Does India Really Need A Bad Bank?

Dr. Raghuram Rajan, the immediate previous Governor of the Reserve Bank of India began a bold task in the last year of his tenure, that to clean up bank balance sheets. Indian banks have been facing a grave issue of rising Non-Performing Assets (NPAs), since the last five years now. The reasons behind this phenomenon are multi-faceted. When Indian firms were experiencing robust growth in the middle of the first decade of 2000, they borrowed in order to increase capacity. The economy was on a sweet spot with high growth and low inflation, and hence low interest rates. This encouraged banks to lend, with no fear of defaults, and rise in potential revenue streams. Most of these loans went out to the Infrastructure sector, mainly power.

In came the 2008 Global Financial Crisis and there was a fear of the run of the banks turning into a run on the banks. The RBI had to take innovative and extraordinary policy measures to ensure that did not happen. Slowly, but steadily, India started experiencing double digit inflation. Aggregate demand fell, rendering the excess capacity installed by companies to be idle. The hit in revenue of companies reflected in their balance sheets. The loans they had accumulated started to look unsustainable, mainly due to two reasons. Firstly, RBI increased interest rates to combat double digit inflation, making loan instalments expensive. Secondly, this same double digit inflation was hurting sales, and hence profits. This reflected in the banks’ balance sheets as NPAs increased. This has been widely discussed in this year’s Economic Survey of India, as the twin Balance Sheet problem.

The solution to this problem, Public Sector Asset Rehabilitation Agency (PARA), or in layman language, a Bad Bank. This formal agency will take care of the bad assets of the Public Sector Banks (PSBs), the ones majorly affected by NPAs. PARA will be responsible for converting this debt of companies who’s loans have gone bad into equity, and to sell this equity at a loss, minimizing the same. The question to be asked is, is PARA really needed in India? My answer is no.

PARA maybe a noble idea, but it may not hit the nail right on the head. The inflation scenario has now changed, with the RBI largely successful in controlling it to the targeted sub-four percentage levels. The rupee is not depreciating out of control either. India’s macroeconomic conditions are better than any other emerging market economy. There has not been a run on any of the banks. What a PARA will do, along with recapitalisation of PSBs is give them a free hand at lending bad loans to big and wilful defaulters. The rise in NPAs has majorly affected honest loan-takers, as the banks have been hesitant in giving loans to them due to fear of default.

Banks should be more careful while screening loan applications and lend prudently. The major issue, that of the aggregate demand needs to be addressed, now after inflation has been tamed in order to build up companies’ balance sheets back to normal, fueling sustainable growth. A PARA  will only make banks stress-free lenders as they know the bad loans will eventually be taken care of. PARA will take away accountability from individual banks about the quality of loans they sanction. The Government needs to go to the root of the problem and solve it, rather than simply fictitiously showing it to be getting solved.

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