Designed to fight the ongoing ‘once in a century pandemic’, the Union Budget 2021-22 rests on six key pillars — health and well-being, physical, financial capital and infrastructure, inclusive development for aspirational India, reinvigorating human capital, innovation and R&D, and minimum government and maximum governance.
Among a slew of measures to turbocharge the growth momentum, formation of bad bank to strengthen the functioning of the financial sector is a differentiating timely policy measure with lasting value.
While expressing anguish on the bad loan woes, the Economic Survey 2020-21 pointed out that the boards of banks and auditors were ‘asleep at the wheel’ while banks accumulated high levels of toxic assets. Banks obviously resorted to ‘ever-greening’ of loans by postponing classification of assets as bad loans. Many banks might have restructured loans to circumvent prudential norms and holding them in books as standard loans even when stress was evident. It led to the current dire straits when the sudden Covid-induced stress exacerbated the asset quality woes to unsustainable levels.
Banks already grappling with bad loans suddenly found an inevitable spike in non-performing assets (NPAs) to a new high, when balancing the activities of recovery and fresh lending was difficult, more so when the external environment turned sour. The Financial Stability Report (FSR) of the RBI already alerted banks that NPAs may shoot to a level of 13.5% in baseline stress and to a high of 14.8% in severe stress. Public sector banks may end up having 17.6% of toxic assets by September 2021. Rising NPAs would shrink the capital adequacy ratio (CAR) to a low of 12.5% severely limiting their ability to expand fresh loan portfolio.
Banks are needed to maintain a minimum CAR of 10.875% till March 31, 2021, and 11.5% from April 1, 2021, as per the Basel Committee norms. Due to the rise in NPAs, it is feared that some weak PSU banks may breach the minimum mark of CAR, preventing them from lending further.
Looking to the impending rise in the NPAs and its huge collateral impact on the economy due to restricted lending capacity of banks, a quick strategy could be to form a separate entity to transfer the contaminated asset portfolio to enable banks to focus on fresh lending. In the meantime, the special purpose vehicle (SPV) proposed in the Budget as a dedicated Asset Reconstruction Company (ARC) can make efforts to recover the bad loans. The idea is not new. Such a proposal was mooted in 2017 but was not considered as the magnitude of the crisis at that time did not merit its formation.
It is a quick remedy to relieve banks from the burden of NPAs in one go. The asset size of banks will come down depending upon the volume of NPAs transferred to it. The CAR – the driving factor to push fresh credit — will rise due to reduction in asset size of banks. It will create additional space for them to start fresh lending to hasten recovery. Banks will also be relieved of the rigour of pursuing recovery of the huge stock of NPAs that can now be transferred to bad bank.
Banks can also work on preventing the accumulation of further NPAs by closely following and nursing the existing borrowers. Globally, setting up a bad bank is considered as a quick remedy. The Government of Malaysia had set up Danaharta Bank to tackle bad loan menace arising out of the global financial crisis. If a bad bank is used as a one-time remedy to ward off the NPA crisis, it can work well. It will open up many opportunities for banks to participate actively in recovering the economy.
The banking system has to operate on a sustained business model. It should be well equipped with requisite policies, processes, systemic controls, internal skills and methodology to manage deposits, lend and recover loans in the normal course of banking activity. The Survey aptly observed that the slackness on the part of the boards and auditors has led to build-up of huge toxic assets.
The proposed bad bank should not develop any sense of complacency among banks or the borrowing community to adversely impact the credit culture of the country. A sound, sustainable and well-regulated banking system is sine qua non for an aspiring India aiming for a $5-trillion economy. Hence, the ARC to take over bad loans should be designed as a one-time solution with a self-liquidating model that should not work beyond handling the pandemic-driven stress.
Taking a cue from the respite provided to banks, it will be necessary to look back into the reasons for the pile-up of bad loans even before the onset of the pandemic. Systemic corrections, business process reengineering of credit administration and more internal reforms, better risk governance and credit discipline may be needed to develop strong systems.
With the improvement in the rigour in implementing debt resolution tools, enhanced regulatory surveillance and robust insolvency and bankruptcy laws, the borrowing community needs to realise that repaying loans is essential to remain in business. A bad loan not only prevents banks from recycling funds but mars their risk appetite. It prevents growth prospects of the credit-starved future generation of entrepreneurs.
Banks and the borrowing community should use this new initiative as an opportunity to mend the credit culture in the long-term interest of growth. The free flow of growth adrenaline through the Budget can be hailed as a historic move to put India on a high growth trajectory. The bold initiative to set up bad bank should be able to nudge banks to shape well.
(The author is Adjunct Professor, Institute of Insurance and Risk Management [IIRM], Hyderabad. Views are personal)
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