Does India Need A Bad Bank To Clean Up The Bad Loan Mess?
An employee supervises dumping at the Municipal Corporation of Delhi’s landfill site on the outskirts of New Delhi, India (Photographer: Sanjit Das/Bloomberg News)  

Does India Need A Bad Bank To Clean Up The Bad Loan Mess?

The Narendra Modi government has named New York University Stern School of Business professor Viral Acharya as Reserve Bank of India deputy governor for a three-year term.

This is an unedited reproduction of an interview Acharya did with BloombergQuint in October 2016.

In 2015 Viral Acharya, CV Starr professor of economics at the NYU Stern School of Business, co-authored a research paper that analysed “the precarious condition of public sector banks” in India. The paper found that “the onus of remedying this situation through radical reform lies primarily with the Government.”

In conclusion the paper recommended a few fixes, mentioned here in brief:

  • Recapitalisation, maybe via deep-discount rights issues
  • Professionalise the process of board appointments
  • Wean them off their funding advantage from government guarantees
  • Privatise public sector banks or reallocate their assets

Since then the state of public sector banks has only worsened. A recent Credit Suisse report said impaired assets at banks are now at 12 percent, with non-performing loans accounting for 8.6 percent. Worse still, the research report house pointed out that, 43 percent of restructured loans have slipped into the bad loan category. Government owned banks (public sector or PSU banks) account for the bulk of bad loans.

Professor Acharya says a bad bank solution is what India needs to stop the bad loan wound from festering further.

I am absolutely proposing, either explicitly or implicitly, that we separate the unhealthy parts of the troubled banks from the healthy parts.

In an interview in New York with Menaka Doshi, Acharya discusses the current state of banking in India, among other things.

Your assessment of the Indian economy and whether it is on the path to recovery?

I would certainly say that we are on the path of recovery. And it particularly helped that we probably looked best in terms of growth prospects as well in the last two years of growth, not just in the emerging markets but also including the developed economies. Of course, we have a long way to go but I think gradually reform plans are coming into place.
I think the fact that we managed to get the GST bill passed is I think is a big positive to the world. More as a signal that the processes and bureaucracy are functioning rather than stalling all critical projects. I think the road and railway infrastructure is also gradually on the upswing. So, I would say by and large we are good shape.
What I am most worried about if anything is global headwinds to growth. I think Europe, in my opinion, is still teetering into not falling into recession. There are parts of Europe that look extremely weak, especially the Italian banking system and now even the German banking system which is not looking great with two of its largest banks not looking good. Japan is constantly in and out. You know Brazil, Russia, China; everything is in a slowdown. China could be in it for a pretty long haul given the extent of disinvestments and the de-leveraging that their banks had to go through.  The U.S. and India in my opinion are like the knights in the shining armour right now.

The Cost Of Negative Rates

One of things that the world seems to be fairly sanguine about is the amount of money that is earning negative interest rates? Nobody is quite sure what the ultimate outcome of this will be. Have you tried to assess what these policies will cost us five years down the line?

It is a very hard question because we are in somewhat of an unchartered territory and we don’t have historical evidence of what has happened if we’ve allowed interest rates to go negative. But, I think history is telling us in some ways already. We already know what happened in Japan in the 90s, which is that we didn’t recapitalise their banks but Bank of Japan said I am going to give you a lot of cheap liquidity. It wasn’t negative interest rates but it was cheap liquidity. What did Japanese banks do; they just rolled over bad loans, extending the maturity by another three to five years. Those bad sectors of the economy where they (the banks) didn’t want to recognise the losses, the rolling over of the credit meant that the resources were getting hogged by the worst parts of the economy. Now, of course we realise that only after the benefit of hindsight.
But right now the same thing has happened in Italy, since 2012, when the European Central Bank (ECB) had limited resources and didn’t recapitalise banks but threw cheap liquidity at them. What happens with rolling over of bad loans is that at a macro level, it looks fine, it looks like credit is growing. But unless you go and observe what the banks are doing at micro level, which is that they aren’t recognising losses they are simply papering over the losses for another 3-5 years, you don’t actually diagnose the problem right.
This is the fundamental problem that I think I have with negative interest rates, which is that I would say that the gains haven’t been demonstrated. We are yet struggling to figure out what the global economies are from the ultra-loose monetary policy. Whereas, now we are seeing emerging evidence of the unintended consequences that these policies have had. So, the biggest problem that I worry with low interest rates is when parts of your banking sectors aren’t healthy; it’s a recipe for disaster.

