India's plan to create its first government-backed bad bank to absorb nonperforming assets from public-sector banks could accelerate the clean-up of the lenders' balance sheet, but the effectiveness will hinge on the amount of capital the government provides, analysts say.
The proposed bad bank, or called asset reconstruction company, or ARC, in India, will take over and repackage existing stressed debt of state-run banks and sell to alternative investment funds and other investors to "realize their value," Finance Minister Nirmala Sitharaman said Feb. 1 in her speech detailing the government's budget proposals for the fiscal year starting April 1. She did not say how much the government will fund the bad bank and when it will be launched.
"A large national asset reconstruction company will have its utility to the Indian financial ecosystem by having an ability to buy out large NPAs. Today most existing ARCs in India are not large in terms of capitalization and their ability to buy large assets is limited," Krishnan Sitaraman, senior director for the financial sector and structured finance ratings at CRISIL, told S&P Global Market Intelligence in an email before the budget announcement.
There are 28 ARCs in India, all are privately owned and are seen not sizable enough to tackle the amount of bad loans straddling the state-run banks, which have generally reported weaker earnings and capital levels than private-sector lenders. A national bad bank is a good alternative for handling bad loans than relying on individual ARCs, said Vikram Kuriyan, executive director at Indian School of Business.
Local media had previously reported that the government was studying the idea of a national bad bank to take over stressed assets of state-run banks. The economic slowdown caused by the COVID-19 pandemic is expected to push the nonperforming asset ratio of state-run banks to 16.2% by September, from 9.7% in the same month of 2020, according to stress tests recently conducted by the Reserve Bank of India. If the nation's macroeconomic environment worsens in a severe stress scenario, the state-run banks' bad loan ratio could rise to as much as 17.6%, the central bank said in a Jan. 11 report.
The Reserve Bank of India expects the gross NPA ratio of the entire banking system could rise to 13.5% by September from 7.5% a year earlier.
Moral hazard
Critics of a national bad bank say it may encourage lenders to take undue risks.
"Moral hazard is a key issue that must be addressed in the national ARC construct," Sitaraman said. "Banks should be appropriately disincentivized from not completely adhering to necessary due diligence while originating assets given the knowledge of the existence of a national ARC which will take care of the situation if the account turns delinquent."
India may look at South Korea and Japan where government-run asset management companies were established following the Asian financial crisis.
A successful model for India would rely on the new bad bank being sufficiently staffed, Kuriyan said. "The key is to staff and empower both banks to behave professionally," he said.
Among other proposals for the financial services sector, the finance minister announced that the government will privatize two state-run banks and one general insurance firm. She didn't disclose the names of the companies the government plans to sell.
She also said the IPO of Life Insurance Corp. of India will proceed this year and announced a proposal to raise the foreign direct investment limit in the insurance sector to 74% from the current 49% and allow foreign ownership and control with safeguards.