Lessons from China on bad banks

GS 3 – Inclusive Growth and issues arising from it.

Source : The Indian Express dated 25/06/2021 https://indianexpress.com/article/opinion/columns/india-bad-bank-national-asset-reconstruction-company-china-7374608/

Context

Finance Minister in her Budget speech revived the idea of a ‘bad bank’ by stating that the Centre proposes to set up an asset reconstruction company to acquire bad loans from banks.
As India gets ready to operationalise a new bad bank, the National Asset Reconstruction Company Ltd. (NARCL), China is struggling with one of its biggest bad banks, the China Huarong Asset Management Co. Ltd. (Huarong). 

What is a bad bank?
  • A bad bank is a financial entity set up to buy non-performing assets (NPAs), or bad loans, from banks.
  • The aim of setting up a bad bank is to help ease the burden on banks by taking bad loans off their balance sheets and get them to lend again to customers without constraints.
  • After the purchase of a bad loan from a bank, the bad bank may later try to restructure and sell the NPA to investors who might be interested in purchasing it.
  • A bad bank makes a profit in its operations if it manages to sell the loan at a price higher than what it paid to acquire the loan from a commercial bank.
  • However, generating profits is usually not the primary purpose of a bad bank the objective is to ease the burden on banks, holding a large pile of stressed assets, and to get them to lend more actively.
What is NARCL?

Setting up of NARCL, the proposed bad bank for taking over stressed assets of lenders, was announced in the Budget for 2021-22.

The plan is to create a bad bank to house bad loans of Rs.500 crore and above, in a structure that will contain an asset reconstruction company (ARC) and an asset management company (AMC) to manage and recover dud assets.

The new entity is being created in collaboration with both public and private sector banks.

How is NARCL different from existing ARCs? How can it operate differently?

  1. The proposed bad bank will have a public sector character since the idea is mooted by the government and majority ownership is likely to rest with state-owned banks.
  2. At present, ARCs typically seek a steep discount on loans. With the proposed bad bank being set up, the valuation issue is unlikely to come up since this is a government initiative.
  3. The government-backed ARC will have deep pockets to buy out big accounts and thus free up banks from carrying these accounts on their books.
NPA picture in India
  • According to the latest figures released by the RBI, the total size of bad loans in the balance sheets of Indian banks at a gross level was just around 9 lakh crore as of March 31, 2020, down significantly from over 10 lakh crore two years ago.
  • While the size of total bad loans held by banks has decreased over the last few years, analysts point out that it is mostly the result of larger write-offs rather than due to improved recovery of bad loans or a slowdown in the accumulation of fresh bad loans.
  • The size of bad loan write-offs by banks has steadily increased since the RBI launched its asset quality review procedure in 2015, from around 70,000 crore in 2015-16 to nearly 2.4 lakh crore in 2019-20, while the size of fresh bad loans accumulated by banks increased last year to over ₹2 lakh crore from about ₹1.3 lakh crore in the previous year.
  • So, the Indian banking sector’s woes seem to be far from over.
  • Further, due to the lockdown imposed last year, the proportion of banks’ gross non-performing assets is expected to rise sharply from 7.5% of gross advances in September 2020 to at least 13.5% of gross advances in September 2021.
Pros of a bad bank
  • It can help consolidate all bad loans of banks under a single exclusive entity.
  • By taking bad loans off the books of troubled banks, a bad bank can help free capital of over 5 lakh crore that is locked in by banks as provisions against these bad loans.
  • It will give banks the freedom to use the freed-up capital to extend more loans to their customers.
  • Cash receipts that come back to the banks and can be leveraged for lending, also freeing up provisions from the balance sheet.
  • Global examples – The idea of a bad bank has been tried out in countries such as the United States, Germany, Japan and others in the past
    • The Troubled Asset Relief Program, also known as TARP, implemented by the U.S. Treasury in the aftermath of the 2008 financial crisis, was modelled around the idea of a bad bank.
    • Under the program, the U.S. Treasury bought troubled assets, such as mortgage-backed securities, from U.S. banks at the peak of the crisis, and later resold them when market conditions improved.
Challenges
  • Former RBI governor Raghuram Rajan has been one of the critics, arguing that a bad bank backed by the government will merely shift bad assets from the hands of public sector banks, which are owned by the government, to the hands of a bad bank, which is again owned by the government.
  • Key reason behind the bad loan crisis in public sector banks, some critics point out, is the nature of their ownership.
  • There is a huge risk of moral hazard. Commercial banks that are bailed out by a bad bank are likely to have little reason to mend their ways.
  • The Economic Survey of 2016-17 said the RBI had hoped ARCs would buy bad loans of commercial banks but that didn’t happen.
    • In FY15 and FY16, Asset Reconstruction Companies bought up just 5% of the total NPAs and found it “difficult to recover much from the debtors”.
Lessons from China
  • In the aftermath of the Asian financial crisis, China set up dedicated bad banks for each of its big four state-owned commercial banks.
  • These bad banks were meant to acquire non-performing loans (NPLs) from those banks and resolve them within 10 years.
  • In 2009, their tenure was extended indefinitely.
  • One of China’s biggest bad banks is the China Huarong Asset Management Co. Ltd. (Huarong).
  • The Chinese government is its principal shareholder.
  • Recently this bad bank stoked financial stability concerns when it skirted a potential bond default.
  • Recent research at the National University of Singapore and others highlights that Chinese bad banks effectively help conceal Non-Performing Loans.