The Deutsche Bank Crisis

Based on research at NYU Stern’s lab we have been saying for the longest time that the French and the German banks are not as well capitalised as they look to the regulators.

You made a mention of the weakness in the German banking system. How do you react to what’s going on with Deutsche Bank over the last few weeks?

You know I am not a bit surprised. Based on research at NYU Stern’s lab we have been saying for the longest time that the French and the German banks are not as well capitalised as they look to the regulators. The trouble with regulation of bank capital is that they follow very static rules and they do not change with the changing risks in the economies. And because the rules aren’t evolving in an intelligent way, banks game them very thoroughly.
One of the problems are that many of the assets are marked for ratings by the bank themselves which is a huge conflict of interest. It doesn’t take much to realise that this could be a big issue.
So French and German banks have been trading at market to book ratios at below 0.7, 0.5 whereas U.S. banks are trading at 1. Now, partly this reflects lack of growth prospects in Europe, and partly that the books aren’t getting marked as well as they should be. So, I think in some ways the European banking sector as a whole to me is little bit like a ticking time bomb.
I was surprised to read today morning that now they have come out saying that we are going to push back on any capital reforms. We are not going to request or force banks, which is what they really need to do to raise more capital. So, the fact that Deutsche Bank has hit the news is more surprising because they are a national champion etc. But, I think that part of the problem is that the creditors in these banks don’t think that they are going to take any major hits. It’s really the shareholder equity that is getting wiped out. And I think ultimately it’s the taxpayers that are on the hook and so turning a blind eye to the fact that the market doesn’t think that the Deutsche bank is capitalised well; I think the regulators are risking the taxpayers’ money in my view.

Are you proposing that there ought to be a bailout? The bank has denied asking the government for help; the government says that they don’t intend to help at this point in time, or so the media reports suggest? Do you think that a bailout is the only solution in sight?

No, that’s not the only solution. Why should the bankers be bailed out, why should the creditors be bailed out, especially the subordinated bond holders? I think the right thing to do is to shrink the size of the bank, they should probably sell out in smaller units, allow foreign capital to come in and buy the franchises of Deutsche Bank. Now this is where the conflict between being a national champion versus achieving the market outcome arise. I think we again and again tell large banks and systemically important banks - the national champions, that every 10 years you can fail and still exist another 10 years to fail all over again. I think, we need to stop that cycle.

India’s Bad Loans Crisis

Banks in India don’t have it easy either. These last few years part of the India story has been about being able to resolve the mounting bad loan crisis that the country has faced. Credit Suisse said in a recent report that it expects the overall ratio of impaired assets to rise from 12 percent to over 16 percent. Clearly, the problem isn’t behind us.

