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 tranche is fully provisioned for. In the remaining three tranches, we assume that provisions progressively decline to 90, 80, and 70 per cent (the average provision coverage ratio in September 2020 was close to 80 per cent). The recovery rate is pegged at a minimal 20 per cent. Standard rules of such recovery are 15 per cent in cash and 85 per cent in sovereign guaranteed security receipts.
Now, the benefits of this process includes the recovered value, and significant lending leverage because of three factors: One, capital being freed up from less than fully provisioned bad assets; two, capital freed up from security receipts because of a sovereign guarantee, and three, cash receipts that come back to the banks and can be leveraged for lending, also freeing up provisions from the balance sheet. Clearly, the benefits are manifold.
Thus, based on certain assumptions, and incorporating the benefits mentioned above, the cumulative benefits stemming from the transfer of Rs 400 to the bad bank work out to around Rs 526 (a multiplier of around 1.3). One can now visualise the apparent benefit of the asset transfer to the bad bank — the estimates of which are at least Rs 2.2 lakh crore as quoted in the public domain and could go up even further. This analysis is assuming a bare recovery rate of 20 per cent and if that improves then the benefits will only increase.
There are several international success stories of a bad bank accomplishing its mission and there is no reason to believe why India cannot accomplish its objective. The current Indian approach will drive consolidation of stressed assets under the AMC for better and faster decision making. This will free up management bandwidth of banks enabling them to focus on credit growth, leading to an enhancement in their valuations. Given that the governance of the AMC and its independence is central to its successful functioning, there are multiple suggestions to make. These include keeping majority ownership in the private sector, putting together a strong and independent board, a professional team, and linking AMC compensation to returns delivered to investors.
Let me end by playing the devil’s advocate in the longstanding debate over the apparent disconnect between the financial market and the real economy. Markets are after all always useful in understanding the future discounted stream of corporate cash flows better than anyone. From that perspective, has the market already factored in a large upside to the creation of a bad bank? Possibly yes, if the recent GDP upgrades are an indication, though notwithstanding the second wave of infections.
This column first appeared in the print edition on March 23, 2021 under the title ‘Bankable idea’. The writer is group chief economic adviser, State Bank of India. Views are personal
RBI Governor Shaktikanta Das. (File) 
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