Bad bank, good move

Description

Context:

Indian banks were written off in the early days of the pandemic when there were expectations of an exponential jump in non-performing assets.
This worry continued well into the third quarter of the year. It was, however, only after the banks, in their forward guidance, consistently talked about the lower number of restructuring requests, and the higher provision coverage ratios that the markets began to get convinced.

Reasons:

First, banks in India and globally were much better capitalised prior to the pandemic.
Second, Indian banks had built up a sizable buffer to provide for bad assets negating any surprise on balance sheets during and even after the pandemic.
Third, independent research shows that as the size of the middle class grows to about two-thirds of Asian households, on the back of a steady rise in disposable income, personal financial assets in Asia will reach about $69 trillion by 2025 — approximately three-quarters of the global total.
Fourth, Indian banks and the RBI brought about financial discipline much before the pandemic to make borrowers realise that timely payments of interest and instalments were necessary and that any breach would affect their ratings and the pricing of loans. For example, units with high leverage were advised to reduce their debt levels in a time-bound manner. All these factors thus corroborate the view that the current exuberance in the Indian financial sector is no flash in the pan.

Recent budget announcements:

The most important budget announcement is in line with global practices — the creation of a bad bank under an Asset Reconstruction Company (ARC)-Asset Management Company (AMC) structure, wherein the ARC will aggregate the debt, while the AMC will act as a resolution manager.
The proposed structure envisages setting up of a National Asset Reconstruction Company (NARC) to acquire stressed assets in an aggregated manner from lenders, which will be resolved by the National Asset Management Company (NAMC).
A skilled and professional set-up dedicated for Stressed Asset Resolution will be ably supported by attracting institutional funding in stressed assets through strategic investors, AIFs, special situation funds, stressed asset funds, etc for participation in the resolution process.
The net effect of this approach would be to build an open architecture and a vibrant market for stressed assets.

Way Forward:

There are several international success stories of a bad bank accomplishing its mission and there is no reason to believe why India cannot accomplish its objective.
The current Indian approach will drive consolidation of stressed assets under the AMC for better and faster decision making. This will free up management bandwidth of banks enabling them to focus on credit growth, leading to an enhancement in their valuations.
Given that the governance of the AMC and its independence is central to its successful functioning, there are multiple suggestions to make.
These include keeping majority ownership in the private sector, putting together a strong and independent board, a professional team, and linking AMC compensation to returns delivered to investors.