Last month, the Union governmentset up the National Asset Recon-struction Company Limited(NARCL) under the Companies Act.It thus delivered on its promise to setup a ‘bad bank’ to clean up the ba-lance sheets of commercial banks.Under the new set up, the NARCLwill take over loans worth almost ₹�2lakh crore from the books of com-mercial banks at a mutually agreedprice. The NARCL will pay 15% ofthe price of these loans upfront incash to banks and then issue secur-ity receipts in lieu of the remainingamount. The NARCL will then try toresolve these bad loans in a time-bound manner with help from theIndia Debt Resolution Company Li-mited (IDRCL). In case the IDRCL isunable to sell these bad loans at asatisfactory price to make good onthe security receipts, the Centre willstep in and fund the gap, but withina budget limit of ₹�30,600 crore. In aconversation moderated by Prash-anth Perumal J., Ajit Ranade andC.P. Chandrasekhar discusss thebad bank proposal. Edited excerpts:

What is the need to bail outbanks? Why not let banksrecognise their losses and letinsolvent banks fail?

Ajit Ranade: First of all, this is aone-time, time-bound eff�ort. Thebad bank has been set up to removebad assets from the balance sheetsof banks and free up capital whichwill allow bank lending to grow. Cre-dit growth is important for econom-ic growth, and bank balance sheetsare constrained by the presence ofbad assets. So, one of the main ob-jectives of the bad bank is to removethese assets from the balance sheetsof existing banks and consolidatethem within a bad bank. Mean-while, the resolution and recoveryprocess can continue. The pro-posed design of the bad bank sepa-rates the trustee part of the NARCL,where the assets will sit, from thethe IDRCL, which will engage in therecovery and turnaround of bad as-sets. So, it’s a twin structure work-ing to free existing banking capitalto enable higher credit growth.

C.P. Chandrasekhar: There aremany reasons to bail out banks but

two in particular are crucial. One isthe fact that there are depositors in-volved here. If you allow banks tofail, depositors who operated underthe presumption that the regulatoryframework would protect their mo-ney would be undermined. Histori-cally, we’ve found that centralbanks try to actually save banks,either by bailing them out or byamalgamating them with strongerbanks, in order to be able to protectdepositors. Two, there is a systemicproblem. If a bank fails, and there isa sort of contagion eff�ect, you couldactually have systemic problems.Banks are the core of the settle-ments system and the credit pipeand allowing them to go downwould be a problem. And fi�nally,there is also the option of gettingbanks to write off� these bad assetsand then the government can recap-italise them. But that would deal asignifi�cant blow to the government’sfi�nances.

Isn’t there the risk of moralhazard linked with bailouts,which makes banks morecomplacent?

CPC: You need to compare the riskto the system itself — the impact thatbank failures would have on depos-itors and the social and political im-plications of it — with the moral ha-zard of bailing out banks. The moreimportant problem is the systemicrisk. But second, here we have a sys-tem in which banks are predomi-nantly publicly owned. So, the pro-blem is, in some sense, the result ofthe state allowing the use of banksfor certain purposes.

Why do you think thegovernment has opted for a badbank over directly infusingcapital into banks?

AR: These so-called bad loans havebeen completely 100% provisioned.However, the manpower of thesebanks is still spent on recovery andsupervision. Now, it’s importantthat these loans be moved to a sepa-rate entity which is exclusively fo-cused on recovery, so that the bankcan then focus on its core business,which is business development, giv-ing new loans, credit growth, etc.

And it is not an exclusive ‘either...or’ for banks. For their growth,banks will need to be infused withadditional capital to achieve the cre-dit growth needed to get to 7-8%GDP growth. So, the governmentwill continue to pour more capitalinto banks, while bad loans will bemoved to a separate entity.

CPC: I think we have to see this inthe context of accumulated baddebt of banks being addressed overa period of time through variousmechanisms. First, we had the LokAdalats, then the debt recovery tri-bunal, and then the SARFAESI (Se-curitisation and Reconstruction ofFinancial Assets and Enforcementof Security Interest) Act, which issupposed to give creditors muchmore power to be able to recoverdebt. Then we had the IBC (Insol-vency and Bankruptcy Code). Theunderstanding till recently was thatthe IBC would allow quick resolu-tion, and the haircut that the bankswould have to take would be rela-tively small. If you have a govern-ment that is committed to a conser-vative fi�scal stance, then to think ofgoing through a process in whichthese large amounts of accumulateddebt will be cleared, which is essen-tially a process of partial write-off�and recapitalisation, cannot be sus-tained if the haircuts are large.When IBC started, it appeared as ifyou’re going to get a pretty high rateof recovery. As we moved along, therate of recovery began to declinequite sharply. So, the point is, byadopting a bad bank mechanism,the government seems to think itwill be in a position to paper overthis contradiction — the need to re-solve the bad loan problem and itsunwillingness to allocate signifi�cantamounts from its Budget.

What is the need for a publicbad bank when India alreadyhas a number of private assetreconstruction companies(ARCs)?

