Why the idea of a bad bank may not work for NPAs resolution

By Omkar Goswami

Deep inside a musty anteroom in the Ministry of Finance lie a couple of ancient Godrej cupboards. An old clerk, now retired, once wrote on a green foolscap sheet, ‘Unused Recommendations Given to the Hon’ble FM: 1’. And then, bored of writing the same thing yet again, wrote ‘URG to Hon’ble FM: 2’, cut the sheet in half, and pasted one on each on the two cupboards. When the finance minister, or his mandarins, are shorn of ideas, they sometimes order the cupboards to be opened to examine if anything in these ancient files can be resuscitated as a new initiative.

It is almost as if that happened early this June. Rightly fed up with the monumental and seemingly evergrowing size of bad loans (or nonperforming assets, NPAs), Piyush Goyal, the officiating finance minister, was seeking a fix for the problem. Soon enough, out came a file from one of the cupboards on asset reconstruction companies (ARCs). Voila! Here was a solution.

Of course, the first two paragraphs are mythical. The fact, however, is that on June 8, Goyal announced the setting up of a committee under Punjab National Bank non-executive chairman Sunil Mehta to give recommendations on formation of an ARC for faster resolution of stressed accounts.

I know Sunil Mehta quite well. We had together served on a board where we had to deal with a very tricky situation in 2004 and, while doing so, I appreciated his honesty and sheer professionalism. So, having researched on bad loans in some detail, here is my list of facts as well as ‘dos and don’ts’ for the committee.

First, we need to recognise that, across the world, almost all successful ARCs or bad banks dealt with sour housing loans. This was true of the Grant Street National Bank that took over Mellon Bank’s bad loans in 1988; the Resolution Trust Corporation of the US set up in 1989 to deal with the savings and loan crisis; the Arsenal and Sponda ARCs in Finland in the 1990s that took over bad mortgage-backed housing loans of two collapsed banks; the two ARCs that came into play in the Baltic States to deal with dud housing mortgages during 2008-09; and the UK Asset Resolution Company that took over the housing loans of Bradford & Bingley and Northern Rock in 2008.

A Complex Matrix

Second, bad housing loans are relatively easy to handle. Each loan is relatively small in value, the mortgages are simple and well-contained. The loans can be easily aggregated into different risk-weighted portfolios. And, with a sufficient discount on the purchase price, all one needs is an upturn in the business cycle to flog these back in the market — which invariably occurs within two-three years.

Third, in sharp contrast, our bad loans don’t deal with housing mortgages. These entirely consist of complexly collateralised corporate assets involving a consortium of lenders to finance large industrial or infrastructure projects. It is extremely difficult to resolve such bad assets through bankruptcy restructuring, liquidation or by shifting these to a bad bank. Separating the assets into saleable lots is fiendishly difficult.

Matters are worsened by shady promoters who show great alacrity in moving courts that are wont to grant stays. This is why bad loan resolutions have failed in Mexico, Brazil, Argentina, Greece, Turkey, South Korea, Thailand, Malaysia, Indonesia and India. In all these countries, the vast bulk were corporate defaults.

Fourth, there is the issue of pricing. Nobody, except under a diktat, will purchase a bad loan at an under-provisioned book value. The buyer will rightly demand a discount, which the seller will be reluctant to do, as it is another hit on his profit and loss account.

Thus, my fifth point: even if the seller was allowed to shift his NPAs at below book value to an ARC, how would the government’s regulators behave? Under Article 12 of the Constitution, public sector banks (PSBs) are a part of ‘the State’ and, therefore, subject to scrutiny of Parliament, the Central Vigilance Commission (CVC) and the Central Bureau of Investigation (CBI). Which executive chairman or managing director of a PSB at the evening of his working life will discount big-ticket bad loans, to risk the CVC or the CBI knocking on his doors shortly after retirement?

Sixth, if a resolution is sought by transferring NPAs to an ARC, how will the government ensure that the provisions of the Insolvency and Bankruptcy Code (IBC) do not come in the way of any future resolution?

A Private Affair

Finally, international experience shows that while governments have sometimes capitalised or conferred sovereign guarantees on ARCs, these bad banks have been always held and run by the private sector. You need a special set of persons to run bad banks — and these are not public sector bankers. Why should one expect those who took questionable term loan decisions to become masters of loan restructuring and quick downselling?

ARCs might work. But Sir Percy Blakeney, a.k.a. the Scarlett Pimpernel, would call it ‘a demmed hard business’. Sunil Mehta and his colleagues will do well to remember this.

(The writer is chairman, CERG Advisory)

This post was originally published here via Google News