How good will be Bad Bank 

The soaring NPAs, despite several interventions like Dispute Resolution Tribunals, Asset Reconstruction Companies and Insolvency and Bankruptcy Code, now get another pill

Foresight of Dr Raghuram Rajan

 Around 2005, much before the global financial crisis swept countries like a tsunami, Dr Raghuram Rajan, then a professor, was interacting with some of us in the Department of Statistics, RBI, on micro data in banking. Being director in charge of banking statistics, I was aware of the type of data he was studying. It was not aggregate level but at the most disaggregated level, at the borrower level loan data. NPAs were important to deal with by individual banks, but they were not so alarming as they are today for the banking sector as a whole. Though we were not privy to the exact study he was doing, we could get a sense that his focus area was the behaviour of borrowers as well as lenders. The incentives given to bank employees for meeting business targets, especially credit, was an area of concern. 

— This anecdote asserts the academic foresight Dr Rajan had. In fact, the studies he made during the early to mid-2010s could have led to his forecasting the financial crisis.  

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Tough Stand by Dr YV Reddy

Prior to 2008, when it hit the globe very hard, the financial crisis was already brewing due to exuberance in the state of the economy in the US and associated relaxed lending environment. The unrealistic optimism and the introduction of several complex financial products, are now generally considered the basic causes for the crisis. There were suggestions, requests, and even pressures for introduction of exotic products and relaxation of standards. Dr YV Reddy would listen to all of them and continue with the tough stand on lending standards. Being in the RBI, some of us had the privilege of seeing the Governor sticking to the conventional wisdom of a central banker. His conservatism won the day. A 19 December 2008 article in the New York Times has credited the tough lending standards he imposed on the Indian banks as RBI Governor for saving the entire Indian banking system from the sub-prime and liquidity crisis of 2008.

— shares Dr AS Ramasastri, former Chief General Manager-in Charge, Reserve Bank of India, pointing out how the bad debt problem has been a festering wound.

The NPA (non-performing asset) issue has been on the rise, and by the time Rajan took over as the Governor in 2013, the bad loans position had become much worse, both in quantum and quality. Rajan did introduce bold measures to clean up banks. “We have to put banks on the right track. I do not think the answer is to pretend and extend or extend and pretend; it is to call spade a spade,” he had said.

 Finance Minister Nirmala Sitharaman in her Budget speech on Feb 1 announced setting up of a bad bank, which will “consolidate and take over the existing stressed debt and then manage and dispose of the assets to Alternate Investment Funds and other potential investors for eventual value realisation”. The Bad Bank or National Asset Reconstruction Company Limited (NARCL), as it is called now, is set to commence operations from June. According to a PTI report, banks are likely to transfer about 80 large NPA accounts, each with a size of over Rs 500 crore, to NARCL for resolution.

The new entity is being created in collaboration with both public and private sector banks. “This is expected to be more efficient in recovery as it will step into the shoes of multiple lenders, who currently have different compulsions when it comes to resolving a bad loan,” says Indian Banks’ Association CEO Sunil Mehta. NARCL will pay up to 15% of the agreed value for the loans in cash and the remaining 85% in government-guaranteed security receipts. The government guarantee would be invoked if there is a loss against the threshold value. Loans classified as fraud cannot be sold to NARCL.

As per the RBI annual report, about Rs 1.9 lakh crore of loans have been classified as fraud as on March 2020. Gross NPAs of banks which stood at Rs 8.96 lakh crore in 2018 declined to Rs 5.70 lakh crore in December 2020. But the pandemic impact is expected to reverse the gains made through various measures, including technical write-offs, recapitalisation, recovery. As the impact of relief measures, including a moratorium on loan repayment, wanes off, gross NPAs of banks is likely to rise to 9.6-9.7% by March 31, 2021, states a report by Icra Ratings. GNPAs may worsen further to 9.9-10.2% by March 31, 2022.

ARCs and India

The idea of a bad bank is not new. Asset Reconstruction Companies were set up as part of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (Sarfaesi Act, 2002) as an institutional alternative for NPA resolution in India. The ARC industry started off with the establishment of Asset Reconstruction Company India Limited (ARCIL), sponsored by five of the largest public banks in India — State Bank of India, IDBI Bank, ICICI Bank and Punjab National Bank, in 2002, and began operations in 2003. Thereafter, private players like Edelweiss and JM Financial came in.

In 2016, the Insolvency and Bankruptcy Code (IBC) took effect. The key distinction between IBC and ARCs is the manner in which the debt is written off. While in the former, the clean-up is through assisting the bank with a restructuring plan, in the latter, the debt is generally completely wiped off, resulting in taxpayer and others, such as employees, losing out on substantial amounts. In 2019-20, the amount recovered as per cent of the amount involved under the IBC was 45.5%, and it was 26.7% for ARCs.

“Asset reconstruction companies play an important role in the resolution of stressed assets. Their potential, however, is yet to be fully realised,” RBI Governor Shaktikanta Das had said. There are 28 ARCs registered with the RBI as on January 2021.