I want to make three points here. The first point is that these numbers already look quite large and staggering and when you separate public sector banks and private sector banks, it looks even worse. The losses of public sector banks are even larger than the average losses. So that’s one point, which is that we ultimately have a problem here like Deutsche bank, which is that the banks that are getting into trouble are the ones which we don’t have a mechanism to resolve.
Now, second point is that historically any bank distress in India has been resolved by mergers. Banks in India haven’t typically failed except for small banks here and there. But the trouble is that a public sector bank cannot under the current statute be sold to a private sector bank.
Now, what our research shows is that there are banks in the private sector like HDFC Bank, Kotak... which are so well capitalised that they actually have balance sheet capacity, in my opinion, to take over the healthy parts of the activities that the public sector banks are engaging in. Clearly, public sector banks have a branched network and franchise that would be very valuable even to private sector banks. Now, the right creative destruction according to my opinion for this would be that even if we cannot repeal the legal statute that easily, we need to find the minimum level of transfer, of assets, branches, franchise that is possible, from unhealthy parts of the banking sector to the healthy parts of the banking sector. I think the reason why this is important is that we need to wean the banking sector of the implicit government guarantees and subsidies that public sector banks enjoy. We need to allow the private sector to grow if they have been healthy. I am not saying we have to make a mission out of the private sector to grow. But if they are performing well and public sector is not, private sector banks should be rewarded for doing this. Right now, we don’t have the mechanisms to do this.
And the third point which I want to come down to, which I think is very important and isn’t stressed upon enough, is that growth numbers are good but they could be much better. Because right now what is happening is that the public sector banks, which receive a big chunk of the deposit savings in the economy, are not lending well at all. They are rolling over bad loans, a big chunk of their assets is stuck in the restructured category, as you mentioned from the Credit Suisse report, and third, their credit growth is very stagnant. So, healthy parts of the economy could be actually getting cheaper credit if we resolve these problems quickly.
So, I am hoping that the RBI and Modi government work out a market friendly solution for this problem rather than saying let’s just kick the can down the road, just like what Japan did in the 1990s, which is what Italy has done in the last 5 years, and I am worried that is what Germany is going to do right now. If we stand out and do the right thing, I think we can push the Indian growth rate above maybe even 10 percent.

Bad Bank, Good Idea?

I am just saying that those who are distressed should be gracefully made to shrink. And if others get distressed in due course maybe it means that it is the final nail in the coffin.

When you suggest that India should try separating the good parts of the public sector banks from the bad parts, for instance the branch network that someone else might be interested in, you are in effect also suggesting that we also create a bad bank? It’s a thought, an idea that keeps coming up; it came up in the U.S. at the time of financial crisis. In India, we haven’t debated it in any big way yet; but that’s what you are suggesting? You also suggested that private sector banks such as HDFC Bank would have enough capital to acquire the good parts. If you can elaborate a little bit more on the type of solution you are referring to?

Let me take the two questions one by one. The first question, I am absolutely proposing either explicitly or implicitly that we separate the unhealthy parts of the troubled banks from the healthy parts. Either as a bad bank which has those bad assets left in the original balance sheet once you have separated the good parts, or you could run it to full maturity, so we are not looking for sellers or buyers. Or you could actually pool all the bad parts together and make an asset restructuring company that looks for buyers for these assets. It takes a lot of time as bad assets have a lot of adverse information about them. But historically, over 4-5 years, in most parts of the world, there have been buyers for these assets. Of course you would have to sell these assets at a discount but governments have usually managed to get something out of these bad assets.  In many countries, bad assets have been run to maturity, which in my opinion is a much better outcome then actually reining in the healthy part of the balance sheet because it is constantly being rolled back in to pay for the losses for the bad parts.

The U.S. did something very similar right after the global financial crisis?

They did it in the 90s as well. Implicitly U.S. has done this through Fannie Mae and Freddie Mac which are their huge mortgage giants. But in the 90s when they had their savings and loan crisis first they had a bail out but ultimately they set up an asset restructuring company, and in 1995 the government exited after 5 to 6 years once this restructuring company was set up.

So, you don’t think that this piecemeal recapitalisation that we have seen the government do is going to be effective enough? The one solution that you are backing is the bad bank and good bank solution?

I don’t like the piecemeal capitalisation at all because it will also mean a very gradual recovery of the credit growth at these banks. And that’s not what the economy needs right now. I understand from the fiscal stand point, it’s an attractive way to go about it, but I think our focus should be on growth and I think I the government feels fiscally constrained for injecting more capital. That’s why they need to precisely locate some of these assets into the healthier part of the banking sector. Because it reduces the onus on the government on how much they need to recapitalise because there is spare capital sitting in the private sector.

