Reserve Bank of India’s (RBI’s) new stressed asset resolution scheme is the latest addition to a long list of band-aids for the bad loans problem. It does allow banks to take an effective haircut of 50% (by converting debt that can’t be serviced by a firm’s current cash flows, into equity and equity-like instruments), but also creates a moral hazard.

Conversion of debt into equity or quasi-equity will help firms deleverage. Many promoters are likely to jump at this offer. Especially, as they can stay on if they sell or dilute their equity holdings. The central bank has said the amount of this sale/dilution should be equal to the haircut taken by banks; but given that the debt-to-market cap ratios of many firms with sizeable debt are greater than 10 times, is this likely to happen?

In any case, equity is always written off before debt and this scheme shouldn’t be an easy way out for irresponsible borrowers. Besides, after a dilution in shareholding, promoters may not be interested in turning around the company.

For banks, this is a new tool to stem the fresh bad loans haemorrhage seen in the last two quarters. Even standard assets and those on the brink of slipping into bad loans can be taken into this scheme. But credit costs will rise since the scheme calls for higher provisioning. On the other hand, for loans which are already classified as bad, banks may be able to write back some provisions. On balance, it is likely that credit costs will rise through the current fiscal year and even in the first half of the next fiscal year if this scheme is implemented successfully.

That implementation itself is a big “if" because of the stringent eligibility conditions attached, such as projects which have started commercial operations (forget power generators) and those that have debt of around 500 crore. If their shareholding is substantially diluted, promoters may have little incentive to provide personal guarantee for the loan. A substantial dilution will also lead to a plunge in the market price of shares leading to huge mark-to-market losses for banks. So lenders might not be too keen to pursue this scheme.

Overall, this scheme will likely help only those banks which have good provisioning cover and adequate capital in the first place. For state-owned banks which suffer on both these counts, this might not be an option. So, the scheme might not be enough to free up capital and kick-start lending.

In all fairness to the central bank though, financial engineering is the only weapon left in its armoury. It cannot cut lending rates massively, something which will increase free cash flow of firms. The government doesn’t have enough fiscal space for a huge capital injection into banks. Given the current set of circumstances, there is unlikely to be a sharp pickup in growth rates.

“If the economic slowdown continues—which I think it will—all these schemes will at best give marginal relief," said Hemindra Hazari, an independent banking analyst.