Bad Bank Lessons From China

Context: Government must clearly define mandate and tenure while facilitating market-based mechanisms for resolving stressed loans.

Multitudes of bad banks in India

• In India, 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).

Background: While India is getting ready to operationalise its National Asset Reconstruction Company Ltd. (NARCL), China is struggling with one of its biggest bad banks, the China Huarong Asset Management Co. Ltd.

The Chinese experience holds four important lessons for India:

1. Finite tenure: 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 US had set up a bad bank in 1989— the Resolution Trust Corporation. It had a sunset clause of December 1996.
2. 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.
   • Allowing a bad bank to exist in perpetuity risks a potential mission creep, which might, in the long run, threaten financial stability itself.
3. Reducing bank holdings:
   • The RBI Bulletin (2021) notes that sources of funds of ARCs have largely been bank-centric; thus, Indian banks remain exposed to these bad loans even after they are transferred to asset reconstruction companies (ARCs).
   • To address this problem, RBI has tightened bank provisioning while liberalising foreign portfolio investment norms- RBI’s initiative had helped reduce bank holding in SRs from 80.5% in March 2018 to 66.7% in March 2020.
4. Reducing multitude of bad banks: The resolution of bad loans should happen through a market mechanism and not through a multitude of bad banks.
   • Setting up of NARCL as a centralised bad bank, the regulatory arbitrage between ARCs and Alternative Investment Funds (AIFs) must end.
   • While AIFs should be allowed to purchase bad loans directly from banks and enjoy enforcement rights under the SARFAESI Act, ARCs should be allowed to purchase stressed assets from mutual funds, insurance companies, bond investors and ECB lenders.

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.