets off the books of the country’s banks.
There have also been pure government-led solutions to bad loans which have been used by Japan and the US.
Japan went through the exercise of cleaning up bank balance sheets in the late 1990s. In 1996, Japan allowed its Deposit Insurance Corp. to channel funds into weak financial institutions through asset purchases. This was followed, in 1998, by a Financial Reconstruction Law, which allowed similar purchases from healthy financial institutions as well.
The US, after the financial crisis, announced the much-debated Troubled Asset Relief Program (TARP) to purchase assets from financial institutions to strengthen the sector. TARP was set up after the collapse of Lehman Brothers in 2008 and initially allowed the US government to purchase up to $700 billion in troubled assets. By the end of 2014, TARP had been wound down with profits of nearly $15 billion.
What will work in India?
A pure government-led solution seems unlikely in India given the constraints on government finances. However, the idea of a fund, which is sponsored together by the government and lenders, is an option that is being considered. Over the past month, government officials including finance minister Arun Jaitley have said that a government-sponsored fund is being considered. The Reserve Bank of India is cautious and has said that such a fund should not be majority-owned by banks.
Meanwhile, the concept of securitization of bad loans is a tough one to implement in India. The securitization market in India has always been thin and there aren’t many sophisticated financial institutional investors who could provide liquidity to this market.