The issues concerning the ARCs are that these are private entities and so don’t enjoy easy access to government or government-backed funding. Their capital base is primarily through domestic sources, particularly banks and as such, capital constraints remain a problem. “Considering that banks are not just the major shareholders of and lenders to ARCs but also sellers of NPAs to ARCs, it may be necessary to monitor if there is a circuitous movement of funds between banks and these institutions,” points out an RBI paper.

International Experience  

During the South East Asia crisis in the late 1990s, financial sectors in several countries were burdened with NPAs and liquidity issues. Governments established AMCs such as the Korean Asset Management Company in South Korea, Danaharta in Malaysia (operational between 1998 and 2005, recovered about 58%), and the Indonesian Bank Restructuring Agency in Indonesia.

Examples of government-led efforts to resolve or reduce stress in advanced economies include the Resolution Trust Corporation in the United States and Securum in Sweden (1992 to 1997), which succeeded in recovering close to 86% of the amount.

Differently Similar?

Whenever the issue of distress comes up in India, discussion automatically moves to setting up a “bad bank”. Yet these proposals rarely describe how the bad bank will resolve existing problems, wrote Viral Acharya and Rajan in their paper ‘Indian Banks: A Time to Reform?,’ in Sept 2020 and cautioned “India’s primary experience with a bad bank is when IDBI Bank transferred bad loans worth over Rs 9,000 crore in 2004 to a wholly-owned special purpose vehicle. Neither did IDBI recover substantial amounts via its bad bank (especially factoring in the delay in the recovery) nor did IDBI Bank’s lending record improve. In part, the bad bank is no solution if it simply transfers bad loans from one government-owned entity to another without changing the incentives to make bad loans at the seller or improving the ability to collect at the buyer.”

CP Chandrasekhar, who taught at the JNU, writes how the almost two-decade long effort to use ARCs has not yielded expected results. “How effective the ARC route to sustainable NPA reduction would depend on: (i) the actual volume of NPAs that are absorbed; (ii) the average discount at which NPAs are absorbed; and (iii) the success with disposal. There remains the issue of from where the ARC/AMC would raise the capital required to acquire the loss-making assets from the banks. This might require another sleight of hand,” he writes in the EPW (May 15).

Acharya and Rajan too point to the functioning of the bad bank. “First, what price will the distressed loan be sold for to the bad bank? Second, will the bad bank be able to write down the loans it buys? Third, will a successful bad bank trigger a political backlash? Of course, while legacy bad loans are being cleared up, the authorities need to prevent yet another build up.”  

God is in the detail. Or will it be a problem of plenty?

Interview:

‘NARC is likely to succeed’

The idea of Bad Bank was mooted a few years ago. But why is there so much activity around it now?

I don’t think it is appropriate to call the proposed entity as bad bank. The right terminology should be either Asset Reconstruction Company or Asset Management Company. It is good that it is now formally referred to as National Asset Reconstruction Company (NARC). As far as the current activity around it is concerned, it is the need of the hour in view of the alarming rise in NPAs and its forecasts in the near future. Gross NPAs, which are already as high as 7-8% at present, are predicted to go up to 15-16% by September 2021.

There are already Dispute Resolution Tribunals and ARCs. Is there still a need for NARC? 

Lok Adalats and DRTs have been in vogue for almost three decades. Their recovery rates, which were not high even initially, have been dwindling drastically during the last decade. ARCs have been active for quite some time, yet their recovery rates have not been very encouraging. Further, the pandemic is having an adverse impact on economic activity, resulting in falling recovery rates. Different banks, geographies, segments and sectors may show different trends, but overall, the recovery position is not good and is likely to get worse. In view of the inadequacies in the existing system and due to the deteriorating position of NPAs and associated capital adequacy and lending capacity issues of banks, there is no question on the timing of NACR.

Is it going to be one more ARC? 

NARC is expected to be more efficient in recovery as it will step into the shoes of multiple lenders, who currently have different compulsions when it comes to resolving a bad loan. It will take over identified bad loans of lenders and its biggest advantage is the aggregation of the bad loans. The new entity is being created as a collaboration among public and private sector banks. The efforts are coordinated by the Indian Banks’ Association. They are backed by the government. Besides, there is a tacit concurrence from the RBI. The distinct advantage of NARC in comparison to separate AMCs is that it could reduce information asymmetries regarding borrower details.

How do you see the future of NARC?

The Kamath panel said that companies in sectors such as retail, wholesale trade, roads and textiles are facing stress due to the pandemic. Sectors that have been under stress even before the pandemic include NBFCs, power, steel, real estate and construction. The panel felt that setting up a national organisation can benefit immensely. There is a definite scope for a well-capitalised and well-designed entity in the Indian ARC industry, and such an entity will strengthen the asset resolution mechanism. To take the process further, the RBI has set up a committee to review the working of ARCs and recommend measures for enabling such entities to meet the growing requirements of the financial sector.

What should NARC do differently? 

The recovery or/and disposal of bad loans depends on the regulatory framework, bankruptcy laws and operational independence. To address these dependencies, the following are required: government backing, legislative changes, regulatory guidelines, quick recovery process and support from all stakeholders. If all the above are in place, NARC is likely to succeed. Its success is in the best interest of banks, borrowers, investors and all economic entities.

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