AR: What the NARCL is doing is pro-viding an asset resolution platform,which is for the banks and by thebanks. There have been some 28-odd private ARCs, which have per-haps not performed. Under the badbank, asset acquisition and trustee-ship has been segregated from assetresolution. The primary purpose ofthe IDRCL is resolution through spe-cialists who can salvage some value.Even if they can recover only 25%,that’s more than what the currentrecord shows. The IDRCL will ac-tually have incentive to resolvedebts effi�ciently because of the pro-fi�t-sharing arrangement. So, the in-centives are aligned.

CPC: The government has said thatof the ₹�2 lakh crore, it will be in aposition to cover only as much as₹�30,600 crore. So, you’re going tobe in a situation where the banksare still going to carry the burdenand take a hit to their profi�tability.On the other hand, if you look atthose who defaulted, a large num-ber of them being big corporates,they are going to walk away withtheir debts resolved at steep dis-counts. Banks might be left withperhaps not new losses, but withlosses nevertheless, which have al-ready been provided for, whereas

those who defaulted would be let off�in terms of their assets not beingseized in signifi�cant measure.

AR: These are two diff�erent things.One is to go after the defaulters andthe other is to recover the asset andsalvage value from it. Corporatesare not going to go scot-free. If thereis an established criminal negli-gence or criminal activity, there is aseparate process for that. Moreover,the bad bank is focusing the ener-gies of banking personnel. The badbank is not to be seen as a recurringthing wherein balances will keepmoving from the existing bankingbalance sheets into this structure. Ifthat happens, you are inviting thetendency of what we call moral ha-zard, as then there is no eff�ort fromthe bank per se to try and recover.

Do you think the bad bank,which is essentially owned bythe troubled banks themselves,will have a diff�erent incentivestructure to effi�ciently resolveloans?

AR: The staffi�ng, the pay scale, etc.in the IDRCL will be diff�erent. Forexample, when the State Bank of In-dia (SBI) runs an asset managementcompany, the AMC employees arenot on the same pay scale as the SBI.So, we have to recognise that the in-centives, pay structure, staffi�ng, ta-lent, and ultimately governance...that’s what’s going to matter.

CPC: There is a lack of clarity aboutcertain things. One is the discountwhich is going to be negotiated bet-ween the NARCL and the banks.Once the bad debt is moved on tothe books of NARCL, it will be hand-ed over to the IDRCL. Now, as in thecase of private ARCs in the past,both these entities would also becharging a managerial fee. So,they’re going to cover a large part oftheir costs through the managerialfee charged to manage and disposeof these assets. What is going to bethe incentive to try and get the max-imum price possible from these badloans is not really clear.

AR: The diff�erence is that in thecase of the existing ARCs, there is noguarantee for the value that will berecovered from the security receipt.So, typically, the average purchaseprice of bad loans by existing ARCsis something like 36%, but there is

no backing for the security receipts;these receipts may end up being ofzero value. The actual recoverycould be just one-fourth of the 36%,which is 9%. In the new structure,the average purchase price will belower, but the security receipts forthe remainder of the value will becovered by the government up to₹�30,600 crore. That in itself chang-es the incentives.

Does the bad bank proposalactually address the root causesof the banking crisis or is thisjust a temporary band aid?

AR: The fact is that over the last fewyears, the NPA ratio has beenmounting and we’ve tried manythings. We now need to bring theproblem to manageable propor-tions. In that sense, the bad bank istaking a small chunk out of the over-all NPAs. But NPAs will continue togrow. Bad loans are a function of bu-siness cycles — during down cycles,the bad loan ratio increases, but inup cycles, the bad loan ratio comesdown. The idea is to keep it withinmanageable proportions.

CPC: There is a structural issue in-volved here. As opposed to the1980s and 1990s, an overwhelmingshare of defaulted debt in this roundhas been corporate debt. Why didthis come about? Earlier, fi�nancingcapital-intensive projects was seenas something which had to happenthrough the government’s budget orthrough development fi�nance insti-tutions specialised in developmentfi�nance. There was also the idea thatyou could fi�nance these invest-ments through long-term capitalavailable through an active bondmarket, which India does not haveto a signifi�cant extent. The govern-ment decided that it cannot mobil-ise the resources to fi�nance invest-ments and decided to get fi�nancialinstitutions to set up commercialbanks. Therefore, the burden of fi�-nancing these investments wastransferred by the state to the publicbanks. And banks are not supposedto do too much of this because thereare signifi�cant liquidity and maturi-ty mismatches. So, we got this pro-blem because we have put the bur-den of fi�nance of a certain kind onbanks, which should not have beenput on banks, which sometimes getsconcealed by focusing on somefrauds here and there.

Will a bad bank fi�x India’s broken banking system? A bad bank can help in debt recovery but it is nosubstitute to fresh capital infusion

C.P.Chandrasekharis Professor at theCentre forEconomic Studiesand Planning, JNU

Ajit Ranade is chief economistat the Aditya BirlaGroup

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PTI

<> The government willcontinue to pour morecapital into banks whilebad loans will be moved toa separate entity.

Ajit Ranade

PARLEY