Will one bad bank fix India’s broken banking system?

Why do banks need to give collateral? Why not let the banks recognize their losses and let the bankrupt banks fail?

Ajit Ranade: Firstly, it is a one-time, time-bound effort. Bad Bank has been established to remove bad assets from the balance sheets of banks and free up capital which will allow the bank to lend. Credit growth is critical to economic growth, and a bank’s balance sheet is hampered by the presence of bad assets. Therefore, one of the main objectives of a bad bank is to remove these assets from the balance sheets of existing banks and consolidate them within a bad bank. In the meantime, the resolution and recovery process can continue. The proposed design of the bad bank separates the trustee portion of NARCL, where the assets will sit, from IDRCL, which will engage in recovery and turnaround of the bad assets. So, it is a twin structure working to free up existing banking capital to enable higher credit growth.

CP Chandrasekhar: There are many reasons banks bail out, but two in particular are important. One fact is that there are depositors involved. If you allow banks to fail, depositors who operate under the presumption that the regulatory framework will protect their money are vulnerable. Historically, we have found that in order to be able to protect depositors, central banks actually try to protect banks, either by collateralizing them or merging them with stronger banks. Two, there is a systemic problem. If a bank fails, and there’s a sort of contagion effect, you could actually have systemic problems. Banks are the core of the settlement system and credit pipe and allowing them to go down would be a problem. And finally, banks also have the option to write off these bad assets and then the government can recapitalize them. But it would be a significant blow to the government’s finances.

Isn’t the risk of moral hazard associated with bailouts making banks more complacent?

CP Chandrasekhar: You need to compare the risk to the system – the impact of bank failures on depositors and its social and political implications – with the moral hazard of bailing out banks. The more important problem is systemic exposure. But second, here we have a system in which banks are primarily publicly owned. So, the problem is, in some sense, a consequence of the state allowing the use of banks for certain purposes.

Why do you think the government has opted for a bad bank instead of infusing capital directly into banks?

Ajit Ranade: These so called bad loans are fully 100% provisioned. However, the manpower of these banks is still spent on recovery and supervision. Now, it is important that these loans are shifted to a separate entity, which is specifically focused on recovery, so that the bank can then focus on its core business, which is business development, new lending, credit growth etc. Is. And it is not a special ‘either… or’ for banks. For their growth, banks would need to tie up with additional capital to achieve the credit growth needed to achieve 7-8% GDP growth. Therefore, the government will continue to infuse more capital into the banks, while the bad loans will be shifted to a separate entity.

CP Chandrasekhar: I think we have to look at it in the context of addressing the accumulated bad debts of banks from time to time through various mechanisms. First, we had Lok Adalats, then Debt Recovery Tribunals, and then SARFAESI (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest)) The Act, which is supposed to give creditors too much power to be able to recover debts. Then we had the IBC (Insolvency and Bankruptcy Code). Until recently, there was an understanding that the IBC would allow for a quicker resolution, and that the reductions that banks would have to make would be relatively small. If you have a government that is committed to a conservative fiscal stance, consider going through a process that will clean up large amounts of accumulated debt, which will essentially entail partial write-offs and recapitalization. process, cannot be sustained. If the haircuts are big. When IBC started, it looked like you were going to get a pretty high rate of recovery. As we progressed, the rate of recovery began to drop quite rapidly. So, the point is, by adopting a bad banking system, the government feels that it will be in a position to paper over this paradox – its need to address the bad loan problem and its reluctance to allocate significant amounts from its budget. .

What is the need of a public bad bank when there are already many Private Asset Reconstruction Companies (ARCs) in India?

