Late last week, interim finance minister Piyush Goyal announced that a committee has been formed to explore setting up an asset reconstruction company (ARC) to take over bad loans of public sector banks.

[Read: Govt mulls new mechanism to resolve bad loan problem of banks https://www.fortuneindia.com/macro/govt-mulls-new-mechanism-to-resolve-bad-loan-problem-of-banks/101979 ]

The ARC way of troubleshooting the non-performing assets (NPAs or bad loans) problem could well be compared to the TARP (Troubled Asset Relief Program) strategy that the U.S. adopted in the aftermath of the global financial meltdown. In October 2008, the U.S. Treasury had “established several programmes under TARP to help stabilise the U.S. financial system, restart economic growth, and prevent avoidable foreclosures”. Initially authorised for $700 billion, the TARP ran as a collective programme worth $475 billion until October 2010.

But, will the TARP-like programme help Indian public sector banks (PSBs)? ARCs are not unknown players in India—the government-backed ones and those from private sectors had failed to take off in their early years. The reason: Banks, in general, were hesitant to take haircuts on the loans that were to be sold to the ARCs. It is only now that ARCs are proving to be thriving businesses.

Bad loans have been fast piling up at PSBs in the recent year.

At the end of FY17, gross NPAs at PSBs added up to Rs 6.84 lakh crore, and they are estimated to be at Rs 10.17 lakh crore at the end of in FY18. The ratio of gross NPAs to gross advances at State Bank of India (SBI)—including its erstwhile associate banks—grew from 2.56% in FY09 to 9.11% in FY17; the ratio at the remaining PSBs rose from 1.75% to 12.95% in the same period.

The government has pumped in Rs 2.02 lakh crore across 21 PSBs between FY09 and FY18. Interestingly, this value is equivalent to 84.29% of the total disinvestment proceeds of Rs 2.4 lakh crore garnered by the government in the same period.

The large quantum of recapitalisation, when greeted by PSBs with higher NPAs—related provisioning—and losses, gives enough reason to ponder if successive governments use taxpayers’ money to bail out an increasingly inefficient public banking system.

SBI, IDBI Bank, Bank of India, Central Bank of India, and UCO Bank were cumulatively recapitalised to the extent of Rs 1.03 lakh crore, accounting for 17.68%, 10.40%, 9.15%, 7.61%, and 6.34%, respectively, of the total recapitalisation amount.

[Read: Public sector banks and the ‘scam cess’ - https://www.fortuneindia.com/macro/indias-scam-cess/101907 ]

Given that these five accounted for 51.17% of the recapitalisation between FY09 and FY17, the belief of taxpayers paying what is popularly called “scam cess” gets stronger. Interestingly, the scam-hit Punjab National Bank immediately follows the top five, with recapitalistion of Rs 12,774 crore—accounting for 6.32% of the total recapitalisation amount.

The question, though, is how will the new ARC or asset management company (AMC) be funded?

Welcoming the move by Goyal to set up a committee to deliberate on forming the proposed ARC, Indranil Sen Gupta, economist and co-head, India research at Bank of America Merrill Lynch, wrote in his June 11 note that the move supports his bank’s standing call that “market concerns over public sector bank capital are overdone as the government is fully incentivised to address their asset quality issues”.

Sen Gupta sees the funding as a three-step process. One, the government will have to recapitalise PSBs to expand their ability to lend/invest. “The key advantage is that Rs 1 of capital pushes up loan supply by Rs 11 at, say, 9% capital to risk-weighted assets ratio (CRAR),” notes Sen Gupta.

Second, banks would transfer their stressed assets to the proposed ARC at a suitable haircut and securitise the balance NPAs into ARC/AMC paper to seed them. This would result in the bad loan exposure being replaced by securitised paper issued by the proposed ARC/AMC.  “The ARC/AMC could extinguish such paper as and when it is able to restructure/sell the NPL (non-performing loans), or, raise funds from the market,” Sen Gupta says.

And, finally, the Reserve Bank of India (RBI) will have to step up open market operations to cool yields and reverse lending rate hikes to prevent further slippage in bank quality. According to Sen Gupta, Rs 1 of RBI liquidity boosts loan growth by Rs 5. “Higher credit supply lowers rates, pushes up demand, strengthens corporate balance sheets and improves bank asset quality,” Sen Gupta adds.

While Sen Gupta believes that the NPA problem is of cyclical nature, there are high hopes that the tweaked and re-tweaked Insolvency and Bankruptcy Code (IBC) will help banks pare NPAs and help bring back gravitas to the public sector banking space..

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