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Bad bank will help clean up balance sheets, but credit culture must change for healthier financial system

The creation of a bad bank does not in any way address the underlying cause of the bad loan problem in India — the credit culture that exists at public sector banks.

By: Editorial |
Updated: September 18, 2021 9:18:50 am
Under this framework, Rs 90,000 crore of loans, which banks have fully provided for, will be transferred in the first phase.

On Thursday, Finance Minister Nirmala Sitharaman announced that the government had approved extending a guarantee of Rs 30,600 crore to the National Asset Reconstruction Company Ltd (NARCL) — colloquially referred to as the bad bank — to help clear stressed loans worth Rs 2 lakh crore from the balance sheets of banks. As the buyer of these bad loans, NARCL, through its operational entity, India Debt Resolution Company, will be tasked with the resolution of these assets. This may perhaps lead to better outcomes as consolidating loans from multiple banks into a single entity may lead to a more effective, and timely resolution process.

Under this framework, Rs 90,000 crore of loans, which banks have fully provided for, will be transferred in the first phase. NARCL will purchase these loans in an 15:85 format — 15 per cent of the value will be paid in cash, while security receipts will be issued for the balance amount. The upfront cash payment will aid cash flows of banks. But the process of price discovery — the price at which NARCL buys these loans from the banks — might prove to be challenging even though the transaction involves the public sector as both buyer and seller. Banks though will have the freedom to sell the security receipts. From the perspective of investors, to the extent that the receipts are guaranteed by the government, their downside is protected. But to what extent a secondary market for such securities evolves is debatable. On its part, the government is pushing for a time-bound resolution of the assets by giving a five-year period for the invocation of the guarantee. But considering that these loans have been written down by banks, it is difficult to gauge what this will yield. The absence of buyers as reflected in the IBC process, the extent to which financial creditors have had to take haircuts on their admitted claims, all raise questions over the market appetite on both sides of the transaction. To be effective, the resolution process will need to be managed in a timely manner by capable personnel as delays will only lead to value destruction. Resolution is after all preferable to liquidation. From the government’s perspective, the security receipts guaranteed by it are a contingent liability. If the proceeds from resolution of these bad loans exceed the guaranteed amount, then there will be no outflow from its side.

The creation of a bad bank could help clean up bank balance sheets — though in the absence of a successful resolution it may end up being a repository for bad loans. But it does not in any way address the underlying cause of the bad loan problem in India — the credit culture that exists at public sector banks. Only by reforming the banking system in India, especially the public sector banks, can the financial system be made more efficient.

This editorial first appeared in the print edition on September 18, 2021 under the title ‘Debt weight’.

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