How Stars Have Aligned To Make The Bad Bank A Reality Now – And Only Now

The announcement of a Rs 30,600 crore sovereign guarantee for the 'bad bank' — the National Asset Reconstruction Company Limited (NARCL) — for a five-year period is expected to take at least Rs 2 lakh crore of large non-performing assets (NPAs) of the banking system off their books. This will enable them to focus on lending again in order to revive the economy.

The bad bank is a good idea right now. The question to ask is not whether there aren’t better ways of dealing with the problem, but why we needed to adopt this particular route to move NPAs out of the books of public sector banks.

Here’s a one-line answer: the bad bank is a political need, not necessarily an economic one. There is nothing a bad bank can do that banks could not have done themselves, especially by taking their NPAs to the bankruptcy courts for resolution, as provided for in the Insolvency and Bankruptcy Code (IBC). They could also have taken haircuts and sold off their bad loans at a discount to existing asset reconstruction companies, transferred their bad loan books to stronger banks who were surer of recoveries than themselves, or written them off completely, if, in their board’s judgement, the asset was largely unrecoverable.

So, why did we need a bad bank to clean up the loans that went increasingly bad over the last decade? Why did banks allow their NPAs to balloon to six or seven times their original size as in 2014 before deciding to do something about them? Why, above all, did the Narendra Modi government take seven-and-a-half years to take up the bad bank idea when the problem was crystal clear in 2014 itself? The bad bank idea has been on the table for more than a decade now.

The answer lies in political calculations and the need for a proper alignment of stars to take the idea forward. A bad bank would not have worked as well in 2014 for the simple reason that it would have been politically flagged as a favour to big business, and there could have been extended witch-hunts of bankers who were bold enough to take a judgement call on a deteriorating portfolio of bad loans. These loans originated in the UPA (United Progressive Alliance) years, and got bloated beyond recognition due to delays in resolving them during the Modi years.

A Rs 100 crore bad loan in 2014 becomes a nearly Rs 200 crore bad loan by 2021 once interest and penalties are added and compounded over seven to eight years. Even a decade. Put simply, bad loans got worse because public sector bankers were afraid that dealing with the problem would have got them into trouble, and Modi government was worried that large write-offs could be politically damaging to it.

And why is now the right time for a bad bank, when this could have been done earlier? There are two reasons why it will work now.

First, most banks have, over the last few years, written off or provided for 70-80 per cent of their bad loans, and the government has recapitalised them to make sure they stay solvent. In short, the government has allowed good money to be poured into weak banks so that they can hold bad loans longer on their books till the time was opportune for their resolution. Now, it is clearly the right time for it.

Second, the Modi government realises that if economy is to recover from its twin-balance-sheet problems (where both banks and borrowers are stuck with largely unrepayable loans), banks need to lend again. Hence, bad loans need to move out of their books.

The sovereign guarantee of Rs 30,600 crore to the bad bank is intended to enable NARCL and the related Indian Debt Resolution Company to buy bad debts in return for paying 15 per cent cash to the seller bank, and 85 per cent in terms of conditional IOUs. If the resolution process recovers more than 15 per cent, banks will get some of the proceeds. So, banks which have already provided for 80-85 per cent of their bad loans can take the cash and clean up their balance-sheets. Banks which provided for less can still take the 15 per cent offered by the bad bank and provide for the amounts they have not provided for in the books this year or the next.

If, in an unlikely situation where zero is the net sum realised, the government guarantee will ensure that the 15 per cent paid upfront to banks for the transfer of bad loans to NARCL will be recovered from the government itself. The Rs 30,600 crore guarantee covers 15 per cent of Rs 2 lakh crore worth of bad loans.

Some years back, when banks had not started providing for their bad loans, it would have been impossible for them to transfer assets to a bad bank since even 15 per cent guarantee would simply not have been enough. Since 2014, a large part of the good assets has been recovered through the IBC process, and recapitalised banks have been steadily increasing provisions for their worst NPAs.

It is only now they are in a position to take 15 per cent cash and dump their NPAs without any likelihood of a witch-hunt being launched to call them to account. The bankers who made those bad loans are now into retirement, and so are most of those who started provisioning for them between 2016 and now. The current ones at the helm will be hailed as heroes for cleaning up their books.

The bad bank is a good idea right now because both banks and government are ready to bite the bullet. The costs of recapitalisation have been amortised over the last seven years, and banks can now take the hit needed without damaging their ability to lend again to revive the economy.

The ultimate truth: the taxpayer has paid for it all but does not know she has been robbed slowly.