Bad bank, good move | The Indian Express

If we remember correctly, Indian banks were written off in the early days of the pandemic when there were expectations of an exponential jump in non-performing assets. This worry continued well into the third quarter of the year. It was, however, only after the banks, in their forward guidance, consistently talked about the lower number of restructuring requests, and the higher provision coverage ratios that the markets began to get convinced. What finally turned the corner were the budget announcements related to the financial sector.

So why this positive surprise for the banking system? There are several reasons for this. First, banks in India and globally were much better capitalised prior to the pandemic. Second, Indian banks had built up a sizeable buffer to provide for bad assets negating any surprise on balance sheets during and even after the pandemic. Third, independent research shows that as the size of the middle class grows to about two-thirds of Asian households, on the back of a steady rise in disposable income, personal financial assets in Asia will reach about $69 trillion by 2025 — approximately three-quarters of the global total. This trend will be the main driver of demand for financial services in Asia, specifically in India. Banks in Asia, including in India, have begun to adjust for this steady growth in the size of pie by experimenting with new business models, rationalising costs and providing faster and superior customer digital experience, as was clear during pandemic.

Fourth, Indian banks and the RBI brought about financial discipline much before the pandemic to make borrowers realise that timely payments of interest and instalments were necessary and that any breach would affect their ratings and the pricing of loans. For example, units with high leverage were advised to reduce their debt levels in a time-bound manner. All these factors thus corroborate the view that the current exuberance in the Indian financial sector is no flash in the pan. This was also helped by exceptionally prudent monetary management by the RBI and the recent budget announcements. Let us now come to that.

The most important budget announcement is in line with global practices — the creation of a bad bank under an Asset Reconstruction Company (ARC)-Asset Management Company (AMC) structure, wherein the ARC will aggregate the debt, while the AMC will act as a resolution manager. The proposed structure envisages setting up of a National Asset Reconstruction Company (NARC) to acquire stressed assets in an aggregated manner from lenders, which will be resolved by the National Asset Management Company (NAMC). A skilled and professional set-up dedicated for Stressed Asset Resolution will be ably supported by attracting institutional funding in stressed assets through strategic investors, AIFs, special situation funds, stressed asset funds, etc for participation in the resolution process. The net effect of this approach would be to build an open architecture and a vibrant market for stressed assets.

Interestingly, till date, there have been no quantifiable estimates in the public domain of the supposed benefits of setting up such a structure. As we understand currently from several news reports, banks may first transfer those assets to the proposed bad bank with a 100 per cent provision on its book and then based on the experience they will decide on transferring assets with less than 100 per cent provisioning at a later date. It is also being speculated that of the total amounts recovered, a specified percentage say 85 per cent will be in the form of security receipts that will reside in the bank balance sheets, but will carry a zero-risk weight, with full government guarantees for a specified period of time.

Let us now put some numbers to understand these assumptions. For the sake of simplicity, assume Rs 400 of bad assets are transferred to the bad bank of which Rs 100 undertaken in the first…