Ignoring the Only Solution: A Bad Bank Structure in India

"IF YOU owe a bank a hundred dollars, it is your problem. If you owe a hundred million, it is the bank’s problem. If you are one of many tycoons borrowing billions to finance dud firms, it is the government’s problem.

That is roughly the situation India finds itself in today. " - Economist.com

As originally feared, the game of pretending that the bad loan problem will disappear beyond the horizon on one fine sunny morning has come to nought- it always does- Japan 1980-90, China late 1990's, Spain 2010. The mega Bank recapitalization funded by the Tax payers of India in favour of ailing Public Sector Banks has been a part of this perpetual 'pretending to see the horizon' mode that has engulfed hapless policymakers- but alas, not even 3 quarters have elapsed and all the money is 'gone'; even before it has actually come in!

Now we are at another decision point. After already having made the folly of extending and pretending, India is again pondering the future course of action as far as bad loans in concerned.

Gentle reader, may I be provided the liberty of immodestly reminding thou, that way back in September 2015, this oft ignored & mostly ignoramus blogger had published "Urgency of Creating a Bad Bank or The National Asset Management Co.(NAMCO)" on this very blog.


I confess that there is no forum, no opportunity lost in all feasible forms of human expression - written word, spoken  expression- that has not been used by this author to receptive compatriots: the extreme urgency of examining similar balance sheet problems in Germany (1980s), China (1990s), Sweden(1992),Ireland(2009),Netherlands(2011), Spain(2012), Portugal(2014), Latvia(2010) and seeing for themselves the great efficacy with which the bad bank concept was employed by these nations to resolve the issue.

This requires great honesty to admit that if more than 20% of the Banking system loans are non-performing and if on an average a 50% haircut is required, then more then 10% -i.e. bank capital has been already wiped out- which means that the Banking system in India is essentially insolvent. We can continue this process of recapitalization by some hapless source of equity- the taxpayer, say- who will continue to face a repeat of the latest fate of vanishing wealth and utility. When the same folly has been tried over and over again, there will be a point when the public will ultimately rebel and question the wisdom of those in charge of public deposits in a manner that may not be very pleasant to countenance.

It is therefore, now a matter of not just extreme urgency; for that point has long passed- a matter of recovering that last shred of public faith in the system before chaos sets in- that we examine why so many nations with balance sheet problems have hit on the same solution - bad bank - to resolve their non performing asset problem.

A painful surgery -amputation- with some hope to survive is obviously better than a gangrened and decaying corpse.


[1]Urgency of Creating a Bad Bank or The National Asset Management Co.(NAMCO)
http://ageofdeflation.blogspot.com/2015/09/urgency-of-creating-bad-bank-or.html
8 September 2015

[2]Talk of a Bad Bank in India- Economist
2 March 2017

[3]The beginning of a blueprint of a bad bank in India- FT- David Keohane
3 March 2017

Demonetization: Rip Van Winkle

                                      Demonetization: Rip Van Winkle

CPI Inflation for November 2016 was at 3.63%[3]against market expectations of around 3.9%. Incidentally this is a two year low. Credit growth in the fortnight post the demonetization has been a negative Rs 61,000 crores[2]This had actually been forewarned 4 weeks back on 18th November in the update "Demonetization: Gearing up for Policy Response" (https://ageofdeflation.blogspot.in/2016/11/demonetization-gearing-up-for-policy.html)

 Now that the first data points on CPI and Credit growth is out it is now clear that the shock to GDP growth for FY17 will range from the minimum of -2.0% and upto -3.7% (as compared to the previous GDP growth estimates prior to the launch of demonetization). The shock to credit is expected to range from a -35% to -10%(at a minimum) at the end of FY'17 compared to October end '16.[1]This collapse in credit by anywhere by 1/10th on the lower side to a 'la Depression 1/3rd of credit stock will pulverize asset markets and crimp economic activity even further in FY'18.

 Unless, off-course, the Government and the RBI act decisively. Till date neither have shown any inclination to act on urgently mitigating the negative growth shock from demonetization. Officialdom have till date justified their inaction on the grounds that there has been no fresh relevant economic data to justify any policy response. 13th December 2016 has taken away that excuse- both CPI and Credit data is now available for study. It will now be a wonder if we continue to behold such stasis until official GDP figures for FY'17 releases somewhere in the middle of Calendar year 2017 for 'contemplation' of some-forgotten urgently pending matter of rescuing a long forsaken ship then already rusting somewhere in the middle of some ocean bed.

