Two years into its tenure, the then NDA government headed by Atal Bihari Vajpayee, which came to office in 1999, faced one of its biggest challenges — a pile of non-performing assets (NPAs) or bad loans as they are known. Then as now, the government had to contend with a slowing economy, low inflation, global growth and little private investment.

In the finance ministry, one of the proposals discussed then and apparently sounded out by the World Bank, was on forming a bad bank — an institution or entity which would buy out the bad or toxic assets of banks, holding it at a discount to its value, thus helping to clean lenders’ books or balance sheets. This was to also help lenders provide loans afresh.

The ministry’s files contain notings on this proposal dating back to the previous government, with much of it based on the experiences of countries such as Japan and Korea, which had struggled to restructure their banks after a huge lending binge in the previous decade.

The bad bank proposal had been put on the table because by 2000-01, gross NPAs had risen to Rs 70,000 crore, with public sector banks sitting on a mountain of toxic assets. As is the case now, this was a legacy of the aggressive lending that Indian banks had resorted to in the mid-1990s, after the economy had been opened up and when Indian corporates built up huge capacities on projections of rising demand and the growth of the middle class.

By early 2000s, however, at least a couple of state-owned banks lacked the mandatory minimum capital while institutions such as IFCI and IDBI, providers of long-term capital then, were also in deep trouble.

The argument against a bad bank, however, besides of course it drawing on capital from a resource-starved government, was that it too could end up as a sarkari bank. The view then was that the government should not be participating in any such venture and that good money shouldn’t be thrown after the bad, particularly to a monolithic entity. After meetings in his ministry, then finance minister Yashwant Sinha and his officials finally agreed that this was a bad idea and decided to drop the proposal.

It was argued in the ministry that it would be far more sensible to build a new framework for Asset Reconstruction Companies or ARCs, which are in the business of buying bad loans from banks and other institutions. These companies would work like private equity firms instead of the government infusing capital. Coupled with this, the then government also decided to strengthen the powers of lenders to recover assets through legislation — Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest in 2002.

In the Department of Economic Affairs, Ajay Shah, then a consultant with the department, and Raghuram Rajan, a young professor from the University of Chicago, worked on this framework. Rajan also worked on a concept note for regulation of ARCs, a little before he became chief economist of the International Monetary Fund. Rajan had been introduced to the finance minister by the latter’s son, Jayant Sinha, Rajan’s classmate at IIT Delhi and who was then working in the US.

By then, the financials of three banks owned by the government — United Bank of India, UCO Bank and Indian Bank — were worrying enough for the government to provide support.

The swelling of bad loans in the books of both IFCI and IDBI had also prompted the government to think of corporatising the institution and in 2004, it merged IDBI with its well-run commercial bank — IDBI Bank.

A variant of the bad bank was then designed, the Stressed Assets Stabilisation Fund (SASF), with government support of Rs 9,000 crore to take bad loans off its books. The fund’s mandate was to recover assets over a period of time and, a decade later, it is still in business.

Preceding that, in 2002, was another innovation — a bad bank of sorts — but which only succeeded later: India’s first mutual fund, UTI, encountered a crisis and was under pressure from lakhs of unit holders, when the government first came out with a bailout scheme. In the second half of 2002, Jaswant Singh, who had succeeded Sinha as finance minister, assigned his joint secretary incharge of the capital markets, U K Sinha, to travel to Mumbai and meet the RBI Governor Bimal Jalan to work out a solution. For over half a day, Jalan provided the intellectual inputs for restructuring UTI along with finance secretary, S Narayan, with the implementation being left to Sinha. Jalan suggested that the bad assets of UTI, which also included loans to companies, be transferred to a new entity — initially called UTI-2 and later SUUTI, while UTI-I became an asset management company. Over time, as the stock markets rebounded and asset prices rose, the government and other investors gained.

In that period, Sinha had been opposed to providing support in the budget to some of these weak banks. He instead backed the idea of a change in management in some of these banks and improving their functioning. But what helped over the following few years were sectoral packages, in steel, textiles, which gradually helped banks, as also the restructuring in the power sector where state electricity boards were virtually broke. And as interest rates began rapidly declining, banks gained in terms of treasury profits, aiding their recovery and helping them to set aside money for the bad loans.

As was the case then, a legacy issue coupled with aggressive lending in the high growth years — 2004-05 to 2008 — has left a trail of toxic assets. Then and in the last episode too, there was regulatory forbearance with questions now being raised about regulatory oversight or supervision.

But India may be in good company. Italy is weighing promoting an agency or a bad bank, given the huge amount of bad loans piled up in its banks. The Italian central bank is involved in the exercise along with its finance ministry but will have to surmount resistance from the European Union, considering rules on bailouts. Indian policy makers don’t have to worry about a similar challenge but will have to convince tax payers on fund infusion, the pricing of loans, the management of such a bad bank and its ownership and related issues in the shadow of the CBI and other agencies. Equally daunting is the spectre of the festering bad loan issue. The economic costs are too high. What is striking about this bad loan mess dating to the late 1990s and the latest one is how as the owner of a majority of these banks, the government appears to have destroyed the value of its own institutions consistently.

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