????: 09^th Jan 2021    ⌚ : 20 Minutes   

GS-3: Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment. Government Budgeting

Context

• Recently, while announcing the budget, the Finance minister has announced the intention of the government of India to set up a bad bank to resolve the growing menace of NPAs in the country.
• In its financial stability Report, RBI has predicted that the Gross NPAs in the Indian economy might increase from 8.5% in March 2020 to 12.5% by March 2021. This number is further tipped to rise to 14.7% if the situation turns more stressful.

Prelims Focus

Non Performing Asset (NPA): NPAs are loans or advances made by a financial institution, on which both principal or interest is unpaid for a specified period of time. Simply stated, NPAs are those loans which have ceased to generate income for the bank. Types of NPA: Sub Standard:  A sub-standard asset is one which is classified as an NPA for a period not exceeding twelve months. Doubtful: A doubtful asset is one which has remained as an NPA for a period exceeding twelve months. Loss: A loss asset is one where loss has already been identified by the bank or an external institution, but it is not yet completely written off, due to its recovery value, however little it may be.

 

Bank Recapitalisation bonds: These bonds have been contemplated to increase the capital infusion into the banks to maintain their capital adequacy ratio. They are issued by the government. Currently, the idea is to get these bonds issued through a holding company. The bonds will be subscribed by the banks themselves. The money collected will be reinvested in the banks in the form of increased equity share of the government in the public sector banks. Since the equity will be increased through a holding company, therefore, the money would not count into the government budget directly and thus, would not increase the fiscal deficit.

 

Other avenues of NPA resolution: Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI Act): Sarfaesi Act was passed in the year 2002. This act empowers the bank to sell off the pledged collateral in case of non-payment of dues. The act corrects the anomaly where despite the presence of pledged collateral, banks were required to go through the difficult and time consuming civil courts to recover their dues, before selling off the collateral. Insolvency and Bankruptcy Code: The IBC code seeks to impose time-bound resolution process to resolve the insolvency. The code is applicable to individuals as well as companies. The individuals are dealt with through the Debt Recovery Tribunals (DRTs), while National Company Law Tribunal (NCLT) is responsible for the resolution of insolvency occurring in the companies. The code allows a period of 180 days, extendable by a period of 90 days, to complete the resolution process.

 

Indradhanush plan: It is a multi-sectoral plan to resolve the issues plaguing banking sector and revive the banking industry following the NPA crisis. It includes: Appointments: by letting the banks hire competent individuals from the private sector. Bank Boards Bureau: to act as the holding company of the banks, thereby reducing government interference in the banking sector. Capitalisation: to improve the capital adequacy ratio. De-stressing: by resolution of NPA crisis and strengthening the asset resolution mechanisms in the country. Empowerment: of bank management and non-interference in the decision making. Framework of accountability: to provide a performance resolution metric, which can transparently gauge the performance of the management. Governance Reforms: it includes gyan sangam to understand the problems of the banking industry.

Mains Focus

What is a bad bank?

• A bad bank is simply an entity which specialises in handling bad loans or NPAs.
• It is basically an entity which buys the NPAs of commercial banks and tries to recover at least a part of the value of such NPAs.
• Usually, banks discount the book value of NPAs when they are transferred to a bad bank. After that, whatever recovery is possible from the bad loan, becomes the earnings of bad bank.
• Unlike commercial banks, bad bank does not undertake deposits, lending or other usual banking operations.
• Another name for bad bank is Asset Reconstruction Company (ARC). It is a company which buys the bad loans of banks or any other financial institution, to let them clear their books and resume lending.

Bad bank history in India:

• Economic survey 2016-17 proposed the idea of setting up a Public Sector Asset Rehabilitation Agency to tackle the growing menace of NPAs, which had started affecting the economy of the country.
• In June 2018, a committee was set up by the then Finance minister to study the suitability of transferring the NPAs to a bad bank or an ARC.
• Budget 2021-22: The finance minister has announced the setting up of a bad bank to take over the bad loans of commercial banks in India.

How do bad loans affect the economy?

• Provisioning: The chief occupation of banks is the business of taking deposits from the savers and lending to the needy. This also constitutes its major source of income in the form of bank spread (bank spread is the difference between the interest bank charges from its borrowers and the interest it pays to its depositors). Now, bad loans lead to banks’ having to save a part of their operating revenue to account for bad loans. This is called Provisioning. The technical term used for provisioning is Capital Adequacy Ratio (CAR) or Capital to Risk (weighted) Assets Ratio (CRAR).
• Loss of Operating earnings: As stated above, banks are required to provision for bad loans out of their operating income. This means lesser availability of capital for future lending requirements. Since lending constitutes the major source of earning for the banks, therefore, lesser leading ultimately leads to lesser profits.
• Loss of sentiment: Financial sector comprises a significant proportion of share markets. Any reduction in the perceived valuation of the banks might lead to loss of share value of the banks, leading to general downfall in the share markets. This could result in wiping out of shareholders’ wealth from the financial markets.

