The article suggests drawing the lessons from China’s experience with the bad bank as India India gets ready to operationalise a new bad bank.

Bad bank in China and issues

• In the aftermath of the Asian financial crisis, China set up dedicated bad banks for each of its big four state-owned commercial banks.
• These bad banks were meant to acquire non-performing loans (NPLs) from those banks and resolve them within 10 years.
• In 2009, their tenure was extended indefinitely.
• Chinese banks can currently transfer NPLs only to the national or local bad banks.
• One of China’s biggest bad banks is the China Huarong Asset Management Co. Ltd. (Huarong).
• The Chinese government is its principal shareholder.
• Recently this bad bank stoked financial stability concerns when it skirted a potential bond default.
• An incentive to conceal: Recent research at the National University of Singapore and others highlights that Chinese bad banks effectively help conceal Non-Performing Loans.
• The banks finance over 90 per cent of NPL transactions through direct loans to bad banks or indirect financing vehicles.
• The bad banks resell over 70 per cent of the NPLs at inflated prices to third parties, who happen to be borrowers of the same banks.
• The researchers conclude that in the presence of binding financial regulations and opaque market structures bad bank model could create incentives to hide bad loans instead of resolving them.
• Broadening of tenure: In case of Huarong, the main source of the problem appears to be the gradual broadening of the original mandate and tenure of Chinese bad banks.

Four lessons for India

• India is about to operationalise a new bad bank, the National Asset Reconstruction Company Ltd. (NARCL).
• The Chinese experience holds four important lessons for India.

1) Finite tenure of bad bank

• A centralised bad bank like NARCL should ideally have a finite tenure.
• Such an institution is typically a swift response to an abrupt economic shock (like Covid) when orderly disposal of bad loans via securitisation or direct sales may not be possible.
• The banks could transfer their crisis-induced NPLs to the bad bank and focus on expanding lending activity.
• The bad bank in turn can restructure and protect asset value.
• Over time, it could gradually dispose of the assets to private players.

2) Narrow mandate

•  A bad bank must have a specific, narrow mandate with clearly defined goals.
• Transferring NPLs to a bad bank is not a solution in itself.
• There must be a clear resolution strategy.
• Otherwise, allowing a bad bank to exist in perpetuity risks a potential mission creep, which might in the long run threaten financial stability itself.

3) Diversify the sources of funds for ARC

• Indian banks remain exposed to these bad loans even after they are transferred to asset reconstruction companies (ARCs).
• The RBI Bulletin (2021) notes that sources of funds of ARCs have largely been bank-centric.
• The same banks also continue to hold close to 70 per cent of the total security receipts (SRs).
• To address this problem, RBI has tightened bank provisioning while liberalising foreign portfolio investment norms.

4) Resolution of bad loans should be through market mechanism

• In a steady state, the resolution of bad loans should happen through a market mechanism and not through a multitude of bad banks.
• In India, the Narasimham Committee (1998) had envisaged a single ARC as a bad bank.
• Yet, the SARFAESI Act, 2002 ended up creating multiple, privately owned ARCs.
• As a result, regulations have treated ARCs like bad banks, although functionally they are closer to stressed asset funds registered as Alternative Investment Fund Category II (AIFs).
• With the setting up of NARCL as a centralised bad bank, the regulatory arbitrage between ARCs and AIFs must end.
• While AIFs should be allowed to purchase bad loans directly from banks and enjoy enforcement rights under the SARFAESI Act.
• ARCs should be allowed to purchase stressed assets from mutual funds, insurance companies, bond investors and ECB lenders.
• ARC trusts should be allowed to infuse fresh equity in distressed companies, within IBC or outside of it.
• Lastly, the continued interest of the manager/sponsor of ARCs should be at par with AIFs, that is, at least 2.5 per cent in each scheme or Rs 5 crore, whichever is lower.

Conclusion

The Chinese experience should nudge Indian policymakers to limit the mandate and tenure of NARCL, while facilitating market-based mechanisms for bad loan resolution in a steady state.

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