It said that 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 12.3 per cent as at end-September 2016, with the ratio significantly higher among state-owned banks.
The ratings agency said that the banking sector would require around $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 $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 ratings agency said.
It said that the bad bank's most likely form would be that of a centralised asset-restructuring company (ARC).
The bad bank's proponents believe that 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 that similar mechanisms have previously been used to help clean up banking systems in the US, Sweden, and countries affected by the Asian financial crisis in the late 90s.
Senior European policymakers have recently discussed the prospect of a bad bank to deal with non-performing loans in the European Union, 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 that 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 ratings 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 the 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.
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