Lessons for India

  1. Finite tenure
    • A centralised bad bank like NARCL should ideally have a finite tenure.
    • Such an institution is typically a swift response to an abrupt economic shock (like Covid) when orderly disposal of bad loans via securitisation or direct sales may not be possible.
    • The banks could transfer their crisis-induced NPLs to the bad bank and focus on expanding lending activity. The bad bank in turn can restructure and protect asset value.
    • Example – US– had set up a bad bank in 1989 — the Resolution Trust Corporation. It had a sunset clause of December 1996.
    • Sweden – established Securum in 1993 with an estimated lifespan of 10-15 years. In 1995, Securum’s board proposed that the company be wound up by mid-1997. The parliament finally dissolved Securum in 1997. At the time of its closure, Securum had disposed of 98 per cent of its assets.
  2. Narrow mandate
    • A bad bank must have a specific, narrow mandate with clearly defined goals.
    • Transferring NPLs to a bad bank is not a solution in itself.
    • There must be a clear resolution strategy.
    • Otherwise, allowing a bad bank to exist in perpetuity risks a potential mission creep, which might in the long run threaten financial stability itself.
  3. Diversify the sources of funds for ARC
    • Indian banks remain exposed to these bad loans even after they are transferred to asset reconstruction companies (ARCs).
    • The RBI Bulletin (2021) notes that sources of funds of ARCs have largely been bank-centric.
    • The same banks also continue to hold close to 70 per cent of the total security receipts (SRs).
    • To address this problem, RBI has tightened bank provisioning while liberalising foreign portfolio investment norms.
  4. The resolution of bad loans should happen through a market mechanism and not through a multitude of bad banks.
    • The Narasimham Committee (1998) had envisaged a single ARC as a bad bank. Yet, the SARFAESI Act, 2002 ended up creating multiple, privately owned ARCs.
    •  As a result, regulations have treated ARCs like bad banks, although functionally they are closer to stressed asset funds registered as AIF Category II (AIFs).
    •  With the setting up of NARCL as a centralised bad bank, the regulatory arbitrage between ARCs and AIFs must end.
    • ARCs should be allowed to purchase stressed assets from mutual funds, insurance companies, bond investors and ECB lenders.
    • ARC trusts should be allowed to infuse fresh equity in distressed companies, within IBC or outside of it.
Conclusion

The Chinese experience should nudge Indian policymakers to limit the mandate and tenure of NARCL, while facilitating market-based mechanisms for bad loan resolution in a steady state.

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