Daily Editorial Update – No real roadblock in proposed ‘Bad Bank’ frameworks

Hello and welcome to exampundit. Here is today’s Editorial from the very best Economic Times titled “No real roadblock in proposed ‘Bad Bank’ frameworks”.

Today’s Topic: No real roadblock in proposed ‘Bad Bank’ frameworks

The idea that India may be requiring a ‘bad bank’ in some shape and form, finds a higher number of supporters today than was the case on August 19, 2015 when the idea of a Sovereign Distressed Asset Fund (SDAF) was discussed in this column of ET. The growing acceptance of a ‘bad bank’ as solution is hardly surprising given that RBI’s efforts to resolve the bad debt problem by means of mechanisms such as Strategic Debt Restructuring (SDR) scheme, 5:25 and Sustainable Structuring of Stressed Asset (S4A) did not move the needle meaningfully.

Of late, India has been presented with overarching debt resolution frameworks such as Public Sector Asset Rehabilitation Agency (PARA), Private Asset Management Company (PAMC), and National Asset Management Company (NAMC). While each proposal differs in terms of operational aspects and ownership, they all seek to shift bad debt from banking sector to the books of a specialised and resourceful resolution entity, thus enabling banks to revive industrial lending for the revival of the economy.

To gain broader acceptance, any scheme relating to implementation of a ‘bad bank’ need to minimise the impact on government finances. The scheme also needs to address doubts pertaining to a) government or private ownership, b) the source of funding of the agency, c) the price at which the agency will buy bad debt.

The author argues that none of these are insurmountable problems or unanswerable dilemmas. Most of these questions stem from neoclassical view of economy peppered with a convenient belief in monetarism. However, the current solution may be better appreciated from a Keynesian or Minskyite perspective with more realistic understanding of banking, credit and money creation.

Government sponsorship critical
Banks at its core are entities which are owned or appointed by the sovereign to lend purchasing power in the economy by way of credit disbursement. Credit creates money (endogenous) which is backed by government.

Troubled banking systems have limited credit disbursal ability, constraining money creation, which limits growth ultimately hitting taxes. Government must step in to revive banks’ credit disbursal ability to keep this cycle intact. Thus the fund resolving bad debt must be sponsored by government.

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Optimising the strain on exchequer

The fund will require money for day-to-day operations and for funding turnaround of distressed companies where possible. Such resources may be raised by selling the fund’s equity stake to GOI, sovereign wealth funds and multilaterals. However, the fund can purchase bad debt from banks by issuing securitiesdebt, hybrids and equity.

Specifically, the fund may issue a senior debt which may be government guaranteed, subordinate debt. These may be zero coupon debt co-terminus with the life of the agency (say 10 years). Over its life, the fund will earn from liquidation and stake sale of revived companies, so it may not have to invoke the government guarantee for debt servicing.

Since fiscal deficit is calculated on the cash basis, there will be no immediate impact attributable to buying bad debt. However, government has to incur some expenses for replenishing the equity of its banks since some haircut of loan value may be required before selling it to the fund.

Pragmatic pricing


Banks will like to sell bad debt at book value since any write-off will erode equity. The fund will like to buy bad debt at discounted prices to improve return. The failure of banks and ARCs to agree on the price has been among the reasons for NPA build-up.

While banks may take some haircut, they may still seek a value higher than what the fund may pay. The fund’s price for the bad debt may be paid in terms of senior debt guaranteed by government, while excess amount demanded by banks (post haircut) may be paid in terms of sub-ordinate debt and equity in fund.

The fund’s success would depend on how it incentivises banks to come clean, check moral hazard issues without going for protracted pricing negotiations. The government should act post haste for creation of such a fund or wait till 2026 to bring down NPA levels. Recall India’s NPA rate touched 15.4% in 1997 and it took 9 years to fall to below 5%.

While fiscal discipline is critical, it must be appreciated that government funding of bank equity, fiscal deficit or overall government liability are accounting entries and per se not physical constraints or monetary constraints as faced by non-money creating entities such as households and corporates. What matters more is the creation of real, physical assets and constraining them by arguing blindly in favour of fiscal discipline or moral hazard will be detrimental to the economy.

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Regards

Team ExamPundit