Bad Bank: Will It Resolve The Npa Crisis?

On 15^th September, 2021, Union Cabinet approved the central government guarantee of up to Rs 30,600 crore to back security receipts to be issued by the National Asset Reconstruction Company Limited (NARCL), also known as the Bad Bank.

• A bad bank is an asset reconstruction company (ARC) that takes over the stressed assets of commercial banks, restructures them and sells them to investors, and recovers the money over some time.

Need for Bad Bank

The Indian economy has been slowing down due to the legacy non-performing assets (NPAs) in the banking sector that had turned the banks risk-averse.

• In RBI’s asset quality review (AQR), it was found that several banks showing a healthy balance sheet but have suppressed or hidden bad loans.
• Within the bank groups, public sector banks' (PSBs) GNPA ratio is 9.54 percent in March 2021.
• Despite a series of measures by the RBI for better recognition and provisioning against NPAs, as well as several tranches of capitalisation of PSU banks by the government, the problem of NPAs continued to fester in the banking sector.
• From the taxpayer’s perspective, the most worrisome fact was that an overwhelming proportion of NPAs was with the PSBs, which were owned by the government and hence by the Indian public. To keep such PSBs in business, the government was forced to recapitalise them — that is, use taxpayers’ money to improve the financial health of PSBs so that they could carry on with the business of lending and funding economic activity.
• According to RBI’s Financial Stability Report, the gross non-performing assets (GNPA) ratio of banks may rise to 9.8 per cent by March 2022 from the 7.48 per cent in March 2021.
• Further, the KV Kamath Committee on Loan Restructuring (August, 2020) said companies in sectors such as wholesale trade, retail trade, textiles and roads are facing stress. So, setting up a bad bank is crucial to revive these sectors.
• There is a need for a one-time settlement of the enormous stock of bad assets in the financial sector, and trying to resolve that through IBC alone might not be right for the economy.
• Many PSUs were uncomfortable selling their NPAs to a private entity. Moreover, the existing ARCs do not have the capital required to buy large assets. In the proposed bad bank major stake is owned by the government.

New Structure of Bad Bank

National Asset Reconstruction Company Limited (NARCL)

• NARCL is incorporated under the Companies Act and has applied to the Reserve Bank of India for the license as an Asset Reconstruction Company (ARC).
• It has been set up by banks to aggregate and consolidates stressed assets for their subsequent resolution.
• Public Sector Banks (PSBs) will retain 51 percent ownership in NARCL.

India Debt Resolution Company Ltd. (IDRCL)

• IDRCL is a service company/operational entity that will manage the asset and engage market professionals and turnaround experts.
• Public Sector Banks (PSBs) and public FIs will have a maximum stake of 49 percent and the rest will be with private-sector lenders.

Working Mechanism

• The NARCL will first purchase bad loans from banks.
• It will pay 15% of the agreed price in cash and the remaining 85% will be in the form of “Security Receipts”.
• When the assets are sold, with the help of IDRCL, the commercial banks will be paid back the rest.
• 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 difference between what the commercial bank was supposed to get and what the bad bank was able to raise will be paid from the Rs 30,600 crore that has been provided by the government.
• This guarantee is extended for a period of five years.

Benefits

Controlling NPAs: The large NPAs will be moved from the balance sheets of commercial banks to an entity that has the resources and skills to handle stressed assets. It helps commercial banks to clean up their balance sheets by taking over bad loans at a value below the book value of the loan.

• Speedy Resolution: As the bad assets will be under single ownership, the resolutions will be faster and not constrained by the need for consensus among many lenders. As it is supported by the government, it will not delay resolution due to governance deficiencies, slow-moving judicial architecture, poorly designed regulation, etc.—the major issues faced by ARCs.
• Efficient Banking System: The one-time transfer of assets out of the bank's balance-sheets will relieve banks of their stressed assets and allow them to focus on their core business operations viz. lending. This would leave bad banks to recover dues through liquidation and asset restructuring.
• Impetus to Economic Growth: Bad banks would also give an impetus to India's economic growth, which has been affected by heightened risk aversion arising from the unbridled growth in NPAs. And the bad bank will unlock trapped capital, which will be a net positive for the economy in the long term.
• Increase Free Capital for Lending: Commercial banks will have free capital for lending. The profitability and credit ratings will improve.

Challenges for Bad Banks

Most of the bad assets are already fully provided for, written down on the books of banks. The banks no longer nurture hopes of a meaningful recovery.

• From these assets, the most critical part will be how banks arrive at a valuation for the transfer of these assets to the bad bank. The ability of the bad bank to resolve these assets in a time-bound manner will be critical for future provision write back by banks.
• In the current situation, when economic conditions are deteriorating, finding potential buyers for distressed assets can be a significant challenge.
• The public sector banks will be both shareholders and customers of the bad bank—and it leads to the danger of the bad bank being nothing more than a means to shift some bad debt from one book to another.

Thus, Bad Bank is a good measure to resolve NPAs in the short run but in the long run there is a need to improve the governance of public sector banks, their risk assessment system, as well as strengthen auditors, boards, rating agencies, and regulatory supervisors so that the cycle of bad loans come to an end.