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Bad bank to take on NPAs? It isn’t all fair & square

The IBA is said to have requested the central govt to set up a 'bad bank' to reduce the impact of the losses banks will face because of provisioning for NPAs. Mint explores the feasibility of the idea

The Indian Banks’ Association is said to have requested the central government to set up a “bad bank" to reduce the impact of the losses banks will face because of provisioning for non-performing assets (NPAs). Mint explores the feasibility of the idea.

What’s a bad bank and how would it work?

A bad bank is a structure that moves the distressed and illiquid assets of a bank into another entity through regulatory structures such as asset reconstruction companies (ARCs), alternative investment funds (AIFs) and asset management companies (AMCs). The proposal envisages setting up an ARC platform to buy these stressed pools from banks and turn them around. This would allow banks to write off the appropriate provisions for the portfolio sold and get the discounted value that the ARC pays for the distressed pool purchase. The stressed assets can alternatively be sold to an AIF, which could turn them around.

What’s the argument against a bad bank?

In a free market, the markets price it right. By forcing the government, in its capacity as the owner of multiple banks, to set up a bad bank and buy distressed assets at “book value" is setting up a way to build opaqueness in its dealing with bad loans. Technically, if a bank owner wants to own an ARC and move bad loans from the bank to the ARC, what precedent does that set for other banks and non-banks to also seek an ARC of their own? The system should not let pools of assets be juggled between a bank book and ARC. This would not allow fair pricing of pools purchased by an ARC.

Is the current framework equipped to handle NPAs?

If there is no appetite for AMCs, AIFs and ARCs to take over bad loans, it could be because the owners of those assets want a price higher than the fair market value. ARCs will buy those pools of stressed assets only if they see continued viability of those pools being recovered and if they are able to get higher returns than the original purchase price.

The bad loan burden
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The bad loan burden

Why is the idea of a new bad bank bad?

Proponents might argue that not much has been done by ARCs in India. The counter view would be that most bad loan declarations of late are taking place due to strict regulatory supervision pressures and lenders’ balance sheets are being cleaned out. Turnaround specialists with specific sectoral skills are needed for the task of ARCs, not just experts with credit underwriting or collections expertise. Let markets accept what can be turned around as well as the current value of a distressed portfolio.

What happens to NPAs if there’s no bad bank?

Lenders would have to pitch for the interest of ARCs in the market to gauge their interest in the distressed pool. They will also have to provide for NPAs in the balance sheets. This might push them to seek more equity infusion from investors, the government being the majority owner in most cases. This would be a transparent way of telling public investors where their money is going. Moral hazarding has no place here. After all, even if a bank fails it’s not sold to an ARC.

The author is an independent markets commentator

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