Will a bad bank fix India’s broken banking system?

Synopsis: Last month, the Union government set up the National Asset Reconstruction Company Limited (NARCL) under the Companies Act. Two experts, Ajit Ranade  and C.P. Chandrasekhar, discuss the bad bank proposal. We list out the key points.

What is the need to bail out banks? 

There are many reasons to bail out banks.

– One is the fact that interests of the depositors is involved here. If we allow banks to fail, depositors who operated under the presumption that the regulatory framework would protect their money would be undermined. Historically, we’ve found that central banks try to actually save banks, either by bailing them out or by amalgamating them with stronger banks, in order to be able to protect depositors.

– Two, there is a systemic problem. If a bank fails, and there is a sort of contagion effect, we could actually have systemic problems. Banks are the core of the settlements system and the credit structure and allowing them to go down would be a problem.

– And finally, there is also the option of getting banks to write off these bad assets and then the government can recapitalize them. But that would deal a significant blow to the government’s finances.

Isn’t there the risk of moral hazard linked with bailouts, which makes banks more complacent?

We need to compare the risk of moral hazard of bailing out banks versus the impact that bank failures would have on depositors and the social and political implications of it.

Why has the government opted for a bad bank over directly infusing capital into banks?

It’s important that these bad loans be moved to a separate entity which is exclusively focused on recovery, so that the bank can then focus on its core business, which is business development, giving new loans, credit growth, etc.

Also, for their growth, banks will need to be infused with additional capital to achieve the credit growth needed to get to 7-8% GDP growth. So, the government will continue to pour more capital into banks, while bad loans will be moved to a separate entity.

Does the bad bank proposal actually address the root causes of the banking crisis or is this just a temporary band-aid?

The fact is that over the last few years, the NPA ratio has been mounting, and we’ve tried many things. In that sense, the bad bank is taking a small chunk out of the overall NPAs to keep the problem within manageable proportions.

Source: This post is based on the article “Will a bad bank fix India’s broken banking system?” published in The Hindu on 8th Oct 2021.