Why not a 'Bad Bank'?

'Let's walk on two legs: Facilitate better resolution under the present system and set up PARA as well by transferring loans amounting to, say, Rs 1 lakh crore,' says T T Ram Mohan.
Illustration: Uttam Ghosh/Rediff.com

The Economic Survey proposed a Public Asset Rehabilitation Company -- PARA, a so-called 'bad bank' -- for tackling bad loans in the Indian banking system.

We already have several Asset Reconstruction Companies, ARCs. So what’s new?

PARA will be much bigger in scale and will have substantial government equity.

Besides, a big chunk of bad loans relates to valuable projects in infrastructure and related areas.

Many of these projects need to be completed through further infusion of capital from promoters.

Some of the debt has to be written off and some restructured in order to restore viability.

The existing ARCs are just not equipped for such a role, at least on the scale required. They are mainly in the business of effecting recoveries through liquidation of assets.

The Survey argued that leaving it to banks to resolve bad loans has not worked. At public sector banks, PSBs, management is unable to write off debt for fear of inviting investigation.

In many bad loans, several banks, public and private, are involved. This gives rise to problems of coordination.

Banks can't agree on the write-off required in a given case.

Transferring some of the biggest bad loans to a well-capitalised PARA could help resolve the coordination problem.

As the government stake in PARA will be 49 per cent, managers can resolve loans without fear of inviting scrutiny.

This sounds fine -- until you get down to the details.

One challenge is the prices at which bad loans will be sold to PARA.

Determining the market prices for bad loans is not easy.

Getting banks to agree on a sale price could pose its own problems of coordination.

If the sale of bad loans to PARA were perceived to be under-priced, PSB management would be exposed to the wrath of the CAG, CVC and CBI.

If they were over-priced, private investors in the proposed PARA would begin to fret.

The challenge of writing off debt remains.

Managers at PARA may be able to exercise their discretion a little more freely. But the government is ultimately accountable for decisions taken by an entity in which it is the dominant investor.

Every resolution will be closely watched. Expect howls of 'scam' to be raised given that high-profile corporates are involved.

• In graphs: The grim story of India's bad loans

The Survey estimated that of the top 100 stressed debtors, 10 would need debt reductions of 51 to 75 per cent and 57 would need reductions of 75 per cent or more!

Over 40 per cent of the debt is owed by companies with an interest coverage ratio of less than one.

As the top 50 companies in this category owe an average of Rs 20,000 crore (Rs 200 billion), the write-offs required are of staggering proportions.

Unlike many of the shrill critics of the public sector, the Survey doesn't see recapitalising PSBs as throwing good money after bad.

Even more striking, the chief economic advisor doesn't believe that finding the necessary capital for PSBs is a big deal -- he thinks it's 'the easiest part' of the loan resolution problem.

Only, the Survey doesn't favour promising large infusion of capital to PSBs before bad loans are resolved.

This, it believes, would create incentives for unduly large write-offs.

So, none of the issues associated with bad loan resolution in the present scheme of things goes away with the creation of PARA: Coordination amongst banks; large write-offs and the potential for controversy; and the substantial capital that would have to be infused into PSBs.

If anything, we stand to lose two advantages we have with the present system.

One, banks' intimate knowledge of projects and hence the ability to arrive at the right resolution.

Two, banks' ability to use the leverage they have with large corporate groups to ensure that they restore viability to troubled projects within the groups.

If the primary motivations for PARA are to have the right incentives for write-offs and to get resolution going, there's a simpler option: Create an oversight mechanism for vetting bad loans.

The Survey mentions that the Banks Board Bureau has created such a mechanism -- we don't know whether it's operational.

We need to merely strengthen the mechanism by getting one created through an Act of Parliament.

In sum, it's not clear that setting up a new agency is a superior way to address the issues that bedevil bad loan resolution.

Giving PSB management statutory backing to resolve bad loans and the capital infusion to cover write-offs could achieve superior outcomes.

Still, there's merit in trying out competing models.

Let's walk on two legs: Facilitate better resolution under the present system and set up PARA as well by transferring loans amounting to, say, Rs 1 lakh crore.

Let's see which model does better. There could be useful lessons to be learnt.

T T Ram Mohan is a professor at IIM-Ahmedabad ttr@iima.ac.in