By Nageshwar Patnaik in Bhubaneswar, May 19, 2021: Banks have come a long way from the temples of the ancient world, but their basic business practices have not changed. Historically, temples were considered the earliest forms of banks. If there were no banks, there won’t have any cash in the economy and the Barter System i.e. exchanging things/goods with each other as per our wants/needs would have been prevalent.

In fact, the banking sector has emerged as the lifeline of the modern economy. A bank is a financial institution whose purpose is to receive deposits and lend money to individuals and businesses, disburse payments, invest funds in securities for returns, and safeguard money. But with the global COVID-19 pandemic emerging as the “black swan” event, the banking sector in India requires extraordinary measures for its survival.

The pandemic came as a crippling blow to the economy, which suffered an unprecedented 23.9 per cent contraction in the April-June quarter. It has hit the Indian economy at a time when growth has slowed to the lowest in a decade. And when there were signs of green shoots of recovery, the second wave struck the country more virulently.

The banking sector in the country continues to face high levels of systemic risk. In the moderate downside scenario, the Indian banking system’s weak loans should remain elevated at 11-12 per cent of gross loans. Credit losses will remain high in fiscal 2022 at 2.2 per cent of total loans, before recovering to 1.8 per cent in fiscal 2023, S&P Global Ratings recently said.

The Reserve Bank of India (RBI) in its Financial Stability Report has cautioned that the gross NPA ratio may increase from 7.5 per cent in September 2020 to 13.5 per cent by September this year. This will be the highest in more than 22 years and will put pressure not just on our banking system but also on the economy. The report had warned that if the macroeconomic environment worsens into a severe stress scenario, the NPA ratio may escalate to 14.8 per cent. With regard to public sector banks, the latest Financial Stability Report indicates that NPAs can go up to 16 per cent in severe case scenario but extreme case scenario has not been portrayed this time.

Several companies and millions of individual borrowers are struggling to repay loans in the aftermath of the Covid-19 pandemic. This has opened the Pandora’s Box swelling the NPA of banks. The impact of the pandemic-induced disruptions on asset quality will be spread over FY21 and FY22, with bad loans expected to rise to 9.6-9.7% by 31 March, 2021, and to 9.9-10.2% by 31 March, 2022.

Despite including pro forma bad loans of about Rs 1.3 trillion, gross NPA ratio stood at 8.3% compared with 8.6% as on 31 March, 2020. A ‘non-performing asset’ (NPA) is defined as a credit facility in respect of which the interest and / or installment of principal has remained ‘past due’ for a specified period of time.

So, what is the solution? Many experts feel “bad bank” could be a good idea to free the banks from the mounting burden of the NPAs. In May, the Indian Banks Association (IBA) had suggested to the finance ministry and RBI to set up a bad bank. The Confederation of Indian Industry (CII) has also asked the government to consider “multiple bad banks” to address the NPAs of state-owned lenders.

A ‘bad bank’ is a bank that buys the bad loans of other lenders and financial institutions to help clear their balance sheets. The bad bank then resolves these bad assets over a period of time. When the banks are freed of the NPA burden, they can take a more positive look at the new loans. Ideally, such a bank should be owned by the banks which have the most of NPAs.

It is quite important that banks are free of their bad-loan burden for post-Covid-19 recovery. One of the ways to unburden it quickly is by selling them off to a bad bank, which may be able to provide some respite and enable restarting lending activities without fear.

In fact, the Narendra Modi government is weighing all options to set up a bad bank to improve the health of the banking sector. The government must take the lead as it dominates the banking system in the country. RBI governor Shaktikanta Das admitted, “Bad banks have been under discussion for a long time, we are open to looking up any proposal on bad banks. It is for the government to come up with such a proposal, and if any, we will examine the proposal.”

The annual Budget also envisages the setting up of a bad bank in the form of an asset reconstruction company or asset management companies, which will purchase stressed assets from banks, restructure them and sell them to investors, seeking to resolve them over time.

In 2004, when IDBI Limited’s bad loans were bought out by a government fund, neither did the fund realize sufficient value from it, nor did IDBI Limited’s lending record improve substantially. This experiment has propped up critics to dub the bad bank idea as eyewash over accountability.

However, this time the bad bank is proposed to be set up by state-owned and private sector banks without any equity infusion from the government. Such an entity will be purchasing stressed loan accounts exceeding Rs 500 crore against issue of security receipts to a wide pool of investors. There may be a sovereign guarantee to back the security receipts but that would fundamentally be to help banks meet regulatory requirements.

But the moot question is will the proposed bad banks be able to manage to monetize the bad assets over a period of time?