Indra Kumar Lahoti

This article analyses the merits of the Government of India’s initiative to tackle the country’s non-performing assets (‘NPA’) crisis via the use of a ‘bad bank’.

Introduction

Finance Minister Nirmala Sitharaman in her 2021-22 budget speech mooted the possibility of establishing an Asset Reconstruction Company (ARC)/ Asset Management Company (AMC) to solve the Non-Performing Asset (NPA) crisis in India. There have been several developments since then as the picture is becoming clear now with the proposed “National Asset Reconstruction Company” (bad bank) initially having around Rs 89000 crore loans including Punjab Nationals Bank’s Rs 8000 crore loans and Union Bank’s Rs 7800 Crore.

The asset reconstruction companies or ARCs are registered under the RBI and are regulated under SARFAESI Act. It buys the bad loans from the banks/ financial institutions and further restructures these loans in the form of bonds, debentures or security receipts and sells them to those who might be interested in buying them. In this article the author will analyze the NPA problem which will deepen post COVID-19 and how creating a proper governance structure is important for establishing such a ‘bad bank’. The author will also look into global experience of establishing such institutions.

Non-performing assets – situation post-Covid

Reserve Bank of India defines ‘non-performing asset’ (NPA) as a “credit facility in respect of which the interest and/or instalment of principal has remained ‘past due’ for a specified period of time.” Under normal circumstances if a loan is not serviced for 90 days, it turns bad but last year RBI has extended this to 180 days due to the pandemic. The NPAs are basically loans or advances from the banks to the borrowers who are not able to repay their contractual obligation of principal and interest, thereby causing credit crisis in the system and overall efficiency and effectiveness of the functioning of the financial system.

The Financial Stability Report of January 2021 has alarmed everyone by stating that the gross non-performing assets (GNPA) for Scheduled Commercial Banks (SCBs) may rise from 7.5% of advances in September 2020 to 13.5% of advances by September 2021 in the normal case, and up to 14.8% of advances if the situation deteriorates more. The Public Sector Banks (PSBs) GNPA ratio of 9.7 per cent in September 2020 may increase to a whopping 16.2 per cent by September 2021 and private sector banks (PVBs) GNPA may increase from 4.6% to 7.9% over the same period. The Supreme Court has also declined to extend the moratorium period which means that the banks will now have to declare bad assets as NPAs for March quarter.

Why a bad bank?

The IBC regime is still at its nascent stage with the code going through repeated amendments in order to get the necessary infrastructure in its place. The whole process is primarily driven by a tribunal (NCLT) in which a resolution has to be presented in a specific period of time after which the company is bound to go into the liquidation process. The problem with IBC solving all the NPA problems will require huge manpower, judicial capacity, time and innovative mechanisms which the code would not permit to do.  Further, even after identification, successful restructurings are few and far in between, and the cases that reach the NCLTs through the IBC route line up in an unending queue in the overburdened tribunal. Experimenting this in the COVID ridden weak economy will further have unintended consequences.

There are two approaches to resolve this crisis. One is to keep the loan current i.e. to continue funding the project and hope that time and growth will set the project or company back on track. This will encourage all types of malpractices like evergreening and zombie lending. The other approach is to recognize the problem and start diagnosing the problem. Hence, a one-time special purpose vehicle – a bad bank or in a more formal way – an Asset Reconstruction Company (ARC) can be given a chance to take over the mess of ‘stressed assets’ in the banking sector.

A model framework for a bad bank

Raghuram Rajan and Viral Acharya in a recent paper have argued that the bad bank will not be a solution if it simply transfers the bad loans from one government-owned entity to another.  In addition, India’s experience with bad banks in the case of IDBI bank in 2004 was not successful. Neither IDBI Bank nor its bad bank were able to recover the due. There are around 20 odd ARCs in India with a balance sheet of a few thousand crores. Mostly they are private and banks are hesitant to transfer any loans to these ARCs because of the fear of investigating agencies like CBI, CVC and CAG. That’s why we have to design the right incentives so that the whole restructuring process can be set in motion in the right direction. Some questions about the functioning of an independent bad bank arise immediately which are discussed below –

Structure – One of the main considerations before setting up a bad bank will be the nature and extent of the banking crisis. The type of bad bank we want to establish will depend on how deep the crisis is in our banking sector. Globally it is preferred that individual banks initially set up an internal restructuring unit. If the problem doesn’t stop and spirals over the whole banking sector then a single entity is established by a consortium of banks. In such situations, it is possible that the government creates a single centralized bad bank with some amount of public financing instead of creating several bad banks.

As we have seen earlier that post COVID, in all circumstances, the stressed assets of the banks will rise to a considerable extent, a proposed solution was made by Viral Acharya few years ago by creating two ARC i.e. a private Asset Management Company (PAMC) and a National Asset Management Company (NAMC). The former will look after short to medium term stressed assets and the latter will focus on strategic assets which may have little value today, but are likely to be more valuable as the economy grows like the power, aviation, and energy sector.

Dr. Acharya proposed this public-private distinction to inculcate a sense of competition in the market and also to prevent government monopoly and excessive bureaucratic discretion. The Indian Banks Association (IBA) and the government are more interested in a single entity namely “National Asset Reconstruction Company” (NARC) preferably to have a protection of sovereign guarantee over the assets for the banks as well as potential buyers.

