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The Union budget for FY22 proposed to recapitalize public sector banks (PSBs) for 20,000 crore and set up a bad bank to remove toxic assets, two decisions that are expected to improve credit flow.

Friday’s Economic Survey had suggested a clean-up of bank balance sheets along with a subsequent recapitalization, with the growth in non-food credit remaining flat around 5.1-6.7% between March 2020 and January 2021. Indian banks have had to spend much time recovering bad loans, estimated to be 7.5% of all loans. Some of them were because of lax underwriting standards in the past, but many were genuinely affected by extraneous factors. A bad bank would take over stressed assets from the books of banks, paving the way for cleaner balance sheets and faster recoveries.

“The high level of provisioning by public sector banks of their stressed assets calls for measures to clean up bank books," finance minister Nirmala Sitharaman said in her budget speech. The idea, she said, is to take over the existing stressed debt and then manage and dispose of the assets to alternate investment funds (AIFs) and other potential investors.

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The bad bank idea has been around for some time. In 2018, a panel led by Sunil Mehta, then non-executive chairman of Punjab National Bank, suggested a five-pronged strategy to manage stressed assets, proposing an asset management company and an AIF for it. “Apart from improving reported financials, this will also free up the bandwidth of the management to focus on core lending operations," said Karthik Srinivasan, group head (financial sector ratings), ICRA Ltd.

There are global parallels to taking the bad bank route in cleaning up stressed assets. An oft-cited example is Malayasia’s Danaharta, created in 1998 to clean a mountain of bad loans. In a smaller way, the Indian government had set up a Stressed Asset Stabilization Fund and hived off stressed assets from IDBI Ltd in 2004.

“The Indian Banks’ Association (IBA) had proposed the creation of a bad bank during the course of the pandemic when the banking sector was expecting a hike in stressed assets," said Rajkiran Rai G., CEO, Union Bank of India. Taking over bad loans reduces the provisioning requirements and enhances the ability of banks to lend to productive sectors of the economy to spur growth, Rai said. The government seems to have taken note of the recent Financial Stability Report by RBI and the stress in the banking sector on account of bad loans, according to Gaurav Dayal, partner, Lakshmikumaran & Sridharan Attorneys. The bad bank and capital infusion will clean up bank balance sheets and allow PSBs to meet regulatory norms, Dayal said. “The funds for the bad bank are expected to come from the government as well as the sponsor banks. Allowing participation of AIFs in the bad debt space is a welcome move and will only increase competition among bidders," he said.

The proposed capital infusion of 20,000 crore into state-owned lenders, though lower than market expectations, will bolster their capital position and aid credit growth, provided demand recovers as well. The government did not allocate any recapitalization funds in the FY21 budget, but had later sought Parliament nod to infuse 20,000 crore through a supplementary demand for grants. So far in FY21, the Centre has injected 5,500 crore capital in PSBs through non-interest bearing special securities and another 4,557 crore in IDBI Bank.

“State-run banks’ access to capital markets is currently limited. They collectively raised equity of about $1 billion between August to December 2020 from the capital markets, as banks had to settle for considerably smaller amounts even compared with their modest expectations," Fitch Ratings had said in a note on 31 January.

Fitch Ratings cautioned that PSBs will be forced to continue on a path of risk aversion and soft loan growth without adequate capital support from the government.

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