Chief Economic Advisor Krishnamurthy Subramanian said recently that unless issues regarding banks taking substantial haircuts on sale of toxic assets were resolved, a bad bank would be of little help in addressing the problems of non-performing assets in the financial system.
- There are 28 asset reconstruction companies that are functional. And their job is to take bad loans from banks and act as bad banks. But one key part that needs to be kept in mind is when a bank sells bad loans, it has to take a haircut (i.e. a loss of share).
- When it takes a haircut, it impacts its balance sheet. And that is one of the key aspects affecting the sale of loans. So, till that is not addressed, creating a new structure may not be as potent in addressing the problem.
What is a ‘bad bank’?
- A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution. The entity holding significant nonperforming assets will sell these holdings to the bad bank at market price.
- When a bank is sitting on mountainous non-performing loans (NPLs), provisions eat into its capital base, slow recoveries hamper its lending and the resulting losses erode depositor confidence — the lifeblood of any bank.
- When the problem becomes pervasive and too big for individual banks to handle, governments often propose the setting up of a bad bank to buy out all toxic loans from banks.
- This helps banks get on with business as usual, while the bad bank grapples with recovering the loans or realising cash from selling the underlying assets.
- India has toyed repeatedly with the idea of a bad bank to resolve its bad loan mess.
- In 2017, the Economic Survey suggested Public Sector Asset Rehabilitation Agency or PARA, to buy out the largest NPLs from Indian banks.
- Recently, in proposing Project Sashakt, a five-point plan to revive Indian banks, the Sunil Mehta panel suggested that a new Asset Management Company (AMC) be set up to tackle mammoth bad loans of over ₹500 crore.
- The AMC will in turn set up alternative investment funds that will buy up stressed assets in different sectors, from asset reconstruction companies, then try to auction them off to raise cash. However, the global experience with such methods suggest that they often don’t deliver results.
- International experience –
- In 1999, China set up four state-controlled AMCs — Cinda, Huarong, Great Wall and Orient — to mop up bad loans from the country’s ailing banks.
- In 2012, after teetering on the brink of a payments crisis, Spain set up a bad bank — Sareb — to take over about €50 billion worth of property and loan assets from the country’s ailing banks, with the intention of turning the loans around.
- But while the bad banks of China and Spain have helped take doubtful assets off the banks’ hands, they themselves haven’t succeeded in fully restructuring these assets or making money off them.
- China’s AMCs have found restructuring not so lucrative, and have ventured into lending and investing in foreign bonds for profits. Spain’s Sareb has remained a loss-making entity from the word go.
What is the issue here?
- When banks offload their non-performing assets to a bad bank, they’ll have to take immediate haircuts on the value they realise from those assets. If they refuse to do so, they’d be stuck with the loans. Also remember that someone has to cough up the capital to fund the AMC. If that someone is domestic banks, we’re back to square one. Hence, the CEA wants the issue of ‘haircuts’ to be resolved first.