Private sector banks don’t want any exposure to this (infrastructure lending). If they wanted any you would have seen private sector step up and lend to many of these projects. Why would they get involved now?

I want to make two points there. Clearly, 75 percent of our banking assets are with state-owned banks. Even in the healthy sectors of the economy there is a lot of lending that happens by the public sector banks, so that share could be easily transferred over, in my opinion, to the private sector banks. Private sector banks could grow in lending to unhealthy sectors, if big chunks of deposit savings aren’t automatically getting funneled to the public sector banks, regardless of what their quality is. Once you have India, Maharashtra or a state’s name in the name of the bank, the depositor knows it implicitly that the bank is very, very safe.

The End Is Nigh?

But in effect what you are suggesting is also possibly the last nail in the coffin of the public sector banking system in India? You are saying, let’s find the right solution, let’s make tough decisions, even if it means that public sector banking in India effectively comes to an end because of something like this?

I am not saying that it should necessarily come to an end. I am just saying that those who are distressed should be gracefully made to shrink. And if others get distressed in due course maybe it means that it is the final nail in the coffin.
You look at the last 25 years of private sector growth, the private banking sector growth is flat. Indian private banking hasn’t raised its market share beyond 25 percent. In fact, it shrunk after the 2007-08 crisis because the depositors, especially the corporates, flew back to State Bank of India and other public sector banks.
The last point I would like to make is that the deposit franchise of these public sector banks ought to be quite valuable to the private sector banks in my view, because there are certain parts of branching restrictions that have been never been openly available to the private sector banks without them actually getting into priority sector lending etc...
Government on one end, along with RBI, has been relaxing the private sectors norms to make it so broad so that it isn’t a private sector norm anymore. Bu, now we should reap the full benefit of that by saying that let me get some of these rural branches of the public sector banks even in the private sector banks because the lending restrictions aren’t that strict anymore.

You know that is the problem with kicking the can down the road, you can’t actually attach a very clear timeline to when your problems are going to get solved, because if you let a wound fester, you don’t know what extra problem it is going to lead to.

The solutions that you’ve sounded out right now, just require I think a lot more courage than may be any politician in the country has. This is such a sensitive issue, there are unions involved, depositors involved and laws involved and all of that. I’m not going to suggest that this is going to be easily accomplished, but it does give us a talking point to start looking at solutions, which are more serious in nature. Because so far every scheme that the RBI came up with, whether it was the CDR (Corporate Debt Restructuring) scheme or now the SDR scheme (Strategic Debt Restructuring), which allows banks to convert debt into equity or thereafter I think the S4A scheme (Scheme for Sustainable Structuring of Stressed Assets) announced more recently. Every effort that the RBI has made to help resolve this bank loan has just not seemed strong enough. In fact, I’ll continue to quote from the Credit Suisse report - “we estimate that another 4.5 percentage loans are stressed and therefore expectation of return in an asset quality cycle at this point of time seems rather pre-immature”. Do you believe that the RBI has also not done enough to recognise this bad loans problem?

I would say yes and no. In my opinion RBI could have potentially acted little earlier than they did. I think may be the asset quality review that they undertook could have actually been started in 2013 & 2014 itself. In fact, there was a Credit Suisse report in 2014 that suggested that we had a problem in our house. Nevertheless, I would say that the asset quality review, tough marking down of bank losses requiring recapitalisation along with, you know, you have to work with the government. Unfortunately when you’ve have public sector banking in such a large measure to get these banks to be recapitalised to a healthy level is the only way to grow in my opinion. And I would actually like to say, even at the cost of having a short term shock to the market in terms of recognition losses it is perhaps not such a bad thing. Like think about which banking sectors out of the 2007 and 2008 crisis have come out well. It is the U.S. banking sector. Why? Because they took the biggest pain, they took the biggest hit.  What did they do? They took an actual, serious bank failure. They took Lehman Brothers, Wachovia, Washington Mutual. Why did that work? Because it aligned political thinking with economic needs for the United States banking sector at that point. I find that the gradual recognition of losses doesn’t escalate the matter to a point that it needs to be.
So, I’m not suggesting that we should have full grown banking crises, I don’t think we need that. But I think we need to be tough in marking down the losses of banks to ensure that capital needs are being correctly accessed and have an open dialogue with the government that listen if you can inject then let’s figure out an alternative way of transferring some of these assets and branches into the private sector.

