Bad Banks: A Lullaby to NPAs’ Cry for Help

The cornerstone of a long-lasting banking sector is built on well-designed recovery mechanisms. It supports the long-term viability of the borrower and lender relationships. Surprisingly, non-performing assets (NPAs) have significantly increased in India. Global instances indicate that the NPA situation is distressing and necessitates state action to avoid a
downturn.

The Indian Banks have put-up Rs. 5,140 crore worth of NPAs for sale in fourth-quarter of fiscal year 2021. Although, there is comprehensive literature available on the schemes under the Reserve Bank of India’s (RBI’s) Framework, Insolvency and Bankruptcy Code 2016, etc., the author seeks to delve into the untapped alternative suggested by the Indian Banks’ Association – ‘Bad Banks’ as a viable key to the principal issue of non-performing assets (NPAs), which are expected to substantially rise due to the Pandemic.

The author shall discuss the functioning of a bad bank in light of the many challenges that may
fright it from aiding the NPA woe to worsening the banking crisis. The author shall also analyse the need of a bad bank in resolving the NPA crisis in light of the framework on Insolvency in India and how certain measures must be followed to seek the probable benefits from a bad bank.

By Shhreiya Agarawal

bad banks

INTRODUCTION

“The first bad bank loan was no doubt made around the time of the opening of the first bank.”

– James Grant

The Indian financial market is driven by the banking sub-sector. Indian banks provide majority of the funding required for longer gestation projects. Bank-owned assets can be divided into two categories:

a) good assets, and

b) Non-performing assets (NPAs) and other
high-risk securities.

Bad Banks operate to buy the assets falling in the second category from the banks, for the bank-owned assets to represent their core business. The Indian banking system is heavily fraught and held back by the massive amount of NPAs.

The Indian debt issue is a key reason for fresh investments not being made as per the required scale. [1] This has led to decline in economic growth and employment opportunities. In order to tackle the bulkage of non-performing assets (NPAs) or bad loans a financial entity is required to buy these loans. A bad bank, thereby, purchases these bad loans from the banks themselves.

However, a bad bank does not function like a bank. The simple aim of setting-up a bad bank is to take-away the bad loans off of the bank’s balance sheets and to enable them to lend to customers without any restraint.

In 1988, Mellon Bank, headquartered in the United States, established the first bad bank to retain its “toxic properties”. In many nations, including the United States, Belgium, Indonesia, Sweden, and Finland bad banks have been implemented and perceived to be effective. In the case of Mellon Bank Corporation, a new entity named Grant Street National Bank (GSNB) was formed to retain the bank’s toxic assets by spinning off its own resources and some board members. [2]

Mellon’s poor loans were acquired at a 53% discount by GSNB. It should be recalled, though, that GSNB was a private-sector experiment with no government funding. After meeting its goals, GSNB was disbanded in 1995 after focusing on the restructuring of bad loans under independent management.

In comparison, the latest proposal in India requires the government to make initial investments. In such a case, it is unclear how a bad bank would serve. Another factor for the resurgence of the bad bank concept in India is the substantial discount on stressed loans for asset reconstruction companies (ARC). The IBA has recommended that the bad bank buy stressed assets at book value, net of minimum regulatory requirements, thus avoiding the valuation and due diligence process. As a result, it is likely that the bad bank would buy stressed assets at the price desired by banks, causing market distortions in stressed assets.

Another problem that could emerge is the sale of stressed assets to prospective investors and the resolution of the system’s underlying crisis. [3]

Quarantining of NPAs- How Does a Bad Bank Function?

A Bad Bank is not a bank by way of its function, it functions partly as an asset-reconstruction company (ARC) and partly as an asset-management company (AMC). The specialists at Bad Banks take the load of maximizing the value of the acquired assets and, further, ‘quarantine the stressed assets’ from the banks. It essentially forms a pool of NPAs acquired from different banking institutions and realize their full value by selling them to wilful buyers. This avoids banks or corporates individually attempting to realize their full value. It reduces the risk and burden of the liabilities from the bank’s balance sheet.