Rationale for a bad bank

• Free up resources: As earlier mentioned in the article, banks have to set aside a part of their operating revenue to cover up for the potential doubtful advances. A bad bank can take over the bad loans of the bank, thereby freeing up the bank from the provisioning requirements. This means since the banks are not required to provision for the bad loans, the same money can be utilised for lending purposes.
• Incremental lending: Banks take advantage of the fact that a major portion of the deposits lies dormant in the bank accounts. This deposit can be used towards lending. Similarly, not all advances banks make are withdrawn immediately from the accounts. Therefore, a fraction of such loans can be used to advance further credit. Therefore, the more money banks have, the more they can advance to the needy. This is useful for the revival of the credit cycle and boosting investments in the economy.
• Specialisation: A bad bank would be specialised in maximising the recovery out of a bad loan, as this would be its primary task. In contrast, banks are not in the business of recovery, therefore, their capability to resolve the loans is minimal.
• Economic slowdown: Reports have pointed to a potential increase in stressed assets due to economic slowdown in India. Combined with the COVID-induced lockdown, this may create a situation in which the NPAs might increase to an unsustainable limit. To resolve such a situation, it is pertinent to be proactive and try to work out a solution which can be optimised to reverse the effects of slowdown in the country.
• Improved sentiment: Industry needs to come out of the crisis it is facing if India is serious about its stated goal of a $5 trilion economy. This requires a bullish sentiment in the economy. A bad bank can provide such an impetus to the industry by freeing up the books of banks. This is manifested in the pre-budget consultations with the finance minister, where the industry-representative body Confederation of Indian Industry (CII) threw its weight behind the idea of bad bank. In fact, CII has proposed setting up multiple bad banks to resolve the NPA crisis.
• Lesser need for recapitalisation of banks: Recapitalisation of banks is required to fulfill the capital adequacy ratio of the banks. The NDA government has committed more than Rs 2 lakh crores to the recapitalisation of banks in its tenure, including the revenue realised from the bank recapitalisation bonds (see inset). With the formation of a bad bank, it is expected that this amount can be utilised elsewhere, including towards public welfare and infrastructure creation.

Issues associated with the bad bank

• Shifting the problem: A bad bank is expected to take over the debts of commercial banks under itself. However, to what extent it will be successful in resolving the NPA crisis is not clear. This is because almost all of the remedies which are available in the market have been tried by the existing commercial banks. Therefore, the bad bank can only be expected to aggregate, but not resolve the problem.
• Haircut for the banks: When the bad loans are being taken over by a bad bank, the banks are expected to transfer such a loan at a discount to its original value. In such a scenario, the value of discount might prove to be controversial as both the entities, i.e. commercial bank as well as the bad bank, are being financed by the exchequer and are subject to public scrutiny. Also, banks have been cautious of taking big hair cuts because of the scrutiny from the 3 Cs (CBI, CVC and CAG).
• Losses for the banks: Similar to the last point, the haircuts taken by the banks would reflect on its profit and loss account and affect its profitability. This might raise questions on both the management of the bank as well as its decision making regarding both earlier and future haircuts.
• Fear of unethical practices: Since there would be pressure on the bad bank to perform, it is possible that the employees might turn towards unethical practices to boost recovery out of a bad loan. This has been a continuing problem earlier as there have been reports of harassment of the banks’ clients, who were unable to pay their dues. 

• Initial funding: Indian Banks’ Association has suggested an initial outlay of ₹10,000 crore for setting up a bad bank. In the times of global recession as well as COVID-induced lockdown, this might prove to be tricky for the government as it is already pressed to provide for increased healthcare and vaccine procurement costs, while at the same time, constrained by decreasing revenues due to a general fall in the level of economic activity and tax payouts.

Way Forward

• Improve the fundamentals: Experts have consistently pointed to the need for improving the examination process during the initial stages of the lending process. Usually the cause of bad loans has been traced to reckless lending undertaken by the banks to meet their lending targets. This has manifested in the Sub-prime crisis in USA, which led to the recession of 2008. It was caused due to careless lending on the basis of already over-leveraged assets, ultimately snowballing into collapse of banks like Lehman brothers.
• Asset Quality Review: While the spike in NPAs was a result of RBI-mandated Asset Quality Review, it is to be understood that the process was a mere recognition of the extent of the problem facing the financial sector of India. It is important to gauge the extent of the issue if corrective actions are expected to yield results.
• Firm steps required to address the crisis: Government has emphasized on the ‘4R strategy’ to yield result in the resolution of NPA crisis. It constitutes Recognition of NPAs, Resolution of bad loans and recovery of value from the assets, Recapitalisation of the banks by the government and Reforms in the banking sector. Apart from that, government has also come up with various other schemes like Indradhanush plan and Gyan sangam (meeting between government officials and the bank officials to understand and resolve the issues plaguing banking sector.

Conclusion

• Despite its potential benefits, the concept of bad bank has its own limitations. Therefore, the need of the hour is to strengthen the fundamentals of the economy in the first place and emphasize on better banking practices.
• At the same time, it would be a fallacy to pin all hopes on the new institution. It is important to give it due time whenever it is created and let it create its own path towards the resolution of NPA crisis facing the country.

Practice Question

• It is dangerous to shift all responsibility of fiscal prudence and examination to a single entity like bad bank, which is yet in nascent stages of its creation. Critically comment.

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