So, you recommend - a more realistic recognition of bad loans, some of which is already under way and definitely more recapitalisation, the absence of which will mean that we should look at a bad bank good bank kind of solution, right?
Now if these were not to take place where do you think this bad loans problem is headed? Do you think we have another 2-5 years of pain to face, or do you think it might be a shorter term period? Or do you think we are over the hill now?

You know that is the problem with kicking the can down the road, you can’t actually attach a very clear timeline to when your problems are going to get solved, because if you let a wound fester, you don’t know what extra problem it is going to lead to. So I don’t have a good sense of what it is? What I can definitely say from historical research everywhere is that it’s well capitalised banks that lend healthily to the deserving parts of the economy. Undercapitalised banks either don’t lend or if they are thrown cheap liquidity at, they lend to the wrong parts of the economy.
So I don’t know when we can end the cycle but what I know for sure is that it ‘s at least 2-4 years and what we can do which will actually bring about a turnaround quicker than that, is to actually recapitalise the banks expediently over the next one year.
So my sense is we don’t need to have a clear sense of when we can get out of this mess, because it’s a mess and we have to figure out how quickly we can get out of it. Focus should be on not having to answer the question on when we’ll get out of the mess if we don’t fix it, we should just fix the mess and I think there are clever solutions even if that requires some political will to make that happen. I don’t think half baked solutions like taking RBI’s profits and putting them into public sector banks is the way to go. I think that is just like putting on a band aid and actually it’s a pretty bad band aid in my opinion, because it kind of distances the fiscal authority from the monetary, it reduces the distance of the two. It kind of almost says that central bank should generate profit because you have to recapitalise the public sector, everything smells wrong about it.

If there was a government to take these difficult decisions it ought to be this one, because it has come to power with a historic mandate.

We are growing at a decent growth rate. I think this is the time to actually amplify the growth by actually getting the banking sector to be healthy. It is not the time to lay shy saying I am not sure if growth prospects are high, am I going to be able to collect taxes that I am going to need to inject capital into the banking sector. We are growing well we have tremendous potential, this is the time to clean up the mess.

“Best Looking Growth Haven Now”

Professor Acharya we have spent almost all of our time talking about banking. So I’ll put in one very quick last question. There are several other challenges facing the Indian economy, a potential Fed rate hike, a recovery in commodity prices. How would you rank where we are in the economy and the biggest challenges facing us right now?

Let me make three quick points
1. I think we need not be as worried as we were when we wre hit in 2013 by the announcement of the Fed rate hike, the taper tantrum that happened and hit us before former Governor Rajan took on. Partly because RBI has shown a massive reserve increase since then, almost 3-4 fold.
2. Our banks have longer term foreign deposits than they had at that point.
3. We are actually the best looking growth haven now, both in emerging markets and developed countries.

The second point I would make is that I think we have much more political stability right now than we had at that point in time. You know we were looking at a change of government around then.

The third point I would make is that, I think a lot of investor sentiment about India right now has been built to the right level, both on the fiscal as well as the monetary front. I think it helps a lot that we have actually reined in inflation. We are not actually talking about a massive depreciation of currency coming from that and so the central bank has a lot of levy in stabilising the currency if required. The government has a lot of levy in pushing through growth reforms faster if the need be and so I am worried about the global growth headwinds, I am not so worried about flight of capital

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