The creation of a ‘bad bank’ could accelerate the resolution of stressed assets in India’s banking sector, said Fitch Ratings. However, the move may face significant logistical difficulties and would simultaneously require a credible bank recapitalisation programme to address the capital shortfalls at State-owned banks, it added

While it has estimated that the banking sector will require around $90 billion in new total capital by FY19 to meet Basel III standards and ongoing business needs, Fitch said this estimate is unlikely to be significantly reduced by the adoption of a bad-bank approach.

More capital needed The agency believes that the government will eventually be required to provide more than the $10.4 billion that it has earmarked for capital injections by financial year ending 2019 — be it directly to State-owned banks or indirectly through a bad bank.

India’s banks have significant asset-quality problems that are putting pressure on profitability and capital, as well as constraining their ability to lend.

Fitch expects the stressed asset ratio to rise over the coming year from the 12.3 per cent recorded at end-September 2016. The ratio is significantly higher among State-owned banks.

“Asset-quality indicators may be close to their weakest levels, but the pace of recovery is likely to be held back by slow resolution of bad loans,” said the global credit rating agency.

Govt too in favour A bad bank that purchases stressed assets and takes them to resolution was featured in the government’s latest Economic Survey, and in a speech on Monday by a senior Reserve Bank of India official.

RBI Deputy Governor Viral Acharya said: “It would be better to limit the objective of these asset management companies to orderly resolution of stressed assets with graceful exit thereafter; in other words, no mission creep over time to do anything else such as raise deposits, start a new lending portfolio, or help deliver social programs.”

Fitch said the most likely form of a bad bank would be that of a centralised asset-restructuring company (ARC).

The agency elaborated that “its proponents believe it could take charge of the largest, most complex cases, make politically tough decisions to reduce debt, and allow banks to refocus on their normal lending activities.”

Has worked abroad Similar mechanisms have previously been used to help clean up banking systems in the US, Sweden, and countries affected by the Asian financial crisis in the late 1990s.

Senior European policy-makers have recently discussed the prospect of a bad bank to deal with non-performing loans (NPLs) in the EU.

Fitch believes that a bad bank might provide a way around some of the problems that have led Indian banks to favour refinancing over resolving stressed loans.

“For example, large corporates often have debt spread across a number of banks, making resolution difficult to coordinate. The process would be simplified if the debt of a single entity were transferred to one bad bank. This could be particularly important in India’s current situation, with just 50 corporates accounting for around 30 per cent of banks’ stressed assets,” it explained.

The agency observed that several small private ARCs already operate in India but they have bought up only a very small proportion of bad loans in the last two years, as banks have been reluctant to offer haircuts on bad loans even where they are clearly worth much less than their book value.

This is, in part, because haircuts invite the attention of anti-corruption agencies, making bank officials reluctant to sign off on them. Reduced valuations also increase pressure on capital.

Fitch felt that a larger-scale bad bank with government backing might have more success. However, it is unlikely to function effectively without a well-designed mechanism for pricing bad loans, particularly if the intention is for the bad bank to be run along commercial lines and involve private investors.

One estimate from the Economic Survey suggests that 57 per cent of the top 100 stressed debtors would need debt reductions of 75 per cent to make them viable. Fitch underscored that banks would need capital to cover haircuts taken during the sale of stressed assets, and the bad bank would most likely require capital to cover any losses incurred during the resolution process.

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