Bad Bank: An Idea From The Good Ol’ Banking Book
The Indian government is looking to revisit the idea of a bad bank as a way to rid the banking sector of over Rs 6 lakh crore in bad loans, BloombergQuint reported on Wednesday. The government has been asking financial sector professionals for views on the concept and how it could work in India. Earlier in the week, Reserve Bank of India governor Urjit Patel said that resolving the bad loan problem needs “skill and creativity.”
The idea of a bad bank, however, is neither new nor creative. The concept has, infact, been tried a number of times across different economies. In the aftermath of the global financial crisis, a number of countries set up bad bank like structures. The United States set up the Troubled Asset Relief Program (TARP), Ireland put in place the National Asset Management Agency and Spain established an entity called ‘Sareb’ to which troubled and illiquid assets were transferred.
While the bad bank concept made a comeback during the financial crisis, it had been tried as early as the late 1980s when US-based Mellon bank segregated its stressed assets into a subsidiary.
Mellon Bank: Shedding The Bad, Keeping The Good
One of the first reported instances of a bad bank is in the case of US-based Mellon Bank, which later become Mellon Financial and eventually morphed into the Bank of New York Mellon.
In 1988, when Mellon Bank found its balancsheet riddled with bad loans, it decided to separate the good from the bad. According to a report on the European Investment Bank website, Mellon Bank sold $1 billion in loans to a newly created subsidiary called the Grant Street National Bank. The loans were sold at a discount to the newly created entity, which allowed the cleaned up Mellon Bank to raise fresh capital and revive its operations. Grant Street National Bank went on to focus on recovery of bad loans under an entirely separate management.
The Mellon bad bank, however, was an entirely private sector experiment with no involvement or capital from a government entity.
Japan: The Long Road To A Banking Clean-Up
Japan went through the process of cleaning up its banking sector in the late 1990s after years of recession. The process which played out over a period of almost 15 years was a mix of capital infusions and purchase of bad assets. In 1998, the Japanese government set up a capital injection facility for banks which had essentially stopped lending, leading to a credit crunch in the Japanese economy. The facility helped stabalise the situation but was only the first step. Another round of capital injections followed in 1999 in the form of Tier-1 capital.
Over this period, the Deposit Insurance Corporation was also active and granted funds to failed banks and also bought assets from them. This was made possible after Japan amended its deposit insurance laws to allow for asset purchases from failed institutions. In 1998, that law was further amended to allow for asset purchases from healthy institutions as well. Such purchases continued all the way until 2004.
According to a 2010 report by the Nomura Research Institute, Japan’s deposit insurance agency bought loans worth 6834 billion yen and recoveries by 2009 stood at 8002 billion yen, marking a profitable exit for the deposit insurance company.
Sweden: Quick And Deep Surgery
The banking crisis in Sweden emerged from the shadow banking system and had spread rapidly to the broader financial sector by 1992. Apart from bringing in a deposit insurance framework, Sweden set up a bad bank named Securum.
According to a 2015 research paper available on the website of Riksbank, the Swedish central bank, Securum was formally constituted in October 1992 and took over roughly a third of the balancesheet of one of the country’s largest banks Nordbanken. A similar bad bank called Retriva was set up to take over the bad loans of another lender named Gota. Securum and Retriva were later merged.
The research paper notes that Securum was given considerable financial support and independence. Over a period of the next five years, Securum liquidated, sold and recovered assets.
Securum was wound down by 1997.
Indonesia: A Mammoth Exercise In Bank Restructuring
The Indonesian Bank Restructuring Agency was set up at the height of the Asian financial crisis in 1998 as part of a package of financial sector reform driven by the IMF. This package included a government guarantee for bank liabilities, the setting up of the IBRA and a broader corporate restructuring plan.
The IBRA’s mandate was to close, merge or takeover, and recapitalize stressed banks. The task was to be completed within five years, according to an agreement with the IMF. More than a third of Indonesia’s banking system was placed under the IBRA’s supervision, according to a 2002 working paper by the IMF. The IBRA went on to take over seven large banks and closed seven smaller banks.
In September 1998, IBRA also launched a recapitalisation program which included contributions from both the government and private sector owners of some of these banks.
The IBRA was finally closed in 2004 and was not seen as a success. The IMF, in its country report for Indonesia in 2004, cited lack of adequate political support as one of the key reasons why IBRA could not deliver on its objectives.
Lessons For India
While there are a number of other such bad bank experiments that have been attempted, the few examples cited above throw up some clear lessons.
For one, while a bad bank experiment may ease the pressure on banks, it may not ease the pressure on the government. The government would still need to provide capital to the new entity. The choice then is between providing additional capital to existing banks or to a new entity which holds the bad assets of these banks.
A second important lesson suggests that the process has to be swift rather than one which is staggered out over years. The management of the bad bank has to be professional and experienced and focused on quick recovery and resolution.
The final lesson appears to be that an entity of this nature, if created, must be kept far away from any political influence or interference so it can function effectively.