Home >Opinion >Bad loans: of desperate times and desperate measures

The country’s bankers and the government are thinking of a way to resolve the substantial pile of bad loans that have accumulated in the books of the banking sector. Given that the country’s listed banks are now sitting on bad loans worth 5.8 trillion, there is no doubt that a plan is urgently needed. This immediate need appears to be driving banks and the government towards desperate measures.

A caveat—there is very little precise information about what exactly is being discussed.

Finance minister Arun Jaitley said the government is considering setting up a stressed asset funds in association with banks that could provide equity or debt capital to stressed companies. On Tuesday, Mint reported that banks are envisaging a fund that will provide equity capital or working capital debt to stressed companies and also employ stressed asset specialists to turn around the assets ( ). It would be different from an asset reconstruction company (ARC) because the assets would remain on the books of the banks, a senior banker told Mint. When asked about the plan, Reserve Bank of India (RBI) governor Raghuram Rajan did not offer much clarity except to say that banks should not be the majority owners in such a fund. Let’s try and break this down to see whether any part of this plan makes sense.

First, setting up yet another ARC is pointless. There are a number of existing ARCs in the market, and large global funds like Apollo Global Management LLC are planning to enter the segment. Among the existing ARCs (in fact the oldest existing ARC) is the Asset Reconstruction Co. of India Ltd (Arcil). This is a company that was set up in 2002 and is sponsored by the top banks of the country. Its largest shareholders are State Bank of India (19.95% stake), IDBI Bank Ltd (19.18%), ICICI Bank Ltd (13.26%) and Punjab National Bank (10.01%). So, a bank-sponsored ARC already exists. Unfortunately, it has done little good because the banks and the ARC have failed to agree on the price at which assets are to be sold. Besides, the recovery track record of ARCs has been modest at best.

If you scratch out the option to set up an ARC, you could have two other possibilities.

One, a kind of vulture fund or special situations fund that buys equity or debt securities of distressed firms.

And two, a fund which specialises in providing working capital and short-term finance to these companies.

The first option of a vulture or a special situations fund would be counter-productive and a conflict of interest. If such a fund were to operate independent of its bank sponsors, it would look to invest in distress assets at throw-away valuations. The bank sponsors would want to do the opposite and get the best possible valuations. On the flip side, hypothetically, the bank sponsored fund could invest in assets at lower-than-justified prices and benefit from the upside that eventually comes from a turnaround in the stressed asset. This could be a conflict of interest if the management of the fund and the bank are not completely ring-fenced.

The second option may be to set up a fund that provides short-term working capital finance to stressed companies. But why can’t banks lend directly? There is no bar on banks lending to assets that have been classified as non-performing assets (NPAs). In fact, the RBI governor has urged banks not to cut off new funding to companies just because they have turned NPAs. Bankers, however, fear they will be questioned about extending financing to defaulters and stay away from such lending. It is possible that a third-party fund can come in and lend to these companies to help tide them over, but there are existing non-banking finance companies (NBFCs) that have the capacity to do this should they choose to. At the right price, which builds in risk appropriately, finance is available.

There is, of course, the third (and most undesirable) option of setting up a bad bank like structure. Such a structure should be taken off the discussion table if it was ever there. Rajan has cautioned against it and the previous experience of IDBI’s stressed asset stabilisation fund suggests it does not work ( ). Setting up a bad bank would be a massive moral hazard.

There is a fourth option. The one that makes most sense but also involves the most pain. That is to take the long road towards resolving the stressed asset problem. This pile of 5.8 trillion in bad loans has been created over years. Some of it is because of circumstances like stalling of infrastructure projects and falling commodity prices. Some of these will slowly come back to life as the cycle turns. Then there are the bad loans created out of poor lending decisions. Let the banks take the pain for those.

As for the government, it will have to find a way to increase the capital it provides to state-owned banks. The 70,000 crore committed is grossly inadequate. An upfront capital infusion (along with reforms to ensure its proper usage) is the best way to reduce the pain of the bad loan clean-up.

Ira Dugal is deputy managing editor, Mint.

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