Bad Bank

Bad Loans: A Brief History

Loans are assets for a bank. An asset becomes non-performing when it ceases to generate income for the bank. The Reserve Bank of India (RBI) defines a non-performing asset (NPA) as a credit facility in respect of which the interest and/or principal has remained overdue for a period of more than 90 days.

The origin of bad loans or NPAs in the country may be traced to the period 2006–08 when economic growth was strong and commercial banks, in an attempt to make the most out of the growth momentum, engaged in irrational lending without following due diligence. Then the global financial crisis of 2008 struck the financial markets worldwide. The years of strong growth before the financial crisis were followed by a slowdown. Coupled with policy paralysis on account of government inertia, the slowdown rendered several projects unviable as there were delays in completion and costs overrun. As a result, these projects failed to even service their debt, let alone repay the principal. The stress in the banking sector began to show in 2011–12. The crisis became more evident following the asset quality review conducted by the banks at the behest of the RBI. Most of the bad loans are spread in steel, power, road infrastructure, and the textile sectors. The existing NPAs amounted to Rs 8.3 lakh crore (by end of March 2021) and were expected to increase due to the COVID-19 pandemic. In August 2020, the RBI had formed an ‘Expert Committee on Resolution Framework for COVID-19 related stress’ under the chairmanship of K.V. Kamath to make recommendations on financial parameters to be considered in restructuring of loans impacted by the pandemic.

Internationally, many countries have experimented with the idea of a bad bank in the past including the US, Sweden, Finland, Belgium, and Malaysia. It was Mellon Bank Corporation in the US which pioneered the idea by establishing a new institution, called Grant Street National Bank (GSNB) to take care of its bad assets. The GSNB purchased Mellon Bank’s bad loans at a 53 per cent discount. Danaharta was established by the Government of Malaysia to act as its national asset management company with the objective to turn around its financial sector by purchasing non-performing loans from financial institutions and maximise their recovery value.

The Need for a Bad Bank

The Economic Survey 2016–17 had argued in favour of setting up a Public Sector Asset Rehabilitation Agency (PARA) to help tackle the problem of bad loans.

The previous attempts of the government to resolve the twin balance sheet crisis (of the banks and the corporate borrowers) through mechanisms such as the Insolvency and Bankruptcy Code (IBC), Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI Act), and the Debt Recovery Tribunals have failed to resolve the crisis as a substantial amount of NPAs continues on the balance sheets of banks as revealed by the Asset Quality Review of banks’ assets. Not only is the stock of bad loans large but it is fragmented across various lenders. Even after infusion of capital in public sector banks (PSBs) under Indradhanush plan for revamping PSBs, the crisis continues.

In 2020, the Indian Banks’ Association (IBA) had submitted a proposal to the finance ministry for setting up a bad bank for swift resolution of NPAs. In the circumstances, in the budget of 2021–22, finance minister Nirmala Sitharaman had announced setting up of a bad bank as part of resolution of bad loans worth Rs 2 lakh crore.

The idea of setting up a bad bank was to resolve the growing problem of NPAs. An overwhelming proportion of NPAs lies with the public sector banks. To keep these banks in business, the government attempted to recapitalise them to improve their financial health and enable them to carry on with the business of lending and funding economic activity. But with each passing year, NPAs continued to mount. Moreover, the economy itself started to lose its growth momentum since the start of 2017. The problem of mounting NPAs necessitated the arrival of a mechanism which could approach the problem in a wholistic and broad-based manner.  Accordingly, the idea of a bad bank gained shape.

A ‘bad bank’ is supposed to be an entity where all the bad loans from all the banks can be parked, thus relieving the commercial banks of their stressed assets and allowing them to focus on their normal banking operations, especially lending. The so-called bad bank would try to sell these stressed assets in the market. So, it should be clear that a bad bank is not a bank at all in conventional terms; it will not hold public deposits or lend money to the public as a normal bank would do. Nor is it ‘bad’ in the sense that it holds worthless assets.

In a technical sense, a bad bank is similar to an asset reconstruction company (ARC). It will take over the bad loans from the books of the commercial banks, manage them, and finally guide them towards resolution or liquidation. The bad bank will normally acquire the bad loans at less than their book value and, subsequently, will try to recover as much as possible. The removal of the stressed assets from the balance sheets of commercial banks will enable the banks to focus on their lending business and revive credit growth in the economy. Moreover, aggregating the stressed assets of banks and transferring them to one entity will pave the way for a quicker and more effective restructuring of bad loans.

