EconomicsRudra N. Dubey

Bad Bank : Reconstructing the Reconstructors

Bad Bank

Reconstructing the Reconstructors: The future of Indian Banking

Krishnamurthy Subramanian quoted “India can’t become the third-largest economy
with the health of the banking system that it has”.Well, the health of the banking
system is like a patient who was ill for a long time and now the conditions became
even worse as it’s infected with the coronavirus. The conditions are deteriorating
continuously but he’s still not getting the proper treatment as doctors believe that
he’ll eventually get immune.

In the current scenario, RBI and the government are the doctors and the patient, as
we all know is the Indian banking system. Even the reports given by the doctors(RBI
and government) states that the deterioration would continue, as according to the
financial stability reports given by the RBI, bad loans could rise from 8.5% in March 2020
to 12.5% by March 2021 under the baseline scenario and by 14.7% if the stress is
severe, which is inevitable unless a miracle happens. The patient is urging for
proper treatment as he knows that getting immunity to fight the virus and eventually
beating it can’t be done without the help of doctors, as bankers warn that businesses
may not be able to square their positions by March 2021 due to continuous delay in
demand resumption and as a consequence, bankers assert that it’s going to be very
tough to get moratorium dues by March 2021, which would lead to the proliferation of
bad loans and this proliferation might freeze the whole banking system. The
patient, though unintentionally, is infecting the whole community, and the infection
would surge if not given the proper treatment asap, here the community refers to
the Indian Economy.

In order to prevent the worsening of the conditions or even freezing, the government
has taken various steps over the past few years which mainly included capital
infusion, but at this particular point in time, there’s a need for concrete measures
and one measure which I personally believe would be insanely effective(if managed
properly) would be the establishment of a ‘bad bank’. Recently the IBA has drafted a
proposal for setting up PARA (Public sector asset rehabilitation agency), and in the
simplest of terms, PARA would be an asset reconstruction company funded and
managed by the government. Bad banks have previously been set up in various
developed countries like U.S and Sweden and they’ve worked quite well there. In the
current scenario I don’t believe there’s a better solution than setting up a specialized
entity focusing only on one issue – recovering as much as possible and letting the
banks do what they’re supposed to do especially in a crisis- LEND. It will also reduce
the burden on the already stressed IBC.

Well, as Friedrich Hegel famously quoted that every thesis has an antithesis, unfortunately, this proposal has many. There are various rational arguments against it but the strongest one is the issue of ‘moral hazard’ which has been highlighted by various prominent economists including Raghuram Rajan, as they assert that it would give an incentive to the banks to again start the process of reckless lending, which initially caused the illness! An alternative for this would be an efficient market for
asset reconstruction with private asset reconstruction companies completing against
each other, but in such an environment, making the asset reconstruction market
efficient again would take ages.

My interpretation of the moral hazard argument suggests that there has to be a fundamental change in the banking system to stop the practice of reckless lending, so that the system won’t suffer from the same illness in the post-covid era. The possible and effective solution to stop this phenomena of reckless lending would be ‘RING FENCING’.

In 2012, the Vicker’s Commission was formed in the UK to recommend the measures for
the future of banking in the UK after the crisis. The commission recommended that the
retail operations of the banks should be ring-fenced. The idea of ring-fencing is to
take all the retail loans and retail deposits and allocate some of the bank’s capital
dedicated to deposits and some of the reserves to retail loans and ring-fence it, so
that all the other activities of the bank like trading assets, wholesale borrowing, etc
would have its own separate capitalization. So even if the banks lose a lot of money
or fail in other activities like trading assets, wholesale borrowing, etc, the part of retail
deposits and loans would be legally separate and due to the allocation of capital to
these loans and demand deposits. So, the state, taxpayers, and the government would be less
on the hook as there will be more of a buffer capital to absorb.

So, after the crisis, there should be a new round of regulation in the Indian banking system which would
require the banks to raise more capital against the more risky part of the portfolio
and as a direct consequence, the reckless lending practices which initially led to the
the crisis would reduce as stopping irrational elasticity in the post-crisis era is as
important as providing elasticity during the crisis because too much elasticity
eventually leads to crisis. This could be the future of the Indian banking system after the
crisis. An article in Financial Times stated that due to the new round of regulation in
Europe(same regulation mentioned earlier, requiring the banks to raise capital for
allocation especially against the more risky part of the portfolio) stated that the
European banks were racing to deleverage the loans which were losing their value, by
trying to pack some of them together and securitize some and selling the rest of
them to private asset reconstructors for cash.

If the same thing happens in India in the post covid or crisis era, it will yield highly
effective results.

  • First, the banks, due to the regulation, would eventually reduce the
    reckless lending practices.
  • Second, due to ring-fencing, the interests of depositors and the government would be safeguarded.
  • Third, optimistically saying, if due to the regulations, banks would start selling the loans which are losing their value for cash at reasonable prices, banks could use this cash for paying out its borrowings(short term debt, debt from RBI, etc), this practice would clean their balance sheets and the banks could start fresh off for their new market-making activities.
  • Fourth, being optimistic again, as happened in Europe due to the regulation, the number of sellers in the asset reconstruction market would increase in the post-crisis era when markets would be
    up again, and as sellers increase, the buyers would ultimately emerge. This would lead to the alternate solution of the government-funded bad bank – Reconstruction of the reconstructions, making the asset reconstructing market efficient again.
  • Fifth, even if the next crisis occurs(which is inevitable), banks would hold enough capital to lend
    and absorb losses. Bank of England’s Financial Policy Committee initially supports the
    statement as FPC’s financial stability report suggests that the banks have enough
    capital and have the capacity to be the ‘savior’ by lending country’s compliances
    and absorb billions in losses which is likely to arise due to the pandemic (when the
    regulations were imposed Britain was a part of the European Union)

The regulations would undoubtedly yield highly effective results in the long run and
could be the future ahead. The only condition for yielding the results would be
proper management of the bad bank and unlike other laws, strict and efficient
implementation of the regulation.


This article represents the personal views of the author Rudra N. Dubey and is authorized by the administrator.

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