Responding to the distress in Indian banking

Economic Times, 30 June 2014

There is a balance sheet problem in Indian banking. Some are proposing an `asset management company' be setup to deal with the bad debt, so that banks can get on with life giving out fresh loans. This proposal panders to the worst behaviour in banks, borrowers and policy makers. There is a case for specialisation in processing bad loans -- by selling bad loans outright at market price to ARCs.

All over the world, banking is a highly leveraged business. Even though the assets of banks are opaque and illiquid, the leverage of banks exceeds the leverage in the Nifty futures. Small losses on the portfolio drive a bank into distress. In India, there are bad assets which have been recognised as such, there is bad news that has been postponed using CDR, and there is bad news that has been concealed. It is likely that the equity capital in place does not cover all these problems. In addition, there is a global push towards less leverage in banking; the Basle-III requirements imply a further increase in equity capital.

If RBI is technically sound, Indian banks will be forced to reduce the growth of their balance sheets, owing to inadequate equity capital. They will be forced to take in fewer deposits and give out fewer loans. This is going to exert a drag on economic growth: the price that we pay for mistakes in banking regulation and corporate law of the past. Some are enamoured of an easy solution: Setup a `National Asset Management Company' (NAMCO) with government money, and transfer bad assets out to NAMCO. Once the distressed assets are out of the way, banks will get back to happy days.

But there is no free lunch. When there is a bad asset, the bank has suffered a loss, and someone has to pay for it. The NAMCO proposal envisages the taxpayer paying for it. This may be concealed in some complicated financial engineering, but that's how it is.

Here is one example of how it could work. NAMCO will have Rs.20,000 crore of equity capital, and it will issue Rs.80,000 crore of government guaranteed bonds. Using Rs.100,000 crore, it will buy up bad assets at par. Banks will be delighted as a loan worth 25% on the public market generates proceeds of full 100%. Now the NAMCO is holding Rs.100,000 crore of bad debt. It spends a few years processing them and converts them into Rs.25,000 crore of cash. That leaves a hole of Rs.75,000 crore. This is paid up by the government because the bonds are guaranteed by the government.

There are two problems with this scenario. First, resources have alternative uses. Rs.100,000 crore of public money can retire Rs.100,000 crore of public debt, or it can build 10,000 kilometres of six-lane expressway. We must ask ourselves whether NAMCO is a good use of this money.

The second problem is moral hazard. We have a mess in Indian banking for four reasons: technical failures in regulation and supervision at RBI, public sector ownership, failure in bond market development, and the lack of a bankruptcy code. The best strategy is to solve these four problems. The danger of the NAMCO is that for two years, we will forget all about these problems. RBI will write bad regulations and supervise ineptly; banks will give out bad loans; we will ignore the bond market so investment will only be possible using bank loans; we will fail to draft and enact an Indian Bankruptcy Code.

We have seen this movie before: in the late 1990s. The then finance minister, Yashwant Sinha, was under a lot of pressure to setup a NAMCO then. The tough decision was taken, to not setup a NAMCO then, and that's the right path today. Once it was clear NAMCO was not going to be setup, there was a greater focus on solving deeper problems, and we got some institutional improvements such as SARFAESI.

There is no case for such a NAMCO, but there is a case for private ARCs who are experts on processing bad debt. ARCs are mere private equity funds. Banks must do a simple auction of bad assets, and the ARCs must pay cash only. That's a simple and clean arrangement, where the asset completely transfers out from the bank to the ARC, and the bank fully recognises the loss immediately. After that, the ARC would be a specialist which processes the bad loan.

There would be much value in having ARCs of this genre in the landscape today. While such policy thinking on ARCs dates back to the late 1990s, those early beginnings were contaminated by badly drafted RBI regulations. In effect, ARCs have become irrelevant in addressing the crisis of bad debt. This is a good time to address the mistakes of RBI regulations about ARCs.

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