  References

[1]
https://ageofdeflation.blogspot.in/2016/11/demonetization-gearing-up-for-policy.html

[2]
http://www.news18.com/news/business/bank-credit-plunges-by-rs-61000-cr-in-post-note-ban-fortnight-1322474.html

[3]
http://m.economictimes.com/news/economy/indicators/retail-inflation-cools-to-two-year-low-3-63-in-november/articleshow/55961750.cms

Demonetization: Gearing up for Policy Response

Impact on GDP growth of Government's recent Demonetization move: India's Revised GDP estimates for FY17 and FY18 have been published by at-least two Institutions and a similar exercise is on with feverish pace at most Banks, Rating agencies, Brokerages and Research think tanks. The revisions are not flattering and the first such published study estimates FY17 GDP growth figures lower by 3.3% and by 1.5% in FY18(as compared to the previous GDP growth estimates prior to the demonetization). Another study pegs the estimated growth lower by 03-0.5% in FY17. While economists and think-tanks crunch the revised GDP numbers as above, we are also interested in the consequent impact on Inflation due to the estimated shock to growth. At the current CPI(October'16) rate of 4.20% , the estimates for CPI rates at the end of FY 17 and FY 18 for the various GDP shock scenarios are provided below:

So we are staring at CPI rate scenarios ranging from 0.8% on the lower side to 3.6% on the upper side. While the upper side scenario is not a great concern, the lower end scenarios do not augur too well and call for concerted fiscal and monetary resuscitation to get economic growth back in shape. The Government(for the fiscal response), RBI and the Monetary Policy Committee(for the monetary response) must dispassionately examine the impact on economic growth and prepare for the most likely scenario that is likely to evolve in its best judgement. We shall not delve here into other relevant factors such as the external macro environment viz. Brexit, new US Administration and the like, but the range of estimates clearly indicates that for scenarios (a.) and (b.) above urgent fiscal and monetary action would be required. It is recognized that authorities have ample space to act in both areas. It must be then be utilized to the fullest and at the correct time, even preemptively if the scenarios (a) and (b) materialize/are most likely to materialize. Offcourse, a CPI print below 2% will trigger the framework between RBI and the Central Government which clearly says that CPI rate target is the range between 2% on the lower side and 6% on the higher side and must not be allowed to breach either. The necessity for fiscal and monetary resuscitation is made all the more urgent given the forecast of sharp drop in Credit in the above scenarios:

So clearly, in the scenarios (a) and (b) strong fiscal and monetary medicine would be urgently required. We did not have control on either the rollout or the implementation of the demonetization. But we must be prepared to respond to all the probable implications to this step in the near future to maintain strong economic growth.

Dilemma of the Central Banks: To push further NIRP?

Dilemma of the Central Banks: To push further NIRP?

There's no Zero Lower bound for Nominal interest rates. If you think Capitalism is in danger because of this sudden realisation, then unfortunately, it is too late a realisation. Realisation should have dawned earlier when Deflationary tendencies swept gradually across Japan, US, wide swaths of the EU and Governments left the job of resuscitation to Central Banks without taking any onus to timely rescue their respective economies in the fiscal sense of the act.

So now that the damage has been done, what is the way out of this? Glibly blaming NIRP(Negative Interest Rate Policy) is the easiest way out. NIRP is the symptom. Not the cause. Blaming the symptom is like saying your cough is to blame for the illness you have and not that virus that is causing the cough in the first place.

Banking Reforms
Japan had a Banking problem right from its Chaebol like cross holdings of its banks with its large corporates. US had a banking problem in a great many ways that are well documented leading into 2008. EU has a festering Banking problem which is in part also related to its ill conceived Currency/Monetary Union without a fiscal union in place.

So most of these negative interest rates issues actually arose from a faulty banking system and erroneous structures and incentives in place in all these jurisdictions facing this issue. That's the underlying cause. Don't just blame the symptom.

Spain and Ireland have done well to try and reform by setting up effective Bad banks and resolution mechanisms. Other nations such as Italy, France and even Germany should immediately start on the path of reforming their Banks. Japan has to reform its banking ownership structure- Big borrowers cannot also be owners of banks.

RBI outgoing Governor Raghuram Rajan has laid out a fairly full agenda for reforming the banking system in India. Missing is the bad bank piece which would gradually come about along with the other reforms that the RBI alongside the Indian Government is pursuing vigorously.

So should ECB and the BoJ cut rates further? Should they continue to expand their Balance sheets by way of commitment to more QE? It would be wonderful if the EU Council supports Governments such as the one in Italy to commit more to Fiscal support to their hard pressed economie. Secondly Banking reform must be carried out by Italy, France and Germany to fix the credit flow to the real sectors of the economy. NIRP and QE will work when both these issues are sorted out. Standalone QE and NIRP will not work. They must go hand in hand with Fiscal resuscitation and urgent Banking reforms.

