Let a Bad Bank lighten our Sisyphean load of Bad Loans

Context: Just as Public Sector Bank’s health was recovering, with capital infusions, slowing slippages and higher provision coverage ratios, COVID has threatened to roll them back into the dead.

Issues with the Public Sector Banks (PSB’s):

• Impact of COVID: Rise in stressed assets and deteriorating asset quality of banks.
• Long resolution of stressed assets: The Insolvency and Bankruptcy Code (IBC) process takes an average of 340 days for resolution, which amplifies the second-order effects of stressed assets.
• This restricts bank capital and managerial bandwidth turning the bank risk-averse.

Purpose of a Bad Bank:

• Swift Unburdening: It is a mechanism that allows PSBs to offload stressed assets in an equitable manner so that they can hit the reset button and focus on credit creation.
• Bargaining power: It will enjoy scale efficiencies, even as coordination frictions are minimized, and decision-making gets both centralized and faster.
• Recovery potential: They can add significantly to the quality of resolution and the quantity of recovery.

Challenges with Bad Banks:

• May lead to capital write-downs in some banks: leading to recapitalization by the government after funding the purchase of stressed assets from the banks.

• The pricing of distressed loans is relatively opaque, and their trading illiquid.

• Undervaluation of distressed loans: Due to uncertainty overvaluations and the public-sector nature of banks, bank managers suffer from perverse incentives. 
• This leads to risk-averse by banks making the banks reluctant to sell these loans

Way Ahead: Designing the Bad Bank

• Funded by private capital and managed by specialists: who focus on maximizing recovery, unconstrained by political concerns, legacy relationships with promoters, and prospects of post-retirement opportunities. (which clouds the judgement of PSBs)
• The government can provide seed equity capital and mobilize private capital for the bulk of the funding, while also providing partial credit guarantees and/or low-cost currency hedging options.
• Minimizing risk, maximizing incentives: By issuing tradable participation rights, which confer upon selling banks the right to participate in recoveries over and above the price at which they sell loans.

Conclusion: A well-capitalized, professionally-managed and time-bound bad bank could alleviate asset quality-related risk aversion among Indian PSBs.