Ajit Ranade: What NARCL is doing is providing an asset resolution platform, which is meant for banks and banks. There are some 28 private ARCs, which may not have performed. Under Bad Bank, asset acquisition and trusteeship have been separated from asset resolution. The primary objective of IDRCL is to solve through experts who can save some value. Even though they can recover only 25%, it is more than the current record. IDRCL will actually have an incentive to resolve the loans efficiently because of the profit-sharing arrangement. So, incentives are aligned.

editorial | Endgame: On the new ‘Bad Bank’

CP Chandrasekhar: The government has said that out of ₹2 lakh crore, it will be in a position to cover only up to ₹30,600 crore. So, you will be in a position where the banks are still going to carry the burden and affect their profitability. On the other hand, if you look at the defaulters, a large number of whom are large corporates, they are going to settle their loans at huge discounts. Banks may not be left with fresh losses, but still with losses that have already been forfeited, while defaulters are left with their assets in case a significant amount is not confiscated. Will go

Ajit Ranade: These are two different things. One is to go after the defaulters and the other is to recover the property and salvage value from them. Corporates are not going to be left out. If there is an established criminal negligence or criminal activity, there is a separate procedure for that. In addition, Bad Bank is focusing the energy of banking personnel. A bad bank should not be seen as a recurring thing in which the balance will continue to move in this structure from the existing banking balance sheet. If this happens, you are inviting the trend of what we call moral hazard, because then there is no effort on the part of the bank to try and recover.

Do you think bad banks, which are essentially owned by troubled banks themselves, will have a different incentive structure to resolve loans efficiently?

Ajit Ranade: Staffing, pay scale etc. will vary in IDRCL. For example, when State Bank of India (SBI) runs an asset management company, AMC employees are not on the same pay scale as SBI. So, we have to accept that incentives, pay structure, staffing, talent and ultimately governance… is what matters.

CP Chandrasekhar: There is a lack of clarity on some things. There is an exemption which is going to be negotiated between NARCL and the banks. Once the bad debt is in the books of NARCL, it will be handed over to IDRCL. Now, as was the case with private ARCs earlier, both these entities will also charge managerial fees. Therefore, they are going to cover a major part of their cost by way of managerial fees charged for managing and disposing of these assets. It’s not really clear what the incentive is going to be to try to get the maximum possible value out of these bad loans.

Ajit Ranade: The difference is that in case of existing ARCs, there is no guarantee of the value to be recovered from the security receipt. So, generally, the average purchase price of bad loans by existing ARCs is something like 36%, but there is no support for security receipts; These receipts can be of zero value. The actual recovery may be only one-fourth of the 36 per cent, which is 9 per cent. In the new structure, the average purchase price will be lower, but the security receipts for the remaining price will be covered by the government up to ₹30,600 crore. This in itself replaces the incentive.

Does the Bad Banks proposal really address the root causes of the banking crisis or is it just a temporary band-aid?

Ajit Ranade: The fact is that the NPA ratio has been increasing in the last few years and we have tried many things. Now we need to bring the problem down to manageable proportions. In this sense, the bad bank is taking out a small part of the total NPAs. But NPAs will keep on increasing. Bad loans are a function of business cycles – during the down cycle, the bad loan ratio goes up, but in the up cycle the bad loan ratio comes down. The idea is to keep it in manageable proportions.

CP Chandrasekhar: There is a structural issue involved here. Unlike in the 1980s and 1990s, a large proportion of defaulted loans in this period have been corporate loans. Why did this come? Previously, funding of capital-intensive projects was considered to be something that took place through the budget of the government or through development finance institutions specializing in development finance. There was also the idea that you could finance these investments through long-term capital available through an active bond market, which India does not have to a large extent. The government decided that it could not raise the resources to finance the investment and decided to set up commercial banks for financial institutions. Therefore, the burden of financing these investments was transferred by the state to the public sector banks. And banks shouldn’t make too much of it because there are significant liquidity and maturity mismatches. So, we got this problem because we have burdened the banks with a certain kind of finance, which should not have been passed on to the banks, which is sometimes hidden by focusing on some fraud here and there.

CP Chandrashekhar, Professor at the Center for Economic Studies and Planning, JNU; Ajit Ranade is the Chief Economist of Aditya Birla Group