The Bad Bank is a Bad Idea

Setting up something like this ignores the basic issues that caused the bad loans in the first place

From time to time, the idea of the Bad Bank, which will house all the bad loans of public sector banks and deal with them, crops up. The idea is that an institution should be set up that takes over all the bad loans and focuses on finding a way to monetise them. Meanwhile, public sector banks currently saddled with loads of non-performing assets (NPAs) can now get a fresh start with a clean balance sheet. It will allow them to raise funds more easily. And it would also help the government move faster with its plan for merging the smaller banks to form a few, big banks. The biggest advantage would be that with clean balance sheets, the banks could see improvement valuations and higher stock prices – which could help the government if it decided to sell some of its shares.

This idea appeals to a lot of people who point to other countries that have done this successfully – Malaysia, in the aftermath of the Asian financial crisis or the US, which created the Troubled Asset Relief Programme (TARP) after the Lehman crisis in 2008.

The idea is gaining some traction because NPAs are expected to balloon once the post-pandemic bad loans are recognised. The Reserve Bank of India (RBI) has repeatedly cautioned about this and it has also talked about why setting up a Bad Bank might help in dealing with the problem.

Three things though, often get overlooked in these discussions. The first is whether the Bad Bank will actually be able to handle the NPAs any better than their current owners have managed. The problem is that a great many of the loans have turned into NPAs because the businesses which took them have stopped functioning, gone bankrupt or had fraudulent promoters to have siphoned off the money and run away from the country.

Bankrupt companies with decent physical assets do find do find buyers. But as the IBC process has shown, for every company that finds buyers there would be a dozen or more that go into liquidation. In the vast majority of the cases, the businesses have reached a stage where they cannot be revived – especially in the case of the small and medium companies. Their debt will not find buyers and the assumption that a dedicated Bad Bank can find solutions to make money from them is a tad optimistic, in my opinion. In the cases where frauds have taken place, the Enforcement Directorate or CBI are probably better suited to pursuing the promoters and getting them to cough up.

Why did a Bad Bank idea work in some other countries? One reason may be that they had better and deeper debt markets. The other could be that the underlying assets could possibly be in a better shape than most NPAs in India and were probably sold off quickly before the assets became useless.

The second reason why the Bad Bank is not a good idea is that just focusing on removing the NPAs of a PSB does nothing to make them better banks. There are primarily two reasons why there are so many NPAs currently. The first is that the risks were not properly assessed when they were being given. A great many cases of NPAs are because the bank kept giving loans to well connected promoters or simply big name businessmen without doing proper due diligence long after it was apparent to others that the business had turned sour. This happened in too many cases.

Unless banks – mostly PSBs but also a few others such as Yes Bank – follow risk management systems better and their officers know when to put pressure to get the loan back, nothing much will change. Five years down the line, you will end up with the same problem and look at the same solution. Unless the bank management structures are revamped, the problem of bad loans piling up is not going to be solved.

The third issue has to do with the government itself. Governments have priorities and they encourage loan melas. While private banks manage to step away, public sector banks are forced to do what the government wants. Both former RBI governor Urjit Patel and deputy governor Viral Acharya have dealt with these in their respective books. This has been happening for decades and is unlikely to change unless the government of the day bites the bullet and stops interfering in the commercial lending of banks.

The government is also responsible for the overall business environment of the country, which determines whether the majority of the businesses are profitable or loss making. A good business environment because of good and stable policies and relatively free of interference is the best long term solution – along with better risk management at the bank level – for the NPA problem.

Sure, there will always be some NPAs. Some businesses will always fail. And some banks will always make bad loans. But these do not become insurmountable problems except in cases of external shocks. And these are manageable if the business environment in the country is good and the banks are well run and regulated.