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February 10, 2021

Know all about Bad Banks and How it will work in India

by CA Shivam Jaiswal in Corporate Law, RBI

Know all about Bad Banks and How it will work in India

A bank’s or non-bank lender’s core business is to lend money and collect it until the last amount due, hopefully on time and every time. Based on the performance of the loan, it may be categorized as a standard asset (a loan where the borrower is making regular repayments), or a non-performing asset (NPA). NPAs are loans and advances where the borrower has stopped making interest or principal repayments for over 90 days. The issue of Non-Performing Assets (NPAs) in the Indian banking sector has become the subject of much discussion and scrutiny. The banks’ capacity to lend has been severely affected because of mounting NPAs.

Any business could become a stressed one, due to a variety of reasons, including an industry cycle shift, poor business strategy or execution, nefarious intent of the promoter (which the law provides to be dealt with differently). The COVID-19 crisis is unprecedented in its fury and has disrupted global economies and local (consumer and investor) sentiments too.

To reduce the impact of the losses that the banks will face due to provisioning for non-performing assets and the recapitalisation of banks that the government (as majority owner in most PSBs) may be forced to spend on, there was a proposal presented to the government, to set up a “Bad Bank” in the form of an Asset Reconstruction Company (ARC), to move the NPA portfolio from banks (at book value and not at the lower market value) into the new entity (to be set up with a capital of Rs 10,000 crore).  

What do you mean by ARC’s? 

  • An Asset Reconstruction Company is a specialized financial institution that buys the NPAs or bad assets from banks and financial institutions so that the latter can clean up their balance sheets. In other words, ARCs are in the business of buying bad loans from banks. 
  • ARCs clean up the balance sheets of banks when the latter sells these to the ARCs. This helps banks to concentrate in normal banking activities.
  • Banks rather than going after the defaulters by wasting their time and effort, can sell the bad assets to the ARCs at a mutually agreed value.
  • ARC’s are registered with RBI under Section-3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.
  • There are many licensed ARCs in India, which provide turn-around specialists (with specific sectoral skills) and not just credit underwriting understanding.

What do you mean by a bad bank?

  • A bad bank is simply a corporate structure that isolates liquidity and high-risk assets held by a bank or a financial organisation, or perhaps a group of such lenders.
  • Bad banks as a concept works efficiently when the domestic debt market is deep and the number of market participants is wide enough to allow sufficient price-discovery and market-making.  
  • It’s a place where a struggling financial institution can put assets it wants off its own books to eventually sell or unwind.
  • Often, it is made up of businesses or holdings that are dragging the bank down, such as risky and illiquid derivatives or delinquent loans.

What would be the effect of incorporating bad banks?

  • The bad bank would help expedite the pace of debt restructuring by reducing the number of lenders who must agree to a proposed deal.
  • It also makes it easier for foreign funds to build controlling positions in the debt of a firm by allowing them to negotiate with a single seller.
  • Placing non-core assets in a separate division could help make a restructuring more efficient and transparent by providing investors with financial disclosures to better track the progress of a lender’s overhaul and hold management accountable.
  • Shedding the assets in the bad bank then frees up capital that could be used to bolster a firm’s financial strength or be redeployed to more profitable businesses.
  • If it’s a separate entity, it could also allow a bank to clean up its balance sheet, reduce losses and protect depositors.
  • Like all policy moves, depending on the details, there could be unintended consequences.
  • If ownership were to lie with Indian banks, which originated the loans, the transfer price might risk being inflated.
  • That could end up freezing the growing secondary market for distressed credit and deter foreign funds, which have been showing burgeoning interest in the opportunity.
  • Without new external capital to help bolster the fragile financial system, taxpayers could be left on the hook.