Though there are 28 private ARCs operating, restructuring of bad loans has not picked up because the banks and the ARCs have differences over setting a fair value on the stressed assets. Moreover, the existent ARCs are effective only with small debts. This necessitated the formation of a platform or a mechanism that will make it easy for the ARCs to engage productively towards resolution of a bad loan, especially a large one.

Bad Bank: Structure and Working Mechanism

Structure To tackle the growing problem of mounting bad debts in the banking sector, the government announced the formation of a bad bank that will be tasked with acquiring bad debts from banks’ balance sheet.

Under this framework, an entity known as the National Asset Reconstruction Company Limited (NARCL) has been set up.

The main features of the NARCL are as follows:

• It has been incorporated under the Companies Act and will act as an ARC.
• It has been set up by banks with the mandate to aggregate and consolidate stressed assets for their subsequent resolution.
• Public sector banks will have 51 per cent ownership (in the form of equity participation) in it, with Canara Bank holding 12 per cent stake, as its promoter.
• It will acquire stressed assets worth about Rs 2 lakh crore from various commercial banks in different phases (with about Rs 90,000 crore worth stressed assets to be transferred in the first phase).

The resolution process, however, will be carried out by a separate entity, namely, India Debt Resolution Company Limited (IDRCL), the main features of which are as follows:

• Private sector institutions would hold 51 per cent equity in it, and 49 per cent stake will be held by PSBs and public financial institutions.
• It will act like an asset management company and try to sell stressed assets in the market.

The NARCL-IDRCL combination is the structure of the new bad bank.

Working The NARCL will acquire the stressed assets, and then the IDRCL will manage it and work towards value addition.

The NARCL will take over NPAs from banks’ books for a mutually agreed-upon value (a net value after a haircut – i.e., the extent of sacrifice a lender needs to make on a loan while getting a defaulting borrower to pay his pending dues). The NARCL will pay 15 per cent of the agreed net value of the bad loan upfront in cash and the remaining 85 per cent in the form of security receipts (SRs). This is a standard practice for purchasing stressed loans by ARCs. The SRs will be redeemed by the banks when the bad loan is resolved or liquidated by the bad bank. In case the stressed assets are sold, with the help of the IDRCL, the commercial banks will be paid back the amount realised by the bad bank from the resolution of the bad loan.

The SRs issued by the NARCL are to be backed by a government guarantee of Rs 30,600 crore. If the bad bank is unable to sell the bad loan, or has to sell it at a loss, then the government guarantee will be invoked. The government guarantee will be used to cover the shortfall between the amount realised from the successful resolution of bad loans and the face value of SRs issued to the banks. It will help in proving the value of SRs, their liquidity and tradability. The guarantee will be in the form of contingent liability (a liability that may occur in the future if NARCL fails to resolve the bad loan for the mutually agreed-upon value) and will not require an immediate cash outgo for the exchequer. The government guarantee can be invoked only when there is resolution or liquidation of a bad debt.

The bank may also trade the SRs for cash.

To begin with, banks have identified 22 fully provisioned stressed accounts, including Videocon Oil Ventures Ltd, Reliance Naval and Engineering Ltd, Amtek Auto Ltd, Jaypee Infratech Ltd, Castex Technologies, GTL, Visa Steel Ltd, Lavasa Corporation Ltd, among others, for transfer to the NARCL. In each case, the banking industry has at least Rs 500 crore exposure.

How is the bad bank different from the existing ARCs?

Under the proposed bad bank framework, the NARCL is the bad debt aggregator while the IDRCL will take care of the resolution of bad assets. This structure is different from the existing private ARCs, which do both bad debt aggregation and resolution.

The bad bank will have an edge over the existing ARCs as it can use the government backing and comparatively well-capitalised balance sheet to buy bad loans from multiple banks having exposure to a corporate defaulter. This aggregation of loans, which the other ARCs take a long time to complete, will give the NARCL a distinct advantage.

Moreover, PSBs will be less reluctant to deal with the NARCL, an organisation in which the PSBs hold a substantial stake.

