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Article

31 Jul 2020

A clean slate: good times for bad banks

A clean slate: good times for bad banks

Pratish Kumar
Juris Corp, Mumbai
pratish.kumar@jclex.com

Ankit Sinha
Juris Corp, Mumbai
ankit.sinha@jclex.com

Garima Parakh
Juris Corp, Mumbai
garima.parakh@jclex.com

The development of complex financial structures has led to an increased appetite for risk taking, subjecting balance sheets to diverse exposures. While the inevitable spin of the economic wheel does periodically produce a recession, the failure of large financial institutions has become rather widespread. Various methods that can be adopted to soften the adverse effects of a recession and prevent long-term detrimental effects. Historically, a number of countries that have faced banking crises, have implemented, or considered implementing a bad bank structure for weathering the storm.

Let us evaluate the models adopted by Sweden and United States to see if they could be implemented in India. These models were instrumental in resuscitation of their respective economies during the 1992 and 1987 banking crises, in Sweden and the US respectively.

Swedish and US models: the success story

The Swedish banking crisis was a result of the real estate bubble burst and a fixed exchange rate of the Swedish Krona.[1] As major Swedish banks reported large losses, the Swedish government swung into action, announcing guarantees for all bank loans in the banking system. In doing so, they created two bad banks: Securum and Retriva[2] Both were government funded bad banks, with the government being their largest shareholder. They purchased the non-performing assets and other high-risk default assets at market value, leaving the ‘good’ assets with the respective banks. In doing so, they enabled the severely affected banks to focus on managing the ‘good’ assets without the non-performing ones dragging them down.

In contrast, the US model involved a purely private bad bank. Grant National Bank was set up by the former Mellon Bank Corporation ('Mellon Bank') in 1987. It was privately funded by US $123m from Mellon Bank and US$513m by short-term bonds sold by Drexel Burnham Lambert (a private investment bank).[3] All troubled assets were then sold by Mellon Bank to Grant National Bank with a five per cent write-down, after which Grant National Bank worked on managing and liquidating these assets.[4] This improved Mellon Bank’s loan portfolio and boosted investors’ morale. On fulfilling its mandate, Grant National Bank was wound up in 1995.

India: stimulating a fresh start

Various stakeholders have initiated debates at different times on establishing of a bad bank/national asset reconstruction company to address the omnipresent issue of non-performing assets, which plague India’s finance sector. A couple of years ago, under Project Sashakt, a proposal was submitted for setting up a three-pronged resolution model for bad loans above INR 5bn (approximately US $66.75m). A similar approach has now been proposed by the Indian Banks’ Association, involving: the sale of troubled assets to the government owned asset reconstruction company; the management of the assets by an asset management company with participation from both public and private entities; and the subsequent sale to sector specific private alternate investment funds (AIFs).[5] The initial capital requirement for setting up of the asset reconstruction company and an alternative investment fund is estimated at approximately INR 100bn. Furthermore, the non-performing/risky assets are to be purchased at book value.[6]

Some critical issues to be ironed out before the Indian Bank Association’s proposal can reach fruition include:

  • Whether sale of loans which are undergoing investigations on account of fraud should be permitted? According to us this should be allowed. The ultimate aim is to clean the books of banks and therefore all kinds of bad assets should be permitted to be transferred.
  • Would the estimated returns from the bad loans justify their purchase at book value? It is better that the purchase should be on market value rather than book value.
  • The model is based on public acquisition of the bad loans but subsequent private purchase and management. How will the returns generated from the bad loans be equally distributed among the investors, originating banks and the government agency? Our view would be that the return will be directly linked to investment. Management fee would be on an ‘arm’s length’ basis.
  • Will the stability of this model be ensured by appropriate regulations and legislations? If the model is successful elsewhere, this may also be successful in India, provided legislation and regulations are created to augment its ultimate aim.

Concluding remarks and recommendations

A plethora of literature has been published on bad banks, with a common thread running through most: the importance of revitalising the banking sector through establishment of accountable and efficient institutions and bipartisan support for such measures. As effusive as that may sound, countries such as Sweden, where bad banks have been a resounding success, offer sufficient proof of the positive impact of such bad banks. Political cohesion and a bureaucratic structure with minimum corruption is one of the major reasons for success of the Swedish model.[7] Fair division of returns among the public and private power structures will be an efficient approach to resolve the problem of bad and troubled loans permanently.

Below is a sample structure on the lines of the Swedish model, which could be adopted in India.

 

 

The bad bank would function on a public-private partnership model, with the returns obtained from isolated bad loans distributed among the public and private shareholders. Furthermore, a guarantee may also be provided by the government to the deposits and loans under the ‘good’ bank, to maintain/rebuild the bank’s reputation. Private investment in the bad bank can be exacerbated through majority shareholding by government or government agencies in the bad bank. A single bad bank may not be the right approach for a vast and complex economy such as India, and it may be necessary to establish three or four such institutions.

Notes

[1] Spyridon Repousis, ‘“Bad Bank” Strategy in Greek Banking Sector and Receivables from Banks under Liquidation’, International Research Journal of Finance and Economics, Issue 162, July 2017.

[2] Panagiotis Liargovas’ and Spyridon Repousis, ‘Is a “Bad Bank” Solution for a Possible Future Greek Banking Crisis? ’in Panagiotis Liargovas (ed), Greece: Economics, Political and Social Issues (Nova Science Publishers, 2012).

[3] Morrison Foerster, ‘Good Bank-Bad Bank: A Clean Break and A Fresh Start’, 18 February 2009, available at: https://media2.mofo.com/documents/20090218goodbankbadbank.pdf, last accessed 18 July 2020.

[4] Ibid.

[5] Ritu Singh, ‘Indian Banks Association submits “Bad Bank” proposal to government, RBI’, CNBC TV18, 2 May 2020, available at:

https://www.cnbctv18.com/finance/iba-submits-bad-bank-proposal-to-government-rbi-5901621.htm, last accessed 18 July 2020.

[6] Ibid.

[7] Ibid n 2.