Good bank, bad bank

As the liquidity crunch continues unabated for India’s non-banking financial corporations (NBFCs), a plethora of steps have been suggested by market participants and policy experts. These include extending special credit lines, tighter regulation, imposing liquidity ratios and access to depositor funding. While all these measures have some merit, it is critical to triangulate the root cause of the crisis before applying any of the above remedies to avoid a situation where the cure turns out to be more deadly than the disease.


That NBFCs have been operating like shadow banks and running an asset liability mismatch is well known and that this mismatch became problematic in the aftermath of the IL&FS crisis, has been discussed to death. But the question is why should the demise of a single large NBFC that took unnecessary risks and possibly indulged in fraudulent activities affect the liquidity for an entire sector. The answer lies in the economic interplay between insolvency and liquidity. While it is widely known that illiquidity can cause insolvency (Diamond-Dybvig model), it is less known that insolvency of a single large shadow bank can also cause illiquidity (Diamond and Rajan, NBER [2002]). This happens because expectations of investors change due to a prominent insolvency and they now doubt the quality of assets on the books of other NBFCs and refuse to roll over short term financing thereby leading to a liquidity crisis for the entire sector.


This is exactly what seems to have happened to the NBFC sector in the aftermath of IL&FS and DHFL incidents. The problem lies in the asset side of the NBFCs where investors who provided them with short term funds (largely Mutual Funds) have lost faith that has led to a flight of liquidity from the sector. Thus the root of the NBFC crisis lies in doubts about their solvency and not because, liquidity that was abundant for them till recently, has magically evaporated.


Most of the remedial measures that have been suggested miss this point. Solutions such as imposing liquidity ratios and tighter regulation are long term measures that will not alleviate the immediate liquidity concerns of NBFCs. Special credit lines and access to depositor funding, on the other hand, are designed to shore up the liability side of the NBFCs ignoring the fact that the crisis is emanating from a lack of confidence in the asset side. These measures would be like treating a life threatening disease with palliatives and will only lead to moral hazard with the potential of causing greater problems in the future. Although the Reserve Bank of India (RBI) did try to tackle the asset side by relaxing (somewhat) securitisation norms for NBFCs, this has had a limited salutary impact on the liquidity position of the NBFCs. This also suggests that all may not be well with the asset side of the NBFCs because under normal circumstances, good assets can be securitised and offloaded quickly to meet liquidity requirements.

Thankfully several precedents exist about tackling insolvency driven illiquidity in banking. The earliest example is from 1988 when Mellon Bank split itself into a “good” bank and a “bad” bank where the good bank held its valuable assets while the bad bank held assets whose quality was in doubt. Existing shareholders were issued new shares in both the banks and new debt was issued to support the bad bank separate from the good bank. This experiment was successful with creditors of the bad bank recovering their debt in full and initial investors in the bad bank accruing handsome returns as the value of “doubtful assets” recovered with time. A similar model was employed very successfully by Swedish regulators during the Swedish financial crisis of 1992. Ben Bernanke was also a vocal proponent of this model during the financial crisis of 2008-2009 as were prominent macroeconomists Paul Krugman and Brad DeLong. During the same period, Irish regulators used it successfully to repair their banking system as well. A somewhat similar scheme was employed in India to tackle the UTI crisis in 2002 when Indian regulators warehoused the guaranteed returns scheme, US 64, in SUUTI to insulate the mutual fund business of UTI from being dragged down by the guaranteed returns commitment of US 64 units.


There are several other examples of this model being used successfully to tackle insolvency driven liquidity crises. A key advantage of this model is that it is organic and market driven instead of being interventionist and loaded with “bail out” risk as the proposed liability side measures of NBFC rescue are. The doubtful assets are transferred to the bad bank at market value and are managed by specialists who have a mandate to maximise their recovery value for creditors. This has the dual effect of disinfecting balance sheets of all institutions by exposing them to the sunlight scrutiny of the market and completely removing any sort of ambiguity about asset quality thereby leading to a resuscitation of credit to the good banks and the overall economy.


Indian NBFCs are a critical conduit in the flow of credit to the real economy. They have increasingly played a stellar role in funding home/auto purchases and discretionary expenditure, all of which lie at the core of the economy and its growth. If some of these pipelines of credit (which is what shadow banks are) are rotten, the optimal solution is to separate them from those that are sound. Pumping more liquidity through liability side measures will only lead to a greater leakage and compound the shadow banking problem instead of allowing market forces to resolve it. Warren Buffet says that using short term financing for long term projects is like depending on the kindness of strangers. Since Indian NBFCs remain at the mercy of strangers in the short term, the RBI should focus on isolating bad assets and restoring the markets’ kindness to beleaguered but sound NBFCs instead of becoming a kind but naive stranger by allowing all of them to access liquidity unconditionally.

/>  The author is a “probabilist” who researches and writes on behavioral finance and economics