Are bad banks a bad idea?

Finance minister Nirmala Sitharaman has directed NARCL to improve its functioning on acquiring stressed accounts.
Finance minister Nirmala Sitharaman has directed NARCL to improve its functioning on acquiring stressed accounts.


Apart from the resignations of two senior executives at NARCL, the bad bank has fallen short of expectations so far

Natarajan Sundar, the managing director and chief executive of National Asset Reconstruction Co. Ltd, resigned last week, a few months short of completing his two-year term. His exit marks the second notable departure from the so-called bad bank in recent months, following the resignation of board chairman Karnam Sekar in September. Sekar had put in his papers citing differences in the institution’s structure and functioning.

A notable point of contention among some senior executives at NARCL is a proposal gaining traction to merge the bad bank with India Debt Resolution Co. Ltd. NARCL, operating as a ‘principal entity’, focuses on acquiring and aggregating bad loans from banks, while IDRCL serves as an agent overseeing the entire resolution process. There is a governance flaw between this relationship, as while NARCL holds an asset reconstruction company, or ARC, licence, IDRCL is expected to resolve the bad debt process. 

Adding complexity to the situation is the involvement of personalities in this institutional disagreement, particularly Diwakar Gupta, former head of IDRCL and currently the chairman of NARCL. The question arises whether this change, initiated by the government, warrants closer scrutiny.

A week ago, finance minister Nirmala Sitharaman directed NARCL to “further improve its functioning on the acquisition of stressed accounts". There’s a possibility that the government is looking to offload bad loans from public sector banks in which it holds stakes, possibly to ensure that their books are clean and prepare for potential mergers or disinvestments. 

However, the question arises: does NARCL possess the necessary turnaround expertise and management bandwidth? The answer seems to be no. Effectively managing an asset reconstruction company requires turnaround specialists with sector-specific skills. Not just individuals with credit underwriting or collections expertise–especially not those whose earlier roles or employers may have contributed to the creation of those problematic loans. 

When the plan to establish a bad bank was unveiled in February 2021, the government estimated the transfer of over 2 lakh crore of bad loans, projecting NARCL as the largest bad asset turnaround company. However, NARCL has fallen significantly short of this expectation. 

As at the end of November, 10 public sector banks had transferred bad debts totaling 11,617 crore to NARCL. This performance not only reflects poorly on its execution capabilities but also casts a more favourable light on private asset reconstruction companies. 

Without tangible evidence of its effectiveness, NARCL appears to serve as a mere accounting and legal mechanism for transferring bad loans from state-owned entities to a banks-owned entity.

The initiation of a bad bank was fueled by the public sector bank lobby, and the government believed it could outperform the asset reconstruction industry. 

The current lack of interest from ARCs in taking over bad loans might be attributed to the owners of such assets seeking prices higher than the fair market value. ARCs typically engage in purchasing pools of stressed assets only if they foresee continued viability and potential for higher returns. 

Also, public sector bankers might be missing an opportunity in not engaging with other ARCs in their anticipation that NARCL would solve for their bad loans problems. 

Taking bad loans off the books of government-owned banks (and putting them on the bad bank’s books) would improve the eligibility of these banks for lending. But if resolutions do not happen or are delayed, that doesn’t address the underlying problem, resulting in continuing distress and with implications for the economic cycle.

That’s why globally, some experts see the idea of a bad bank as flawed.

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