Setting Up The Indian Bad Bank
Indian banks entered 2020 with 8% of Gross NPAs. Fast forward one year, RBI expects the NPAs to cross 13.5% this year. The lingering NPA problem has arisen due to lending by public sector banks to cyclical industries, infrastructure sectors, weak risk management systems, political interference, and adverse judicial decisions creating stranded assets. While India has already allowed private Asset Reconstruction companies since 2002, they have not meaningfully resolved the NPA problem so far. Insolvency and Bankruptcy Code (IBC) attempted to solve it, but it has been temporarily suspended by the Supreme Court due to pandemic. Even its recovery ratio (21%) and resolution time (270 days+ for most cases) have been abysmal. The government has injected 2.5 trillion Rs. Cash into PSBs as part of the recapitalization, but that still didn’t solve the problem. Hence, the government decided to try out the ARC-AMC model with the establishment of NARC (National Asset Reconstruction Company)
What is a bad bank?
A bad bank as a concept is essentially Asset Reconstruction Company. As per McKinsey’s analysis in 2009, there are four ways a bad bank could be formed. They could have the risks on the books/off the books, and they could be structured as SPEs or as a separate bank unit.
In the Indian context, the bad bank proposed will have a contribution from 16 entities with Canara Bank its sponsor (with a 12% stake). It will have paid-up capital of 74 Cr and is expected first to take over INR 82000 Cr worth loans followed by INR 2 trillion loans. It is expected to pay the book value (after provision) of the loans to the banks (15% in cash and 85% in government-backed notes). The entity is planned to be cash neutral, meaning no significant expense to the exchequer.
Bad banks in the global context:
Bad bank as a concept has been tried earlier in the US, Europe, and Asia with varying degrees of success after financial crises.
As per a study by BIS working paper analyzing 135+ banks with NPA issues, it was found out that recapitalization and asset segregation in tandem could improve credit in the system. The measures performed individually didn’t result in a significant change in the credit. India’s current model focuses mainly on segregation as the recent recapitalization of 20,000 Cr sounds meaningfully inadequate for a system in NPAs more than 10 lakh Cr+.
National Asset Management Agency from Ireland and Danaharta from Malaysia would be the two relevant institutions for reference.
NAMA, Ireland:
Under the global financial crisis, Ireland suffered deflation in real estate prices. Hence, bank books with exposure to the sector were stressed. Ireland changed the tack, after first proposing a sovereign guarantee due to adverse market reaction. They decided to set up NAMA (National Asset Management Agency) with a focus on real estate loans and gave it sweeping legal powers. The agency purchased the loans worth $74 billion book value for a long-term economic value of $54 billion, $7 billion more than market value. It was set up with a mandate to return the proceeds and complete the projects by 2020. It proved reasonably successful, with assets worth $2.8 billion stranded as of now, and has yielded a profit of $4 billion to the government.
It had a clearly defined purpose and timeframe to complete its operations. Its assets belonged to real asset classes with geographical diversification. Having a single asset class meant it could bring unique expertise to resolve this category of loans. Its critics claim that it overpaid for the assets.
Danaharta, Malaysia:
After the financial crisis in 1997–98, Malaysia set up Danaharta, an asset management company, to take over stranded assets with a time frame of 5 years. It was financed by the government. Although it bought the NPLs at market price (often at a discount to book value), it promised the banks upside in case recovery exceeds Danaharta’s estimated value. This model was successful, and it achieved recovery of 60% assets and is considered one of the best in its category.
While it did inherit loans from different asset classes, it had special powers from the government. It could compulsorily acquire, change boards, liquidate without any interference from Malaysian courts. This made sure that Danaharta could quickly resolve NPAs, and legal proceedings didn’t hamper the recovery. It is also important to note that Danaharta was accompanied by Danamodal, a government-backed recapitalization entity. Hence segregation accompanied by recapitalization was effective.
How does NARC compare vs. NAMA and Danaharta?
While NAMA had a narrow mandate of Real Estate loans, NARC is similar to Danaharta in that it will deal with NPAs regardless of the underlying sectors. It will suffer from a lack of focus to bring expertise in loan resolution in different industries.
It is expected that NARC will pay 15% cash and the remaining 85% with government-backed notes to the participating, which would be paid on recovery. This model is similar to Danaharta, as it bought the NPLs at an estimated price and promised 80% of the upside to the banks in case of outperformance of loans. In contrast, NAMA purchased the loans directly and did not provide any upside to the banks. NARC and Danaharta’s model is better since the initial cash outlay is lower, and banks still have the potential for the upside.
NARC also differs from NAMA and Danaharta in their ownership. For NAMA, 51% was owned by private equity, and it could issue government-backed debt to fund the buyout. In the case of Danaharta, the government provided the funding with zero-coupon bonds. Indian model has the participating banks themselves own the entity.
Opportunities:
It will allow the ‘good banks’ to focus on their non-toxic portfolio and resume fresh lending. It can serve as a Single Point of Contact for restructuring as well as for foreign distressed debt investors. It should lead to quicker resolution of NPAs. Government backing would certainly improve confidence for foreign market participants. It will be able to assemble a team of experts to extract value. Potentially securitization of the debt could create a liquid market for the NPA loans.
Threats:
Indian model suffers from moral hazard as the participating banks themselves will be offloading the bad loans to the Bad Bank. It may inflate the consideration paid by the BB for the NPLs. A dual ARC-AMC structure would be problematic from an accountability perspective. It is not accompanied by any concrete proposal for recapitalization. In the absence of that, banks will not increase the credit, which is the prime motive. Even now, despite being flush with liquidity, banks are unwilling to extend credit. The legal proceedings need an overhaul. Absence special legal powers, bid-ask spreads will stay high, and the interest of buyers won’t improve. If the mandate is not clearly defined, it may turn out to be an even bigger issue similar to Huarong Capital, which was originally a bad bank but went bankrupt with activities outside its scope.
It is a welcome step in right direction. Clear mandate, time bound resolution, special legal powers to the ARC and government capital infusion into participating banks will help kickstart a new credit cycle. This will help resolve the problem of Bad Debts once and for all.
This article has been written by Rishabh Binaykiya, a PGP (2021–23) Student at IIM Ahmedabad . All the views expressed are his own.
References:
1. Martini L. et.al. (2009), ‘Bad banks: finding the right exit from the financial crisis’, McKinsey Working Paper on Risk
2. Brei, Gambacorta, Lucchetta, and Parigi (February 2020), ‘Bad Bank Resolutions and Bank Lending’, BIS Working Paper №837
3. Bhansali U. et.al.(November 2020), ‘Bad Banks in India’, Deloitte Touche Tohmatsu India LLP.
4. Adhikari A. (July 2021), ‘Shaping India’s Bad Bank’, BusinessToday.in
5. Jain N. (June 2021), ‘Will the proposed Bad Bank cure India’s Banking Sector?’, Financial Express
6. Nye, Alexander (2021) “National Asset Management Agency (NAMA),” The Journal of Financial Crises: Vol. 3: Iss. 2, 546–617.
7. Azmi R. (January 2014), ‘The role of Danaharta in Managing and Rehabilitating Financially Troubled Companies in Malaysia — Part One’, Chase Cambria Publishing Company
