Spiking the debt balloon

India plans to set up a so-called bad bank to deflate a post-pandemic rise in non-performing assets and help lenders clean their balance sheets. Will this be the panacea the country’s troubled banking sector needs? Mithun Varkey reports

The government of India is proposing to set up a “bad bank”, or an asset reconstruction company, to manage the rising non-performing loans problems facing Indian banks, especially the state-owned ones.

A bad bank is an asset management and reconstruction company that takes over non-performing assets of a bank, or a group of banks, to help them clean their balance sheets by removing the illiquid and high-risk assets held by the financial institutions. A bad bank helps separate good assets from bad, allowing financial institutions to raise more capital.

Finance minister Nirmala Sitharaman, in her 2021 budget speech, announced: “An asset reconstruction company and asset management company structure will be set up to take over the bad loans on public sector bank balance sheets and manage recoveries.”

With India’s high levels of non-performing assets, there have been demands for a bad bank. However, the pandemic – and the expected rise in illiquid assets as a result – seems to have forced the government’s hand.

India has been staring at a banking crisis on account of high levels of non-performing assets in the system, a situation which has worsened since the pandemic began.

The Reserve Bank of India’s (RBI) latest financial stability report published in January cautioned that “the gross non-performing assets ratio of all commercial banks in the country may increase from 7.5% in September 2020 to 13.5% by September 2021, and if the macroeconomic environment worsens into a severe stress scenario, the ratio may escalate to 14.8%”, a rate surpassing the all-time high of 14.7% reported in 1999.

Public sector banks are especially at risk, with a gross non-performing assets ratio of 9.7% in September 2020 that may increase to 16.2% by September 2021, while private sector banks are expected to see the rate rise from 4.6% to 7.9% in the same period.

“In the severe stress scenario, the gross non-performing assets ratio of state-owned banks, private banks and foreign banks may rise to 17.6%, 8.8%, and 6.5%, respectively, by September 2021,” the RBI report says.

A mechanism to clean up the system is sorely needed because the high levels of non-performing assets erode the ability of banks to raise capital due to the higher provisioning needed to meet the regulatory requirements. According to the government, stressed loans more than ₹5 billion (US$66.3 million) each are to be transferred to the bad bank, which is likely to take more than ₹2 trillion to ₹2.5 trillion of unresolved stressed assets from about 70 large accounts.

Industry practitioners have all welcomed the proposal, however the plan is not without its issues.