The political economy of India’s bad bank

Rohan Chinchwadkar

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A bad bank should not get labelled in public discourse as a government ‘bailout’ of crony capitalists

The idea of setting up a centralized public asset management company (PAMC) or “bad bank” to solve the problem of stressed loans is gathering steam. The Economic Survey 2016-17 proposed the setting up of a public sector asset rehabilitation agency (PARA), which is essentially a centralized bad bank. In a recent speech, Reserve Bank of India (RBI) deputy governor Viral Acharya said there is a “sense of urgency” to decisively resolve Indian banks’ stressed assets. One of his proposed solutions is the creation of a PAMC for sectors in which assets are economically unviable in the short-to-medium term, like the power sector. A day after the speech, chief economic adviser Arvind Subramanian re-emphasized the need to create a bad bank “quickly”.

However, the Union finance minister seems relatively less enthusiastic. In a post-budget interview, he said a bad bank is a potential solution but it cannot be supported by the government alone. He also said that he won’t be able to comment on what solution will eventually emerge. What explains this difference in enthusiasm? The reasons might lie in India’s political economy.

First is the impact of bad bank funding on macroeconomic stability. The finance minister has committed to a fiscally balanced budget with a fiscal deficit target of 3.2% for 2017-18, government-debt-to-gross domestic product (GDP) target of 60% by 2023 and net market borrowing target of Rs3.5 trillion in 2017-18. These commitments do not account for bad bank funding.

The Economic Survey has suggested the use of government debt and RBI’s equity capital for funding PARA. The survey argues that the burden is already on taxpayers since most of the Rs6 trillion stressed assets are in public sector banks.

But the creation of a bad bank puts a strain on government finances in the short term. Even if the government funds only 20% of stressed assets in the banking system, it would exceed the net market borrowing target in 2017-18 by more than 30%. Achieving committed targets for fiscal deficit and government-debt-to-GDP also becomes difficult for the finance minister.

Apart from that, many stakeholders have been sceptical of using the RBI’s equity capital to fund the non-performing assets (NPAs) of public sector banks.

Second, and arguably the more pressing issue in the current context, is the question of public perception and potential damage to the government’s reputation. In 2015, EY, formerly known as Ernst & Young, released a survey of bankers from public, private, foreign and cooperative banks. The survey reported that 87% of the respondents believe that the rise in NPAs is due to fraud or diversion of funds to unrelated businesses. In July 2016, the comptroller and auditor general of India, Shashi Kant Sharma, said that a significant portion of banks’ NPAs was a result of loans obtained by fraudulent methods. This raises questions on the governance practices of public sector banks and the probity of defaulting borrowers, and needs further investigation.

Even if the government funds only 20% of stressed assets in the banking system, it would exceed the net market borrowing target in 2017-18 by more than 30%

Acharya has suggested that the hair cuts taken by banks under a feasible plan should be required by government ruling as being acceptable to the vigilance authorities. If the government shields bankers from vigilance inquiries, it risks a dent in its reputation. It might be seen as helping crony capitalists and corrupt bankers.

Also, since stressed assets are heavily concentrated in large borrowers like Vijay Mallya, opposition parties will be quick to call it the “NPA scam” and raise suspicions on the broader initiative of the bad bank.

Instead, the government can boost its reputation by ensuring that bankers and borrowers involved in fraud are brought to justice. The “Swachh Banking Abhiyan” can be an extension of Prime Minister Narendra Modi’s “Safai Abhiyan” against black money. At the same time, stressed assets can be priced in a transparent manner based on project cash flows. It is essential to separate vigilance inquiries for fraud from the pricing of stressed assets.

Apart from politics, the finance minister has a clear macroeconomic incentive to protect the reputation of the government. One of the main reasons for the massive flows of foreign capital into India is the clean reputation of the current government. If there is a dent in that reputation, it might significantly reduce future foreign capital inflows and affect India’s macroeconomic stability.

A ’Swachh Banking Abhiyan’ can be an extension of Prime Minister Narendra Modi’s ‘Safai Abhiyan’ against black money

The reputation factor also makes the problem of bad bank funding worse. Due to the fear of vigilance inquiries, bankers will be reluctant to sell stressed assets to the bad bank at a substantial hair cut. In that case, the bad bank has to pay more to acquire the assets and thus increase the funding burden on the government.

Macroeconomic and political viability will be a key consideration in the implementation of the bad bank. It is great that the government is eager to clean up the NPAs in the banking system and clear the way for higher growth and employment.

But solutions to the NPA problem will have to be designed keeping in mind the political economy of India. Regular communication about ongoing efforts to bring fraudulent defaulters to justice can help in boosting confidence in the bad bank initiative. In order to make the bad bank a viable solution, the government and the RBI will have to ensure that it does not get labelled as a “bailout” of crony capitalists and corrupt bankers at the cost of taxpayers.