The acquisition of bad loans is traditionally below the loan’s book value, with the bad bank attempting to reclaim as rapidly as plausible. A bad bank provides the illusion that it can run as a bank but has bad assets to begin. Technically, a bad bank is not involved in lending and taking deposits. Once an NPA is purchased from a bank, the bad bank attempts to restructure and sell the same to interested investors. [4] A profit is entered in its operations when a loan is sold at a higher price than it was purchased from a commercial bank. This renders the secondary aim of generating profits difficult. [5] Since the fundamental aim is to destress the bank holding a heavy load of NPAs and to increase lending in the banking sector. [6]

The Korean Asset Management Company (KAMCO), set up after the South East Asian crisis can be an excellent example in this regard. [7] In conjunction with an NPA-fund, it rapidly metabolitized the economy by reducing NPAs from 17.7 percent in 1998 to 0.5 percent in 2004 [8]. While the economy was illiquid, KAMCO acquired NPAs and aided in the recovery of public deposits (2003: 39 percent recovered) [9], which were used to revitalise the financial wellbeing. KAMCO assisted in the creation of a stable investor base in the NPA market, encouraging the restructuring process.

The Covid-19 Hit

Presently, in the Covid-19 market, the Reserve Bank of India offered loan moratoriums and option of restructuring to the debtors and borrowers. Nevertheless, banks and lenders were not provided with a parallel relaxation and were expected to continue repaying and maintaining their obligations. [10] The extended lockdown due to COVID-19 has thwarted economic growth, resulting in a negative effect on cash flow, with implications on obligations such as interest rates, debt repayments, and tax payments.

Non-performing assets (NPA) account for approximately 9.1 percent of total assets in Indian banks.  Owing to the marginal operation of companies, a rise to 18–20 percent is expected. This recent surge in NPAs has reignited the discourse about the use of bad banks as a mechanism for coping with NPAs. [11]

The Indian Bank Association (IBA) has suggested that the government initially fund the establishment and operation of the bad bank. 12 In line with this, the government introduced an economic stimulus package worth INR 20 lakh-crore as part of the pandemic rescue, including INR 8.01 lakh crore in liquidity initiatives announced by the Reserve Bank of India (RBI) to relieve financial distress induced by COVID-19. This scheme included term loan instalment moratoriums, interest deferral on working capital facilities, and funding of working capital.

Pre-Cursor to Running Towards a Bad Bank

Is it not bad governance to transfer a bad loan from one account to a different institution owned by the very same bank or the initial shareholder? As well as to assume the very same set of banks to restructure the asset in order to regain funds since they struggled in the first instance?

The idea of bad banks works well because the domestic debt market is deep and the number of market players is high enough to allow for adequate price discovery and market-making. The burden to recapitalise its public sector banks (of which it is the majority owner) is bound to be an obstacle in the current depressed economy and a slim coffer that governments might have at their disposal.

In the same context, there has been no policy debate or executive judgement about whether the Centre’s shares in its public sector banks and other financial institutions should be immediately monetised. Instead of requesting the government to finance a new institution to accommodate “bad loans” lenders may explicitly provision for them on their books and only request additional capital injection from investors. This will be a straightforward method of informing public investors about how their money is being invested. [13] However, the condition of the Indian banking sector and world economy at large require immediate action in taking corrective steps toward reducing the NPAs.

Restructuring of NPAs- A Good ‘Bad Bank’

Regulations on NPAs are governed by the 5Cs – Courts, Cabinet (bringing in regulatory security for bankers who take credit calls and sell NPAs in the market under existing regulations) CVC, CBI, and CAG.  This may be a turning point in terms of establishing that the capitalist model of market pricing is respected and sets the stage for financial decisions, allowing bankers, rather than bureaucrats, to make business decisions while adhering to complete governance norms. [14] Some of the key aspects in decoding the effectiveness of establishing a bad bank in order to solve the NPA issue are:

Ownership

One of the key factors in the rise of NPAs is the nature of ownership of Public Sector Banks (PSBs). The bureaucrats managing PSBs are often not committed to aim for high profits and do not have substantial financial incentives akin to that of private banks. After a certain point, transferring NPAs to a bad bank would not solve the underlying issue of the NPA crisis.

Furthermore, it gives incentive to commercial banks who are bailed out by a bad bank to stick to their bad policies and not take reformative steps to avoid piling up of NPAs.  A bad bank provides a safety net allowing banks to lend negligently, exacerbating the NPA crisis. However, due to pricing considerations, government-backed financing might not be practical.

In order to achieve the goal of creating Bad Banks, a government-controlled Bad Bank may not bargain well and will be required to purchase the assets at a bank-desired amount. This will be a misunderstanding in the logic of a third party purchasing bad assets at a market-driven price dependent on the success of a business. The NPAs would simply be passed from one party to another, but the underlying cause of the financial crisis would be ignored.

