A Bad Bank to Save the Banking Sector?

Mon, 22 Feb Pre-Open

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India's public sector banks (PSBs) are in a complete mess. Their balance sheets are filled with toxic non-performing loans. Some of these will not be repaid. They received a lot of leeway to deal with this. But the problem just kept getting bigger. Finally, the RBI cracked the whip. It forced PSBs to declare the full extent of its NPA problem. And provide adequate coverage for it.

The result of this exercise, known as the Asset Quality Review (AQR), is now out in the open. PSBs reported monumental losses for the December 2015 quarter. There will be more pain to come at the time of the annual results in April-May 2016. But will that be the end of their worries? Will PSBs become healthy again quickly? We don't think so.

RBI governor Rajan has given a deadline of March 2017 for the completion of this clean-up operation. But we have good reason to be sceptical. PSBs function more as a lending arm of the government, than as professional banks. The mismanagement of these institutions defies belief. We all know what the problems are. Corruption, inefficiency, and lack of independence are just some the big ones. They have social obligations too.

But the rot runs much deeper. We believe the sheer scale of the NPA menace is just too big to be solved quickly. Drastic measures will be needed. The government is thinking of one right now. It's called the 'bad bank' solution. The so called 'bad bank' will be a new financial institution. It will take over much of the NPAs, if not all of it. Of course, it will be fully backed by the government. This will help PSBs clean their books quickly.

Now there are some serious problems with this. Firstly, the NPAs won't go away. They will be merely transferred to the 'bad bank'. This new financial institution will still have to recover these loans. If it can't, will the tax payer be called upon to bail it out? As per an article in the Business Standard, no seems to be the answer. The PSBs will still bear the burden. If that's true, how can they start to confidently lend again?

Secondly, what happens when the PSBs start lending again? Won't they make more bad loans? They will if the managements are not free from political interference. To these, we can add the problems of low salaries and poor corporate governance.

We are not pessimists. We are not dismissing the 'bad bank' idea. It may turn out to be a good decision. But it will be a long drawn out process. There will be several hurdles to overcome. Considering the size of the NPA problem, we believe will be a slow road to recovery for PSBs.

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