By Yash Ahuja and Sruti Jha[1]
United States of America (USA) was the first country to adopt the concept of a bad bank in the 1980s[2]. In several nations, including the USA, China France, Germany, Finland, Belgium, and Indonesia, bad banks have been institutionalised and are viewed as winners.
Introduction
The bad bank concept of distressed asset resolution refers to the establishment of specialised financial institution to acquire and resolve Non-Performing Assets (NPAs) from banks. NPA is a financial institution categorization for loans and advances on which the principle is due, and no interest payments have been paid for an extended period. Loans generally become NPAs after being overdue for 90 days or longer. Policymakers and Economists have considered it to be a workable solution to address troubled financial assets. The Indian government most recently suggested a bad bank structure in the Union Budget 2021, which was released in February 2021.
The goal of establishing a bad bank is to relieve the pressure on banks by removing bad loans from their balance sheets and allowing them to lend to clients without restrictions again.
What are the effects of NPAs on the health of banking industry?
Indian economy is powered by banks. Banks accept deposits from the public by offering them interest. Banks provide loans out of the money they have in deposit to people and businesses at interest rates greater than those offered to depositors. The bank’s operations are supported by the difference in interest rates or net interest income. And if the borrower does not repay the loan, the bank would also find it difficult to return the deposits to its customers, as a result (a) the public loses faith in banks because of rising NPAs, which damage the bank’s reputation; (b) the depositors’ potential withdrawals might cause banks to run out of liquidity; and (c) reduction in investment which may shrink the economy, leading to increase in interest rates, and resulting in unemployment, inflation, and bearish stock exchanges.
How will the bad bank work?
A bad bank is a corporate structure that isolates risky assets held by banks in a separate entity. It is established to buy lethal assets from a good bank at a price that is determined by the bad bank, most likely with a haircut to the book value of the stressed loans being transferred. It may be controlled by the government, and apart from the government, other private players invest in its equity. It may raise loans from other participants. These transactions happen at arm’s length and a bad bank is managed by professionals with domain knowledge of managing stressed assets.
A bad bank profits from its operations if it can sell the loan at a better price than it paid to acquire the loan from a commercial bank. However, profit generation is typically not the primary goal of a bad bank, rather, the goal is to relieve banks of the burden of holding a big pile of stressed assets and to encourage them to lend more aggressively.
[1] Yash, an associate of the firm, wrote this article along with Sruti, who is a senior associate with the firm.
[2] Bad Banks: Historical genesis and its critical analysis by Dr. Sajoy P.B.
For the purpose of bad bank, banks had set up National Asset Reconstruction Company Limited (NARCL) incorporated under the Companies Act, 2013 and has applied to RBI for license as an Asset Reconstruction Company (ARC). NARCL has been set up by banks to aggregate and consolidate stressed assets for their subsequent resolution. Public sectors banks will maintain 51% ownership in NARCL. NARCL will function as an asset rebuilding firm. It will acquire debts from banks, relieving them of NPAs. NARCL will then sell the stressed loans to distressed debt purchasers. The Indian government has previously established India Debt Resolution Company Limited to sell distressed assets in the market (IDRCL). IDRCL will manage these assets and try to increase their value and will make attempts to sell these challenged assets.
What are the opportunities and obstacles?
Opportunities:
- NARCL will assist lenders/banks in getting rid of stressed assets and cleaning up their books by moving them to the bad bank. NARCL will free up capital for banks, allowing them to resume lending. It will be more results-oriented, and hence better able to recover debts from borrowers.
- It is preferable to sell assets to a bad bank rather than bringing corporate debtor to the National Company Law Tribunal (NCLT), because they will not be engaged in the process until the very end. Under the NCLT procedure, lenders must organise a committee of creditors to assess resolution plans under the Insolvency and Bankruptcy Code (IBC) and participate actively in the resolution process, whereas selling loans to bad bank requires no such engagement.
Obstacles:
- It is being contended that by establishing a bad bank, it only moves the issue from one location to another. Without significant changes to address the NPA issue, the bad bank is likely to become into a storage facility for subpar loans with no prospect of recovery.
- Additionally, there is no defined process for deciding which loans should be transferred to the bad bank and at what price. The Government could face political difficulties because of this. Furthermore, the issue of raising money for the failing bank is crucial. Distressed assets are difficult to sell in a pandemic and war affected global economy, and thus the government is going to be in a tight financial spot.
What is the relationship between NARCL and IDRCL?
The NARCL, which is majority-owned by public sector banks, will be helped in the resolution process by the IDRCL, which is majority-owned by private banks. In accordance with the parameters outlined in the ‘Debt Management Agreement’ that will be signed between these two entities, NARCL and IDRCL will have an exclusive agreement. This agreement will be a ‘Principal-Agent’ relationship, with NARCL as the Principal having ultimate approval and ownership of the resolution.
[3] Press Information Bureau – Central Government guarantee to back Security Receipts issued by National Asset Reconstruction Company Limited for acquiring of stressed loan assets.
What is the payment structure?
In a 15:85 arrangement, the NARCL will buy these subprime or distressed loans by paying 15% of the selling value in cash and issuing security receipts (SRs) for the other 85%. The government will provide Security Receipts (SRs) backed guarantee. When the assets are subsequently sold to potential buyers, the government guarantee will basically close the gap between the realised value of the assets and the face value of the SRs.
Conclusion
Evidence world-wide suggests that a centralised bad bank can help in substantial stress reduction and has various systemic benefits, including freeing up banks’ resources for more important core operations, positive signalling to investors and customers, avoiding fire sales, and complementing the activities of the existing public and private asset reconstruction companies (ARCs). Challenges faced by these institutions include how to relieve banking stress without encouraging moral hazard; how to minimise the cost to the government exchequer and how to arrive at a valuation that is fair to both the acquiring entity as well as the seller. Evaluated against the backdrop of international best practices, the paper suggests that the NARCL in India has many favourable design and structure elements. Going forward, continued commitment, professionalism and transparency in operation will help in making the process cost and time effective.[2] A bad bank is therefore a fine idea, but the real difficulty lies in addressing the underlying structural issues in the financial system and proposing adjustments in line with them.
[4] Frequently Asked Questions regarding Central Government guarantee to back Security Receipts issued by National Asset Reconstruction Company Limited for acquiring of stressed loan assets https://pib.gov.in/PressReleseDetailm.aspx?PRID=1755466.
[5]RBI Bulletin dated February 16, 2022 The Link for the same is: https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=53283.