India plans a bad bank for government lenders, the effectiveness remains to be seen

India’s plan to create its first government-backed bad bank, borrowing distressed assets from public sector banks, could accelerate lenders’ balance sheet cleansing, but its effectiveness will depend on the level of government-provided capital, according to analysts.

The planned Bad Bank or ARC (Asset Reconstruction Company) in India will take over and repackage existing stressed state bank debt and sell it to alternative mutual funds and other investors to “realize its value,” Finance Minister Nirmala Sitharaman said in her Feb. 1 Speech on the government’s budget proposals for the fiscal year beginning April 1st. She did not say how much the government will fund the bad bank and when it will be launched.

“A large national asset rebuilding company will be beneficial to the Indian financial ecosystem as it has the ability to buy up large NPAs. Today, most of the existing ARCs in India are not large in terms of capitalization and their ability to acquire large assets buy is limited. ” Krishnan Sitaraman, senior director, financial sector and structured finance ratings at CRISIL, emailed S&P Global Market Intelligence in advance of the budget announcement.

There are 28 ARCs in India, all of which are privately owned and not large enough to handle the number of bad loans that span the state banks, which generally have weaker profits and less capital than private sector lenders have reported. A national bad bank is a great alternative for dealing with bad loans rather than relying on individual ARCs, said Vikram Kuriyan, executive director at the Indian School of Business.

Local media had previously reported that the government was investigating the idea of ​​a national bad bank to take over stressed assets from state banks. The economic slowdown caused by the COVID-19 pandemic is likely to increase the non-performing asset ratio of state banks from 9.7% in the same month of 2020 to 16.2% by September. This is evident from stress tests recently conducted by the Reserve Bank of India. If the country’s macroeconomic environment worsens in a severe stress scenario, state banks’ poor credit ratios could rise as high as 17.6%, the central bank said in a Jan. 11 report.

The Reserve Bank of India predicts that the gross NPA ratio of the entire banking system could increase from 7.5% last year to 13.5% by September.

Moral hazard

Critics of one national bad bank say it can encourage lenders to take undue risk.

“Moral hazard is a key issue that needs to be addressed in the national ARC construct,” said Sitaraman. “Banks should be reasonably discouraged from failing to fully exercise due diligence in asset creation knowing that there is a national ARC to handle the situation if the account defaults.”

India could take a look at South Korea and Japan, where government-run asset management companies were set up after the Asian financial crisis.

A successful model for India would depend on the new bad bank being adequately staffed, Kuriyan said. “The key is to occupy both banks and enable them to behave professionally,” he said.

Among other proposals for the financial services sector, the finance minister announced that the government would privatize two state-owned banks and a general insurance company. She did not disclose the names of the companies the government plans to sell.

She also said that Life Insurance Corp.’s initial public offering of India continues this year, announcing a proposal to raise the limit on FDI in the insurance sector from the current 49% to 74% and enable foreign ownership and control with protective measures.

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