The Economic Survey has suggested that a so-called bad bank be set up to rescue banks buried under a mountain of bad loans.

Such an institution, which the survey calls a public sector asset rehabilitation agency (PARA), can be funded by government securities, an equity infusion from the private sector, or by using the Reserve Bank of India’s (RBI’s) excess capital, the survey said.

The idea for a bad bank is not new, but has found little favour with RBI so far; former governor Raghuram Rajan argued against the concept.

India’s so-called twin balance sheet problem—where stretched corporate balance sheets spill over into a bad loan problem for their lenders— has been a recurring theme in recent economic surveys. The latest one points out that this problem has worsened beyond any emerging nation in the world, except Russia, and is “higher even than the peak levels seen in Korea during the East Asian crisis".

Gross non-performing assets of 41 listed banks reached Rs6.7 trillion at the end of September.

“Market analysts estimate that the unrecognized debts are around 4% of gross loans, and perhaps 5% at public sector banks. In that case, total stressed assets would amount to about 16.6% of banking system loans—and nearly 20% of loans at the state banks," the survey said.

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To deal with this problem, some large stressed companies have attempted to sell some of their assets. However, this has only helped them in buying some time. Over the past few years, RBI measures such as the strategic debt restructuring (SDR) and scheme for sustainable structuring of stressed assets (S4A) have not resulted in any improvement in either the balance sheets of the stressed corporate entities or the banks that loaned them money.

Under SDR, banks have the ability to convert part of their debt in a stressed company to 51% equity, allowing them to take operational control and sell the company to a suitable buyer. Under S4A, banks can break up the debt into sustainable and unsustainable halves, allowing deep restructuring in the latter, while the former continues to be serviced.

Thus, the survey suggests the formation of PARA, an agency that would purchase specified loans from banks and then resolve them, either by converting debt to equity and selling the stakes in auctions or by granting debt reduction.

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The survey suggests PARA be a public sector organization with government shareholding capped at 49%. Apart from issuing government securities and inviting equity infusion from private firms, the survey has suggested that RBI transfer some of the government securities on its books to banks and PARA. As a result, the RBI’s capital would decrease, while that of the banks and PARA would increase, the survey said.

The challenges in setting up a government sponsored agency to buy bad loans from banks would be possible charges of favouritism or excessive government interference.

Ensuring that the agency keeps commercial interests in mind while taking decisions and figuring out the right value for the assets it takes off bank books would also be key.

“This is a good idea which may actually work. However, unless the issues, including judiciary support, governance practices and the fear of future investigation are addressed and more significantly the aspect of providing common equity as accepted under Basel are met with, it may remain a good concept on the drawing board," said Ashvin Parekh, managing partner, Ashvin Parekh Advisory Services LLP

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