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Bank of Japan - Negative Interest Rates-Good move

Bank of Japan has cut its benchmark rate to - 10 bps from 10 bps, a reduction of 20 bps and has left unchanged quantitative easing parameters.

This is immediate response perhaps to the negative index of industrial production data and to the overall sluggishness in the overall Japanese economy in the backdrop of falling Global trade.

As far as Monetary Policy goes this is most likely the best response from the BoJ at this point of time.

Increasing QE at this time would not have been helpful and indeed counterproductive at this point- so BoJ is again right by leaving that unchanged. 

Only Course left to FOMC- Reverse Stance Sooner rather than Later

All that was feared and written about on 24th August 2015 in "Rescuing a Deflationary World"(http://ageofdeflation.blogspot.in/2015/08/rescuing-deflationary-world.html) has ominously come to pass with the US Fed inexplicably raising rates in a haste in December accompanied with a simultaneous JPY carry trade unwind along with the breakage of the USD->CNY carry trade and as illustrated earlier in this blog the world economy is now truly on its knees.

The moot question is did the US Fed really see the ghost of inflation in December when the entire world actually stood perilously on the brink of deflation? And now that it is clear that the world is indeed in THE AGE OF DEFLATION what, pray, does the FOMC plan to do in the next two months? Study the data? Analyze? What analysis do we expect the captain of the sinking Titanic to do and indeed what analysis is on offer? No, please also do not expect the economic situation to revert back to square one to status quo prior to the December hike, if this hike is reversed - only that the route and fallout of the blunder will be slightly bearable to manage and implement a fix.

Why does the US Fed have to be answerable for China, Japan, ex-Asia et al? Because post the SE Asian crisis in 1998, most Emerging Economies' Central Banks have been maintaining a quasi dirty floating peg with the US$ using their respective FX reserves as the cushion to avert a repeat of the 1998 crisis and the result of this stratagem has been that post the 2008 crisis in the US when the US Fed slashed rates to almost zero, most Emerging Nations' Central Banks obediently* cut their REAL RATES to ZERO as well. In some cases , without naming individual Central Banks, the real rates were maintained at fairly high negative levels for much of 2009-2011 fuelling a rather huge credit binge driven asset price rally.
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* The reason is fairly obvious- If an Emerging economy were to maintain a higher real rate of interest higher than that of the US, the export driven economy(most Emerging economies are modelled on this in order to extract the purchasing power arbitrage or in other words the wage differential arbitrage between the Emerging economy worker and the American worker) would suffer as capital flows would make the exchange rate move adversely and make its exports uncompetitive. The saving grace was and is the FX reserves which would be expanded to keep the currency from appreciating too much against the greenback and thereby keeping the export driven model intact. The immediate 'obedient' fallout is that if due to any reason the US Fed has to reduce its real rates to 0, the hapless Emerging economy Central Bank has to follow suit and adjust its real rates at or below that 0 level which is what happened in the aftermath of the 2008 credit crisis. 

During the "taper tantrum" in 2013, when market was trying to price in the probability of the US Fed hiking rates, some emerging economies with weak current account and low FX Reserves were faced with the prospect of either higher domestic interest rates to attract foreign fund flows or a depreciating currency to maintain the export growth led model or deplete their FX reserves or a mix of these mechanisms. 
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In December 2015 when the US FOMC hiked rates in the absence of inflationary dangers, real US$ interest  rates started progressively moving higher as deflationary dangers manifested itself strongly. True to script, economies having weak current accounts or low FX reserves have had to face a brunt either through depreciation of the exchange rate or by raising the domestic interest rates or by depletion of their FX reserves(not an option for most emerging economy Central Banks though) or by a combination of either of these mechanisms.

