How India Finally Got Around to Starting a ‘Bad Bank’

(Bloomberg) -- India has unveiled a plan to set up a bad bank, its latest attempt to tackle the mountain of defaulted debt that threatens to cripple its financial system. With soured assets pegged at a more than two-decade high, the move is aimed at reviving confidence in banks at a time when the virus-stricken economy is emerging from its first contraction in decades. But the problems predate the pandemic: a lingering liquidity crisis has claimed several shadow lenders, triggered India’s largest bank failure and forced the country’s largest fund freeze. Past efforts at fixes have had limited success.

1. What’s a bad bank?

It’s a place where a struggling financial institution can put assets it wants off its own books to eventually sell or unwind. Often it’s made up of businesses or holdings that are dragging the bank down, such as risky and illiquid derivatives or delinquent loans. But the nickname can be misleading, as everything inherited isn’t necessarily bad. It can also include unwanted assets that are no longer core to a firm’s strategy. Many global lenders set up such divisions in-house after the 2008 financial crisis, some with taxpayer assistance.

2. What’s India’s plan?

In this case, the new structure would aggregate bad loans from Indian banks to help them clean up their strained balance sheets. Many details of the plan are yet to emerge, including ownership, control and mechanics. Early comments from officials indicate that banks may capitalize it, at least initially, and that it would aim at being “cash neutral.” That could mean largely paying for the bad loans it buys with securities linked to the eventual cash recoveries from the underlying assets, in part to avoid having to use taxpayer money. However, the Indian central bank in 2015 barred non-cash purchases of bad loans and forced those buyers to pay at least 15% in cash. The new entity would need an exemption from that rule if it is to be fully cash neutral or be formed under a different regulatory category.

3. Why now?

India’s $1.86 trillion financial system entered the pandemic already weakened by about $140 billion of bad loans at its banks and a liquidity crisis at so-called shadow banks that started in 2018. Then business activity collapsed after Prime Minister Narendra Modi’s government instituted some of the world’s strictest shelter-at-home rules in response to the coronavirus. The economy is forecast to shrink in the fiscal year to March 31 for the first time in more than four decades. The Reserve Bank’s stress tests show the bad-loan ratio will rise to 13.5% by September 2021 -- the highest since 2000 -- from 7.5% a year ago. As of September the total amount of bad loans stood at around $106 billion.

4. What else has been tried?

The idea behind the bad bank is hardly new, even within India.

• Under a 2002 law, so-called asset-reconstruction companies emerged to buy bad loans off bank balance sheets and chase down delinquent borrowers to collect cash. At first, these were often floated by consortia of banks, with foreign investors including Blackstone Group Inc. and Lone Star eventually following. But the 2015 central bank rule change limited how much of the bad loan pile they could afford to buy.
• When the pandemic slammed India in early 2020, the central bank allowed lenders to freeze loan repayments through Aug. 31. Jefferies estimates that borrowers accounting for 31% of outstanding loans took up the offer initially, though this eased to about 18% by the end of June as businesses gradually reopened and some realized that postponing repayments could end up being costlier.
• The focus then shifted to a one-time debt restructuring allowed by the Reserve Bank of India for borrowers that were on track to repay before the lockdown. Lenders could grant loan extensions of as long as two years with or without a freeze on repayments. They had until the end of the year to choose which loans to overhaul.

5. How could a bad bank help?

The bad bank serves several purposes. For one, it helps expedite the pace of debt restructuring by reducing the number of lenders who must agree to a proposed deal. It also makes it easier for foreign funds to build controlling positions in the debt of a firm by allowing them to negotiate with a single seller. Generally speaking, placing non-core assets in a separate division can help make a restructuring more efficient and transparent by providing investors with financial disclosures to better track the progress of a lender’s overhaul and hold management accountable. Shedding the assets in the bad bank then frees up capital that can be used to bolster a firm’s financial strength or be redeployed to more profitable businesses. If it’s a separate entity, it can also allow a bank to clean up its balance sheet, stem losses and protect depositors.

6. And what’s the downside?

Like all policy moves, depending on the details, there could be unintended consequences. If ownership were to lie with Indian banks, which originated the loans, the transfer price might risk being inflated. That could end up freezing the growing secondary market for distressed credit and deter foreign funds, which have been showing burgeoning interest in the opportunity. Without new external capital to help bolster the fragile financial system, taxpayers could be left on the hook.

7. Is it all the banks’ fault?

No. Government policies played a role. Some borrowers found life harder when authorities suddenly tightened regulations, the courts canceled coal-mining licenses or ordered payment of telecom fees, natural gas supplies dwindled, real-estate prices fell and interest rates rose. Modi’s unprecedented decision in 2016 to overnight invalidate almost all of the India’s physical currency devastated supply chains and created dangerous imbalances in the financial system as Indians rushed to deposit their cash. Making matters worse, there was long a belief among some corporate executives that they could walk away from debts without facing consequences. Regulators have alleged that some bank chiefs handed tycoons loans that ended up in default.

8. Has this worked elsewhere?

Yes, in similar form. Last year, China approved a new state-owned bad-loan manager to help with the fallout from the pandemic, after such institutions established decades earlier in the country helped carve out record amounts of non-performing loans. The most famous example is Citigroup Inc., which in 2009 started a division to wind down hundreds of billions of dollars of unwanted assets. Michael Corbat, who led the unit, went on to run the bank. Royal Bank of Scotland Group Plc pulled off a similar feat to return from the brink after the financial crisis and later to focus on its U.K. roots. While those two lenders benefited from taxpayer funds, Deutsche Bank AG and several peers sought to restructure on their own. Credit Suisse Group AG closed what it called its Strategic Resolution Unit in 2018, which had been created as part of a pivot away from volatile trading to more stable wealth management.

The Reference Shelf

• QuickTakes on India’s last plan for bad debt, and its shadow banking problem.
• The Reserve Bank of India’s Financial Stability Report, published January 2021.
• Bloomberg Opinion’s Andy Mukherjee writes on India’s new budget plan.

©2021 Bloomberg L.P.