The existent ARCs have been able to deal with small debts; they have shown limited scope and ability in dealing with large NPAs. The government joining hands with PSBs in the NARCL does have a positive effect on the outcome. What sets the bad bank apart is that it is armed with a government guarantee worth Rs 30,600 crore.

A Critical Analysis

While the move to set up the bad bank is in the right direction, the success of the initiative will depend on how soon and how well the stressed assets are resolved. The securities to be issued by the NARCL for taking over and resolving the NPAs have a government guarantee only for five years. The market seems optimistic about expecting big recoveries of stressed assets through the NARCL when similar attempts by the private ARCs in the past have hardly been able to deliver. It will be worth watching how the bad bank is able to effect a turnaround with respect to NPAs in the banking sector.

Merits of a Bad Bank The setting up of a bad bank has the following merits:

• The creation of a bad bank will address a major bottleneck in India’s growth over the last few years on account of heightened risk aversion in the banking sector which, in turn, was largely an outcome of piling up of large NPAs in the system.
• IBC mechanism has turned out to be fairly successful, but the sheer quantum of bad loans required a mechanism which can allow a one-time transfer of bad loans outside the balance sheets of banks. This would enable the banks to solely focus on lending activities to improve credit in the economy, which is crucial for spurring investment, leaving the bad bank to deal with unlocking value by realising sunk capital in stressed firms.
• Commercial banks saddled with large NPAs face the problem of reduced profit on account of provisioning for write-offs of bad loans. The bad bank would help solve this problem by ridding the commercial banks of these toxic assets in one quick move. When the recovered money is paid back, it will further improve the banks’ position.
• As the major part of it is owned by the private sector, the IDRCL can function without the shadow of investigating agencies looming over its decision-making ability. This will help it resolve bad loans faster.
• The resolution company, IDRCL, will focus on resolution of the assets by employing its own turnaround professionals. This will free up bank personnel to focus on lending activities.

Challenges Associated with Bad Bank The following challenges might surface with time to come:

• With a bad bank in place and the subsequent transfer of the NPAs from the books of commercial banks to the NARCL, the whole exercise might seem to appear as parking of NPAs under the banner of NARCL. These NPAs will remain in the financial system unless their recovery takes place. Till then, the transfer of NPAs might just appear a window-dressing of the actual position.
• The banks will receive 15 per cent of the agreed price of bad loans in cash (around Rs 13,500 crore for Rs 90,000 crore of bad loans that will be transferred in the first phase). This amount is miniscule when compared to the outstanding bank credit of Rs 1,09,49,509 crore in 2020–21. So, the argument that it will increase cash flow and hence the lending capacity of banks does not seem valid.
• Even though SRs may be transferable and tradable on account of the government guarantee (which is expected to enhance the liquidity of SRs), they are almost like junk bonds. Even if there are takers for SRs, they will get sold at a steep discount, which will erode the profitability of banks.
• With the bad bank in place and NPAs being removed from the books of the commercial banks, a moral hazard may be created as reckless lending may start once again, on the expectation that NPAs can be transferred to the bad bank.
• The bad bank runs the risk of becoming a warehouse of stressed assets without recovery being guaranteed, as it may be difficult to find buyers for stressed assets.
• The plan of bailing out commercial banks through a bad bank will fail if the bad bank is unable to put the NPAs to resolution.

Conclusion

The creation of a bad bank would have been most fruitful just after the asset quality review conducted by the banks at the direction of the RBI or earlier when the stress was just building up. However, it is better late than never. With the proposed bad bank framework, aggregation of stressed assets at NARCL’s hand is undoubtedly expected to speed up the process for finding interested buyers, transfer of assets, and restructuring of debt. At the same, the resolution arm–IDRCL–needs to have the liberty and flexibility in choosing the resolution path. The success of IDRCL will depend whether the entity is able to buy loans at the right price from banks and its ability to find a meaningful resolution. However, the bad bank will not be a panacea for the NPA crisis as it will not be able to prevent the creation of NPAs in the future. The government must find ways to reduce NPAs, the main reason for banks accumulating losses and pushing back the economy. The creation of a bad bank will not address the structural weaknesses in public sector banks. Nor does bank recapitalisation. The larger systemic issues need to be addressed through structural reforms, such as greater governance and supervision during the lending process as well as strict monitoring of loans for early detection of signs of distress.

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