Now add China and the Commodities complex in an overleveraged# setting to the above and the global economic growth model ignites to the mess we see today- a mega tragedy unfolding.
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#Not that you do not know this simple fact that we live in an era of over-leverage.... but the recent chain of events should not leave any doubt on the matter. Will not venture into a name and shame exercise as to who or what caused this sorry state of affairs, which is an exercise best left for another time or to another person (*a HISTORIAN?). China is a classic basket case of people trying to game the economic model of the state using leverage as an instrument and creating vast misallocation of capital into unproductive or wasteful activity.Take copper for example- in China with its ample land bank, inventory holding costs were low. US$ funding cost was cheap and because the PBOC created an artificial band between which the Renminbi could appreciate/depreciate, you could misuse this to import huge amounts of copper using borrowed dollars and inventory it for a short time while more leveraged buying of the commodity raised international prices- and then you sell it off in the domestic market at a profit because the RMB would not be allowed to :

(a) appreciate against the US$ beyond the band ensuring higher international prices always resulting in higher domestic prices,

(b)depreciate against the US$ beyond the band ensuring savings in hedging cost on the US$ Liability(referred to as USD->CNY carry trade) resulting in assured bumper profits attracting higher participation in a self fulfilling cycle as copper prices in particular and commodity prices in general kept rising -funded by leverage. 


This type of leveraged buying of commodities could not continue for ever as you ultimately need a willing and liquid buyer at the other end- which was ultimately found wanting because sooner someone realized that there was only so much requirement of wires to be extruded from the copper, and the rest had to be inventoried due to the limitation of actual end use.
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While we allow deleveraging to work its way through the system, what is required is a semblance of order and stability which can be used to gain time to resolve the rebalancing issues at hand. Had always maintained that the US Fed was mounted on a rather wild and fast horse in its quest to "normalise" rates and it has erred by a big margin and the time has come to either bailout of the Titanic by reversing course or if it still sticks to the "hike" bandwagon the boat will sink from hereon alongwith the entire bandwagon. 

Urgency of Creating a Bad Bank or The National Asset Management Co.(NAMCO)

The government today discussed the possibility of creating a Bad Bank or National Asset Management Co.(NAMCO) as per press reports available on the web http://economictimes.indiatimes.com/news/economy/policy/pm-narendra-modi-discusses-plan-to-set-up-a-national-asset-management-company/articleshow/48872058.cms

This is a welcome step. A few pointers that should be pertinent to discuss right away since the proposal is now getting seriously looked at as a very urgent measure to shore up the economy and derisk the NPA laden banking space.

1. Bad Banks have provided relief in the past to economies suffering from a credit meltdown post bursting of asset bubbles such as Germany (1980s), China (1990s), Sweden(1992),Ireland(2009),Netherlands(2011), Spain(2012), Portugal(2014), Latvia(2010).

2. Bad banks, in theory, operate on a short time frame project workflow basis for recovery of bad assets; while the good bank can continue to operate on a process driven manner and continue with the job of financial intermediation and credit allocation. The absence of bad assets on the books of good banks allows the good bank to concentrate fully on the evaluating credit proposals without the dead weight of past bad assets.

3. In practice, the threat of moral hazard is very real and the implementation must be such that it does not allow bad lending practices attain official sanction by the "Bad Bank" bailout. Also, small borrowers and small ticket lending that have gone bad must be kept out of the Bad Bank so that enough time is given to small borrowers to recover and repay.

4. So, Bad Bank is to be created out of the non-performing assets of the banking industry at book value or market value whichever is a fair price for the buyer(Bad Bank) and the seller(Original Bank). Needless to say, the original banks have to immediately recognize the value lost post default or due to non-repayment of the loan. But that is a given, or else shy would any investor put money in a Bad Bank and take the risk of losing capital because there is no certainty that defaulter/ borrower will repay the loan in the future.

5. The investor in the Bad Bank can be a private investor, original bank, or the Government or a combination of the three. Any model can work provided a workable and practical model of regulation and laws is put in place quickly and effectively. Even a model where the original bank forms a subsidiary bad bank at an arms length can work as evidenced by CitiBank recently in the US which has successfully implemented this model in the backdrop of the 2008 credit crisis. But the challenge in such cases is strong and effective regulatory oversight and regulatory framework.

6. The Bad Bank is not a going concern with a long life time like normal banks. It is at most a 4 - 5 year project where the investor is interested in recovering the money from the defaulters in a project management sense of business and exiting the business or handing it over to traditional banks who may be interested in buying the now-healthy not-so-Bad Bank.

That said, the creation of Bad banks will require new legislation- but examples in many nations abound as stated earlier above. These nations including Spain and Ireland had to undergo a thorough legislative law making and regulatory rule making before Bad Banks could become a reality and the challenge in the face of urgency is that these tasks be completed with great urgency.

Why should we display so much urgency? The global macroeconomic environment is nothing to be comfortable about, and ditto is the current state of our domestic banking system. If we are comfortable with dribbling the buck , then we can just stick around with the status quo and pray to God to make things better. But if we want to address the fact that every year 1 million young people are joining the workforce, then we can't just dribble- we must advance the game plan proactively to the next level without waiting for some crisis to goad us into action.