Furthermore, in order to overcome the moral hazards, the position of government must be minimised, and a public and private partnership model must be used with a time-bound resolution combined with necessary commercial freedom. In this manner, the financing dilemma can be overcome by relying on both original government funding and private funding through the use of alternative fund contributions.

Transparency

There are several constraints in the smooth and fair disposal of NPAs; with a major issue being transparency. To address pricing issues and concerns relating to the degree to which a public sector bad bank will write down the face value of the loans it purchases, creating a more liquid market for distressed debt sales could be beneficial. This will help to make secondary market debt rates clear, allowing for them to be utilised as reference prices in similar transactions. This may also serve as a model for anticipated recovery upon resolution.

Presently, there is no regulation that governs publicly disclosing the initiatives undertaken by banks soliciting bids to sell off loans barring the final decision to sell. In simple terms, there is no transparent secondary loan market. [15] Standardized loan contracts need to be codified into a data repository to aid the implementation of such a market; a Public Credit Registry (PCR) currently being introduced by the RBI might be a logical place to manage a contract registry. In line with the registry, bids can be collected online.

Thereby, transparency can be maintained on the numbers of bids received, accepted and denied. Parallelly, this shall also set up a mechanism to anticipate sale prices of NPAs and loans and negate the need to clear them from the books. This shall enable the analyzation for improving future prices for buyers and sellers alike.

In-house management team

The bad bank replaces the borrower and appoints a new top management. However, this shall only be possible if its bid wins the assets in the bankruptcy auction. Every bad bank may have in-house management teams that specialize in specific industries. These teams will be headed by retired or hired business executives, and they can replace the promoters and top aides. The team will be paid in part by an equity stake that scales in proportion to the size of the turnaround.

In effect, the bad bank shall take over the management of NPAs from the promoter’s top management. In the face of widespread distress, this places the bad bank in the position of a private equity boss, a required role. The bad bank can only exercise ownership powers if the original promoter is ineffective as a manager and other seasoned market actors are unwilling to bid a fair price for the business.

Timely Disposal

With the implementation of the Insolvency and Bankruptcy Code (Amendment) Ordinance, 2020, the application of the Insolvency and Bankruptcy Code 2016 (IBC) was suspended for a term of six months, or for subsequent period not exceeding one year. As a result, creditors were to consider different options for resolution. Filing civil claims for restitution or enforcing the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (the SARFAESI Act) was not deemed a successful
substitute since it relies on debt recovery.

Disposing off distressed businesses is a herculean activity in and of itself due to a shortage of prospective investors, which delays the turnaround process and thereby defeats the entire aim of liquidation. [16] Furthermore, systematic framework for legitimisation of the risk of bankruptcy is a blessing for banks, particularly because the waterfall provision implies that governmental dues can be paid only after all payments to secured and unsecured creditors have been rendered. [17]

However, whether by settlement or liquidation, this mechanism can only restore the remains.

Bad Banks v. IBC

Bad banks operate in a manner that seeks to promote resolution, maybe even more than IBC, since the percentage of deduction that creditors may experience is minimised. This is because CIRP needs a joint decision-making mechanism and vote rights equal to the percentage of the loan, which can be avoided in Bad Banks because the valuation at which the NPAs are distributed is left to the expert’s discretion, which can be supervised.

The Insolvency and Bankruptcy Code (IBC), as laid in its preamble, states that the “resolution as the soul of the code” is for a time bound resolution for maximizing the value of assets of insolvent persons, while interests of all the stakeholders are kept in mind. IBC’s main aim is resolution, not recovery.

As per National Company Law Appellate Tribunal (NCLAT), IBC is not enacted to provide redressal for individual creditors but recovery of dues. [18] The regime, which includes Insolvency Professional, Committee of Creditors, tribunals, and other stakeholders, is still in its early stages and needs to develop capacity.

Having said that, the government has at last recognised the problem of strained assets and is
trying to improve financial discipline holistically. The process outlined in the IBC indicates that it aims to maximise asset value by accepting the most optimal resolution strategy. Furthermore, at the conclusion of a fruitful Corporate Insolvency Settlement Process (CIRP), the corporation continues to operate as a going
concern, with all stakeholders benefiting to the greatest extent possible.

The rehabilitation mechanism, on the other hand, is designed to optimise the profit to the actual borrower. Since recovery suits the needs of creditors at a first-come-first-serve basis, it leads to an inequitable allocation of assets.

