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

On Thursday, Finance Minister Nirmala Sitharaman announced that the government had approved the extension of a guarantee of Rs 30,600 crore to the National Asset Reconstruction Company Ltd (NARCL) – colloquially known as the bad bank – to help eliminate Stressed loans worth 2 lakh crore of Rs. bank balance sheets. As the purchaser of these bad debts, NARCL, through its operating entity, India Debt Resolution Company, will be responsible for the resolution of these assets. Perhaps this can lead to better results, as consolidating loans from multiple banks into one entity can lead to a more efficient and faster resolution process.

In this context, Rs 90,000 crore of loans, which the banks have fully provisioned, will be transferred in the first phase. NARCL will purchase these loans in a 3:85 pm format – 15 percent of the value will be paid in cash, while collateral receipts will be issued for the balance amount. The upfront cash payment will ease the cash flow of the banks. But the process of price discovery – the price at which NARCL buys these loans from banks – could prove difficult even if the transaction involves the public sector as both buyer and seller. Banks will, however, be free to sell the collateral receipts. From an investor perspective, to the extent that revenues are guaranteed by the government, their decline is protected. But how far a secondary market for these securities evolves is debatable. For its part, the government is pushing for a time-limited resolution of assets by granting a five-year deadline for invoking the guarantee. But given that these loans have been written down by the banks, it is difficult to assess what it will earn. The absence of buyers as reflected in the IBC process, the extent to which financial creditors have had to reduce their admitted debts, all raise questions about market appetite on both sides of the transaction. To be effective, the resolution process will need to be managed in a timely manner by competent staff, as delays will only result in destruction of value. Resolution is, after all, preferable to liquidation. From the government’s point of view, the guarantee receipts it guarantees are a contingent liability. If the proceeds from the resolution of these bad debts exceed the guaranteed amount, there will be no outflow from it.

Creating a failed bank could help clean up bank balance sheets, although, in the absence of a successful resolution, it could end up serving as a repository for bad debts. But it does not in any way address the underlying cause of India’s bad debt problem – the credit culture that exists in public sector banks. Only by reforming the banking system in India, especially 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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