Past Debt Resolution Mechanisms introduced by the Government

  • Post-2014, the government has tried three debt resolution mechanisms:
  • Strategic Debt Restructuring (SDR) scheme of 2015 which allowed creditors to take over firms unable to pay and sell them to new owners
  • Sustainable Structuring of Stressed Assets (S4A) of 2016 which let creditors take 50% haircut to restore the financial viability of firms and
  • Insolvency and Bankruptcy Code (IBC) of 2016 which either revived (resolution) or closed (liquidation) indebted firms.
  • The first two had failed by FY17, primarily because of governance failures as the Economic Survey of 2016-17 explained at some length.

Role of Insolvency and Bankruptcy Code, 2016 (IBC)

  • The Insolvency and Bankruptcy Code, 2016 (IBC), the bankruptcy law of India allows debtors, creditors, and the companies themselves to ask for a particularly stressed business to be sold to another set of promoters.  
  • The critical philosophy of the IBC was the concept of “creditor in possession and control”, rather than “debtor”.
  • The IBC has been stopped from initiating fresh corporate insolvency resolution process (CIRP) until March 24, 2021, by the government and apex court orders prompted by the pandemic-induced economic disruptions.
  • The IBC regulator, Insolvency and Bankruptcy Board of India (IBBI), provides details of stressed asset resolution until September 2020 (Q2 of FY21).  
  • The IBBI’s data shows that the total number of CIRP cases admitted for the IBC proceedings stood at 4,008 (from FY17 to Q2 of FY21). Most of these cases are from manufacturing (41%), real estate, renting, and business activities (20%).  
  • Of these 4,008 cases, 277 ended in resolution (firms continue as going concerns) and 1,025 in orders for liquidation.
  • The total claims were Rs 10.48 lakh crore (Rs 4.34 lakh crore plus Rs 6.14 lakh crore) and the “realisable” amount Rs 2.2 lakh crore” (Rs 1.89 lakh crore plus Rs 0.31 lakh crore). This means the total haircut is the rest Rs 8.3 lakh crore.
  • At this rate, the debt recovery worked out to be 20.9% (79% of haircut).  
  • This debt recovery rate was far lower than the much-reviled UPA-era debt resolution processes when the recovery was 25% (and haircut 75%). The IBBI repeatedly reminded this in its reports to justify the IBC.  
  • There was yet another downside to it.
  • Most of the debt claims ended in liquidation – Rs 6.8 lakh crore or 59% of the total claims.  
  • Besides, out of Rs 18,916.9 crore of debt claims for which the liquidation process has been completed, only Rs 280 crore was actually “realised” – a recovery rate of 1.5% (haircut of 98.5%). The remaining Rs 5.95 lakh crore is under the liquidation process.
  • Liquidation, thus had a triple effect on the economy: Loss of credit/loan, loss of business and loss of jobs too.  

Moratorium also provided by RBI

  • The banking regulator RBI had brought in the concept of offering a three-month moratorium from all lenders (banks and non-banks) to their customers, which was extended by three more months.
  • And due to a case filed in the Supreme Court (SC), this topic of moratorium was currently sub-judice, whose outcome could change the balance sheet provisioning for the entire banking and finance sector.  
  • However, RBI has not permitted a corresponding leeway to lenders. This has necessitated that lenders continue repaying their obligations, without the ability to collect from their customers.  

The new structure would aggregate bad loans from Indian banks to help them clean up their strained balance sheets. Many details of the plan are yet to emerge, including ownership, control and mechanics. Early comments from officials indicate that banks may capitalize it, at least initially, and that it would aim at being “cash neutral.” That could mean largely paying for the bad loans it buys with securities linked to the eventual cash recoveries from the underlying assets, in part to avoid having to use taxpayer money. In June last year, chief economic adviser (CEA) KV Subramanian had said that setting up of a bad bank may not be a potent idea as there are already many ARCs in operation and banks have failed to sell bad loans to them. Also, when a bank sells bad loans it has to sell it at a discount and hence take a haircut. Hence, it will be interesting to see if the Centre finally opts for setting up a bad bank in the system.

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