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Bad Banks: A Step Towards Reviving Public Sector Banks

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Bad Banks: A Step Towards Reviving Public Sector Banks

By: Tavaga Research

The concept of Bad Banks and discussions around how they would help both Private and Public Sector Banks (PSBs) with the non-performing assets on their balance sheet have been making the rounds since the Covid-19 pandemic halted the majority of the business operations across the globe.

The Bad bank concept

In the latest budget presentation in February 2021 for FY22, the Finance Minister, Nirmala Sitharaman announced that in order to take over the non-performing loans existent on the balance sheets of public sector banks and to structure them, the government would set up a bad bank i.e. an asset reconstruction company and an asset management company like structure.

This move will help the government deal with the pile of bad loads that continuously manage to hinder the performance of the banking sector especially Public Sector Banks.

Bad bank meaning – What is a bad bank in India?

A Bad Bank essentially would buy bad loans and illiquid holdings of banks and other struggling financial institutions, thereby helping these institutions in clearing and having a stronger looking balance sheet. It is said to enhance the functioning of the IBC (Insolvency and Bankruptcy Code) by making sure the reason behind loans going bad, whether due to financial or economic stress, and how the issue could be resolved.

These bad banks usually take the non-performing loans of banks at a discounted price and manage them like how an asset reconstruction company does.

Why do we need a bad bank?

Net NPAs (in Crores)
Source: RBI, Tavaga Research

Non-performing loans in India had been increasing till 2018, and have shown an improvement in the last couple of years, namely 2019 and 2020. These non-performing loan numbers, as can be seen in the above chart, have been visibly high for public sector banks.

However, with the onset of the pandemic, the RBI provided a moratorium on all loan repayments. It also allowed a loan restructuring program that was extendable for two years.

The bad-loan ratio for Indian banks is expected to rise to 13.5% by September 2021. Non-performing or bad loans, drag the performance of the bank down, by increasing their illiquidity and the riskiness associated with their loan portfolios.

To counter this situation, banks belonging both to the private and the public sector, have been making provisions to cope with the possible increase in the gross and net NPAs on the balance sheets of their respective banks.

Banks were known to have set aside Rs. 13,653 crores as provisions towards the deferment of loan repayments and the moratorium scheme. With the economy reviving, activities slowly moving back to their pace before the pandemic, and the strengthening of demand in urban areas, lending activities have also seemed to pick up.

Lending activity in India over the years

India'slending activity (YoY)
Source: investing.com, Tavaga Research

The lending activity in India, as is seen in the above chart has shown a rising trend between 2017 – 2019, followed by the fall in the same during Q1FY21 owing to the Covid-19 crisis hitting businesses of various sizes be it large organizations or MSMEs.

MSMEs especially had been making great progress in terms of their reach and enhancing production capacities. Although borrowing by people and businesses is slowly increasing, banks are bound to be cautious of the heavyweights named NPAs, that affect their profitability and overall financial position.

How would the bad banks help?

Bad banks, essentially being banks with a lot of bad assets on their balance sheet to start with, would be able to help out public sector banks, who bear the greater brunt of a higher percentage of non-performing loans on their balance sheet. Post the pandemic, banks are expected to see a deterioration in the quality of loans they have given out in the past, which would increase the importance of the existence of a bad bank.

Bad banks function as asset management company, and help commercial banks with the cleaning up of their balance sheets and resolving their bad loans. The taking over of bad loans would be at a discounted rate and the bad bank would try to recover as much as they can from the recovery processes that they follow.

These bad banks would help in speeding up the process of restructuring loans and emptying up capital that can be utilised by the struggling bank in profitable businesses.

Bad Bank vs ARC (Asset Reconstruction Company)?

The bad bank would follow the model of an Asset Reconstruction Company itself. The ARC would buy the NPAs from the banks and just like an Asset Management Company, help in turning these bad loans around.

What are the downsides of having a Bad Bank?

