The creation of a 'bad bank' will speed up resolution of stressed assets in the banking system, but it will also require significant capital infusion in the state-run banks to meet any shortfall, says a report.
The recent economic survey mentioned about formation of a bad bank that will purchase stressed assets and take them to resolution.
"The creation of a 'bad bank' could accelerate the resolution of stressed assets in country's banking sector, but it may face significant logistical difficulties and would simultaneously require a credible bank recapitalisation programme to address the capital shortfalls at state-owned banks," international agency Fitch Ratings said in a report here today.
It said the country's banks have significant asset quality problems that are putting pressure on profitability and capital, as well as constraining their ability to lend.
It expects the stressed-asset ratio to rise over the coming year from the 12.3 per cent as at end-September 2016, with the ratio significantly higher among state-owned banks.
The rating agency said the banking sector will require around USD 90 billion in new total capital by financial year 2018-19 to meet Basel III standard and ongoing business needs.
This estimate is unlikely to be significantly reduced by the adoption of a bad-bank approach, and could even rise if banks are forced to crystallise more losses from stressed assets than currently expected, it said.
"We believe that the government will eventually be required to provide more than the USD 10.4 billion that it has earmarked for capital injections by the financial year 2018-19 - be it directly to state-owned banks or indirectly through a bad bank," the rating agency said.
It said bad bank's most likely form would be that of a centralised asset-restructuring company (ARC).
Bad bank's proponents believe it could take charge of the largest, most complex cases, make politically tough decisions to reduce debt, and allow banks to refocus on their normal lending activities, it said.
Fitch said similar mechanisms have previously been used
to help clean up banking systems in the US, Sweden, and countries affected by Asian financial crisis in the late 90s.
Senior European policymakers have recently discussed prospect of a bad bank to deal with NPLs in the EU, it said.
The agency believes that a bad bank might provide a way around some of the problems that have led the country's banks to favour refinancing over resolving stressed loans.
The report said large corporates often have debt spread across a number of banks, making resolution difficult to coordinate and the process would be simplified if the debt of a single entity were transferred to one bad bank.
"This could be particularly important in the country's current situation, with just 50 corporates accounting for around 30 per cent of banks' stressed assets," it said.
Several small private ARCs already operate in the country but they have bought up only a very small proportion of bad loans in the last two years, as banks have been reluctant to offer haircuts on bad loans even where they are clearly worth much less than their book value, it said.
"This is, in part, because haircuts invite the attention of anti-corruption agencies, making bank officials reluctant to sign off on them," it further said.
According to the rating agency, a larger-scale bad bank with government backing might have more success.
It is, however, unlikely to function effectively without a well-designed mechanism for pricing bad loans, particularly if the intention is for bad bank to be run along commercial lines and involve private investors.
"Banks would need capital to cover haircuts taken during the sale of stressed assets, and the bad bank would most likely require capital to cover any losses incurred during the resolution process," the report added.
