The bad bank proposal is back on the discussion table once again, but experts believe the concept is past its sell-by date and is unlikely to yield desirable results. Several factors tell us why this could be an ill-timed move.
For one, segregation of impaired assets without sufficient recapitalisation has insignificant impact, but given the prevailing circumstances, neither government funding nor capital raising from the market looks promising.
Moreover, managerial incentives across banks are probably still not fully aligned to maximizing value through early recognition of bad loans, and given the high contribution of retail deposits, the funding stability of banks is uncorrelated with their financial performance. Lastly, corporate deleveraging has been quite slow and so is credit demand from better-rated, large wholesale borrowers.
“A bad bank would have been fruitful 3-4 years back, perhaps just after AQR, or earlier when stress was just building up and banks were looking to delay recognition for various reasons. Today, the banking system is relatively solid with slippages declining in the corporate sector and high NPA coverage ratios, which enable faster resolution. Setting up a bad bank today would aggregate, but not serve the purpose that we have observed in other markets,” analysts at Kotak Institutional Equities noted in a recent report.
Following the Asian crisis, several countries had set up state-sponsored AMCs—including Indonesia, Malaysia, Korea, Spain, and Turkey. Some, like Indonesia, have even given them sweeping powers such as the right to transfer assets without borrowers’ permission and seize debtor’s assets through special administrative processes. One of the early movers is the US, with funding and budgetary support, and the country now commands a recovery rate of 87%.
Korea’s AMC has a recovery rate of 48%, while Malaysia has 58%. But India’s tryst with a bad bank, if it materializes, comes not during a period of elevated slippages but when slippages are near to normal and where the provision coverage ratio has improved to 70% from 40% in the past 3-4 years, according to Kotak.
A successful bad bank, as noted by the Bank of International Settlements and the IMF, needs a critical mass of impaired assets, a robust legal framework for debt resolution, a clear exit strategy and timing of formation, and pricing of assets.
Finally, as analysts at Kotak point out, there are instances of bad banks not achieving the desired objectives, which should also be given due attention.