Will Bad Bank be the answer to the Stressed Asset problem in Indian Banking?

The rising NPA’s in the Indian Banking sector has been a matter of concern reducing the overall efficiency and effectiveness in the lending system. The Gross NPA’s in the banking sector is already above Rs 10 lakh crore and expected to move upwards.

The Insolvency and Bankruptcy Code (IBC) was established to resolve insolvency issues with a timebound process. The IBC came into effect in Dec 2016, but the recovery rates have been very low (less than 40%).

As per the World Bank data, share of NPA to gross loans in Indian banking is 9.5% in 2018, which is significantly higher compared to other developed/developing economies.

A point to note is that a large portion of these NPA’s are in the government owned Public Sector Banks (PSBs). Burdened with stressed assets many of these banks have low profitability and high operating costs.

With one of the key objectives of de-stressing the bank’s balance sheet, the National Asset Reconstruction Company Ltd (NARCL) also called as the Bad Bank has been formed.

What is a Bad Bank?

A bad bank (also referred to as an asset management company or AMC) is a corporate structure which isolates illiquid and high risk assets (typically non-performing loans) held by a bank or a financial organisation, or perhaps a group of banks or financial organisations.

The approach allows good banks to focus on their core business of lending while the bad bank can specialize in maximizing value from the high risk assets.

The first Bad Bank in the world was formed in 1988 by US based Mellon Bank to hold its stressed assets. The model was soon adopted by Sweden, France, Finland, Indonesia, Belgium.

(Source: Wikipedia)

India’s Bad Bank Plan

NARCL, India’s Bad Bank has been formed as the body to resolve the legacy NPAs or stressed asset problem plaguing Indian Financial system especially the public sector banks. 

The NARCL has a capital base of Rs 6000 crores of which PSBs hold a lion’s share along with private sector banks.  

The India Debt Resolution Company Ltd (IDRCL) has been set up alongside NARCL.  NARCL will be responsible for acquiring and valuing bad loans while IDRCL will manage the asset by engaging professionals and turnaround experts.

Stressed assets worth 2 lakh crores have been identified to be taken over by NARCL. Under the first phase, stressed accounts worth Rs 90000 crore that have been fully provided for will be acquired.

For the bad loans acquired, NARCL will adopt a 15:85 structure.  15% of the purchase price or the sale consideration will be paid in cash and the remaining 85% will be paid in the form of Security Receipts (SRs). 

The SRs are tradeable and backed by Government of India guarantee*.    

The guarantee can be invoked in case of any shortfall between the face value of SR issued and the actual realization amount.  A prerequisite for invocation is either resolution or liquidation. Further to discourage any delay in resolution, there is a guarantee fee that must be paid and will increase with time.

*(The Cabinet has approved to provide guarantee of Rs 30600 crore on the Security Assets issued by the Bad Bank valid for a period of 5 years.)

How will the Bad Bank plan help Banks to destress?

1)      Banks will receive 15% of the sale consideration in cash which can be instantly ploughed back as profits as these are legacy stressed assets and fully provisioned in the Bank’s balance sheet.

2)      Guarantee by Government may revive investor interest in creating a demand in the secondary market for SR's.

3)      This will improve the tradability of SRs and the sale consideration can be taken to the balance sheet as profits.

4)     For Banks, this will prove to be quick fix in getting the legacy NPAs out of their books and focus on credit growth.

5)   Banks can reduce their NPAs, augment their capital and strengthen their balance sheet.

Pros and Cons of the Bad Bank Plan

Like any initiative, there are pros and cons to the setting up of India’s Bad Bank.

Let us look at some of them.

Pros

1)      Nationalized entity

2)      Single authority for legacy stressed asset resolution

3)      Domain expertise

4)      Bankers skin in the game

5)      Allows banks to devote their time to routine banking activities rather than recovery process

6)      Plugs in the loophole in the ARC model, government backing may ensure smoother and quicker resolution

Cons

1)      Focus is on resolution of legacy stressed assets, no mechanism to arrest fresh slippages

2)      On the flip side, with bad bank as a fall back for Banks, chances are they could become less vigilant while disbursing loans and the situation could turn precarious.

3)      IBC too was a professional body set up with same purpose, but resolution was below 40%

4)      Transfer of assets to the books of NARCL may prove to be a cosmetic cleanup of balance sheet, especially in case of PSB’s where it is a transfer from one public sector to another.

5)      Demand in the market for SRs is uncertain at this point

Conclusion

The creation of a centralized Bad Bank in India may bring out a certain amount of reduction in the stressed asset and help in cleaning up Bank’s balance sheet.

But will the Bad Bank strategy be a solution to the stressed asset problem in the Indian Banking?

Possibly too early to assess this!

It is a no brainer that in an economy that is overburdened with NPA’s, one needs to look at the root cause of the issue.

In many cases what is seen lacking is a proper appraisal model or a  strong post sanction process framework, inadequate due diligence during the life cycle of loan, ineffective project management, loan covenants not enforced, delayed reporting of deviation/ tightening the controls in account operations, inadequate collaterals, no periodical review of accounts, excessive use of discretion etc. to name a few.

Let the mantra be ‘Prevention is better than cure’. Let the efforts be to prevent fresh slippages rather than invest time in recoveries post disbursement.

An important tool that can be deployed is technology.  Technology is mature today and can be effectively used to gather borrower information from social profiles and categorize the account health. Automated solutions enable better data analysis and provide early warning signals. 

Losses and NPAs that occur due to natural business failures are a part of any banking system. There is always a remedy for such loans where the borrower is bonafide and has a genuine intention to repay. Things go wrong and recovery is remote when the intention is malafide and here is where strong internal controls come to save and prevent the NPA havoc.

Will India’s Bad Bank do the magic that ARCs and IBC didn’t?

Well only time can tell.