Ownership and funding – The next question will be who will fund and manage these ARCs? International experience shows us that the initial funding to a bad bank is provided by the government and then the private sector joins in to absorb the risk associated with the business. The private players use this kind of investment as an opportunity to earn profits by liquidating stressed assets at higher prices. In Korea and Taiwan, more than 90 percent of the financing was through government backed bonds. The Resolution Trust Corporation in the USA and the ‘Securum’ in Sweden were fully funded by their respective governments.

We can also learn from the Swedish bad bank ‘Securum’ which was although owned by government, but the managements consisted of private experts which led to owner-management i.e., Principal-Agent relationship. The expertise of private management will be required to manage the assets in innovative ways like bundling the assets, brokerage services, price discovery etc. The Indian entity will be government backed with a number of public sector banks and NBFCs coming together to form NARC.

The pricing discovery mechanism – This is the most crucial factor in determining the success of a bad bank. The bad bank has to purchase the toxic assets from the regular banks at a certain price which can only be done after a proper valuation of the stressed assets. The difficulty in determining the value of these assets stems from the fact that the Indian secondary loan market is opaque and functions in closed doors.

If the transfer price is too low then the banks will be reluctant to transfer their assets as it will be not in their favor to make any such deal. Additionally, if they do sell the assets at a low price then the three C’s – Central Vigilance Commission (CVC), the Central Bureau of Investigation (CBI) and the Comptroller and Auditor General (CAG) may haul up the entire process. On the other hand, if the transfer price is too high then it will be cumbersome on the bad bank to liquidate these assets.

The RBI has to play a leading role in developing an online database of “loan contracts” like the Public Credit Registry (PCR) to attract bids. Last year it issued “Fair practices code for asset reconstruction companies” (ARCs) which mandated the ARCs to follow transparent and non-discriminatory practices in the sale of secured assets. It also stated that the invitation for auctions for these assets shall be publicly solicited which can create a level playing field for all market players.

Banks may need a regulatory nudge so that they sell loans, and jump-start price discovery in the market. Private sector banks can take the lead here as they have more risk appetite and public sector banks can follow these banks eventually. Once the price discovery mechanism kick-starts, a consortium of banks can be formed which then transfer loans from one bank to another in case against the common corporate defaulter.

Another way to discover the price is through the “Swiss challenge Method”. In this, a prospective buyer i.e. an ARC offers a bid to the lender/bank, which then publicly calls for counter bids for other buyers/ARCs. After all the bids are received, the bank first invites the securitization company to match the highest bid in this counter-bidding process to get the best value. In all the transactions, the ARC has to follow the 15:85 model prescribed by RBI wherein the ARC pays 85% in the form of Security Receipts and 15% in cash. RBI can also work on combinatorial auction schemes where any buyer can bid for a combination of assets. This will give greater choice for investors and can bring synergy in evaluating the assets sector wise and region wise.

Specific purpose and sunset clause – The proposed bad bank should have a definite purpose and a sunset clause, i.e., a specific period say 10 years within which the purpose sought to be achieved. The sole purpose for the formation of a bad bank must be to liquidate the stressed assets, no additional burden like transferring of on-going business activities, banking services should be put on it in order to have overlapping functions with other regulatory authorities. International experience shows that such an entity must be wound up after a specific period of time to prevent it from becoming a feature of the banking system rather than a bug.

Legal framework – All the necessary legal mechanisms must be set up before establishing a bad bank. The SARFAESI Act and erstwhile SICA (now repealed) were well intended statutes but ultimately ended up in court litigation which caused immense delay in liquidating the assets. The legal framework should be designed to maximize the chances of converting the stressed assets into security receipts without court intervention. The solution to our present banking crisis is not to strengthen laws, but to see how we can get a more equitable and efficient-enhancing sharing of losses on default.

Sector specific asset recovery – The proposed bad bank must target sector specific stressed assets and classify them into property, infrastructure and construction, aviation, power, steel, shipping, telecom, and general investment. The highly capital-intensive assets can be looked at initially and restructured as quickly as possible. On the other hand, there may be long illiquid assets which might have little value today but they may be sold when the markets have stabilised enough to secure reasonable prices from their sale. This would take different amounts of time for different assets. The Resolution Trust Corporation in the USA in the 1990s just focused on commercial real estate, land and related assets. About one third of the loans purchased by “Danaharta” were property loans which helped it to target certain potential buyers.

Conclusion

The way forward for the ‘bad bank’ is to create the right incentives. As per the author, the bad bank can be initially funded by the government or the government and the private sector can jointly own such a bank with the management lies in the private sector, so that they can come up with better expertise, restructuring schemes, higher prices for the stressed assets etc. The government’s interference should be minimal in the administration of a bad bank. The part ownership by the private sector will help to improve price discovery and transparency while the part ownership by the government will ensure a sovereign guarantee.

To sum up, the creation of an Asset Reconstruction Company (bad bank) could be a qualitative as well a quantitative part of the solution. On one hand, it will clear the NPA balance sheet of the banks and transfer it to a more professional, market friendly entity which has specialization in managing bad assets without a lengthy legal process and on the other hand, it will allow the banks to focus on improving their core banking services.

Indra Kumar Lahoti is a current undergraduate student at the Hidayatullah National Law University (HNLU), Naya Raipur.