Although this would go against the due diligence measures taken by banks while carrying out their lending activities, one might say that one of the drawbacks of having a Bad Bank in the picture would be complacency on the part of the lender.

Considering they would have an option of giving away their bad loans to free up their capital, a little negligence on the part of the banker could result in even bigger piles of NPAs on bank balance sheets.

How would bad banks and divestments work together?

The government has been aiming at privatizing/disinvesting the operations of two public sector banks in the upcoming financial year 2021-22. However, when one talks about privatization, the first question that would come to anyone’s mind would be, why would a private sector bank with a healthy and steadily growing strong balance sheet, want to invest in a public sector bank that has a pile of NPAs on its financial statements?

Privatization of Public Sector Banks can thus be a challenge, considering the expected growth in NPA ratios in the coming fiscal. Here is where the benefit of having a bad bank in the picture comes into play. If the bad loan accounts of these Public Sector Banks are taken away from their books, then will it make sense for a Private Bank to invest in such an entity.

Banks that have previously lost their value due to high NPAs

Bank Of India

Bank of India founded in 1906, is headquartered in Mumbai.

Bank of India share price
Source: investing.com, Tavaga Research

The share price for Bank of India reached an all-time high of Rs. 558 in October 2010, post which, its price has been continuously falling. The main contributor to this fall in the share price, thus the value of the bank has been their high non-performing loans’ levels.

Bank of India Net NPAs
Source: RBI, Tavaga Research

Bank of India’s share price as of today, stands at around Rs. 60 per share showing the huge fall from its all-time in the upper Rs. 500s per share. If this bank were to be privatised, it would be difficult to find a willing investor to take up a controlling stake in the bank with an NPA heavy balance sheet.

If before that, a Bad Bank were to take over these NPAs, the capital infused could be reinvested by Bank of India in its more profitable businesses.

Punjab National Bank (PNB)

Punjab National Bank, another Public Sector Bank founded in 1894, is headquartered in Delhi. The share price for Punjab National Bank stood at around Rs. 237 per share in April 2011, which in January 2021 stood at around Rs. 33 per share.

PNB Share Price
Source: investing.com, Tavaga Research

Over the years, Punjab National Bank has seen a steady fall in their share price along with an increase in their net NPAs as can be seen in the chart below:

Source: RBI, Tavaga Research

The spike in NPAs for Punjab National Bank can be seen in FY 2018, where the bank disclosed a fraud worth Rs. 11,400 crore associated with Nirav Modi and bank guarantees issued to his group of companies without proper documentation. Such recoveries take time, especially when the transactions are of high value.

Union Bank of India

The Union Bank of India was established in 1919 and is headquartered in Mumbai. Like the two above mentioned banks, the share price for the Union Bank of India has been falling considerably over the years. The share price stood at roughly around Rs. 320 in April 2011. Now, it trades between Rs. 30-33 per share.

Source: investing.com, Tavaga Research

The non-performing loans for the bank have been growing over the years. As can be seen in the chart below, the gradual increase in NPAs has been complemented with a decline in the share price of the bank.

Source: RBI, Tavaga Research

Thus, these banks would be the most benefitted with the establishment of a Bank Bank, to bring in efficiency in operations and an increase in profitability.

Who can set up a Bad Bank in India? – Latest Bad bank news

The Government and the Reserve Bank of India have to agree to set up a Bad Bank in the form of an Asset Reconstruction Company to take care of the mounting amounts of NPAs in the banking industry in India.

The Central Bank recently agreed with the idea of creating a Bad Bank and said that, in case of a proposal to create the same, regulatory guidelines would be put in place.

To conclude, bad banks when introduced, would be beneficial in improving several factors for Public Sector Banks. In addition to bringing about more profitability in their operations, the capital that was previously stuck in the bad loans would be realized and could be used to lend out to more profitable projects, there would be more money in circulation in the system which would prevent lending rates from going up. Furthermore, shareholders and depositors of banks would not be worried by the worsening financial position of banks.

Disclaimer: The above analysis is only for informational purposes. Do not consider it as a stock recommendation.

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