Mothballing

In the midst of insufficient demand, rather than liquidating haphazardly, a safer alternative would be to “mothball” NPAs before demand is ample to reopen them. Due to the exponential long-term capital costs, private companies can find it difficult to mothball investments. A relatively limited, efficiently governed national asset management bad bank may be developed for asset warehousing and resolution or sale akin to the Resolution Trust Corporation in US after the Loans Crisis or the Danaharta in Malaysia after the South East Asian Crisis. [19]

Since the pricing of the NPAs shall be ambiguous, such deals could be smoother between PSBs and bad banks of public sector at first. An alternative to establishing a national asset management bad bank with the intent of mothballing is for the government to give an insurance to the private players who purchase the stressed asset. [20]

Further, the price of guarantees charged to private banks is dependent on the price at which the private banks decide to purchase the NPAs. However, such a government-guaranteed private transaction could be appealing if underlying assets are expected to be best handled in the mothballing stage by private players than by government-appointed fund managers.

Suggestions for the Indian Banking System

To have a significant impact on the banking system, the size of the Bad Bank must be significant enough to cater to a significant portion of bad loans from banks. It is therefore necessary to ensure that the price mismatch between the buyer and seller is overcome. The market price for an NPA must be set by the Bad Bank.

  1. Ownership: One of the most critical considerations is the financing of these institutions, since enough capital is needed for a Bad Bank to make a difference in the current situation. There are many alternatives to consider, including completely government- backed financing, private financing or a public and private partnership.
  2. Asset Resolution: The stage of asset resolution stage is focal point of the process. If these NPAs are not restored, it is likely that these Bad Banks may become a repository with bad debts. If asset demand rises, the market-driven economy will be able to solve this problem over time.
  3. Expert Management: It is imperative that akin to international models, Bad Banks must
    comprise of experts and professionals in its governance structure to incorporate a politics-
    free lens in the process.

The implementation of this scheme would generate a legal tangle, which would be a significant obstacle. Similar to the implementation of the IBC, it is critical that different industries embrace this reform in order to allow systematic and consequential reforms in other necessary legal structures when required.

Renascence of Stability- the Conclusion

The government and population bear the brunt of economic upheaval caused by NPAs. Because of the disasters of laissez-faire, monetary outlook, and skewed incentives, the blame for breaking the paralysis cannot be left to market powers. Until now, neither ARCs nor banks have contributed to the reduction of NPAs. Moreover, owing to the delay in justice in courts an out-of-court restructuring process involving a bad bank to act as a coordinating pin between the creditors and in chorus preserving market’s faith is essential.

In order to address the growing issue of NPAs, the establishment of a bad bank may indeed be one solution. This approach, however, cannot be taken as a fact, and all of the problems that come with it must be weighed before successful alternatives are given. If not, an institution’s expectations of loss will become a reality, and the government will forfeit all the resources expended on purchasing the NPAs and the properties themselves. As a consequence, what is needed now is not just a bad bank, but a good ‘bad bank’.

References:

  1. J. Bhagwati, M.S.Khan and R. Reddy, Can Asset Reconstruction Companies (ARCs) be Part Solution to the Indian Debt Problem?, INDIAN COUNCIL FOR RESEARCH ON INTERNATIONAL ECONOMIC RELATIONS, http://icrier.org/pdf/Working_Paper_338.pdf
  2. Heidi N. Moore, Lehman Brothers and a Brief History of ‘Bad Banks’, The Wall Street Journal,
    https://www.wsj.com/articles/BL-DLB-3333
  3. Deshwal RS, Mor K, Ahooja A, RBI pivotal to Corporate Governance in Indian Banking Sector, Indian Journal of Corporate Governance (2010)
  4. R. Pungaliya, NPL resolution: Lesson from Korean Experience, Centre for Advanced Financial Research and Policy, (2017)
  5. Sudden Bank Bid, The Telegraph, (May 2020) https://www.telegraphindia.com/business/coronavirus-lockdown-sudden-bank-recap-bid/cid/1776722
  6. Brei, Michael and Gambacorta, Leonardo and Lucchetta, Marcella and Parigi, Bruno Maria, Bad Bank Resolutions and Bank Lending, BIS Working Paper No. 837 (2020)
  7. Viral V Acharya, Raghuram G Rajan, Indian Banks: A Time to Reform?, https://faculty.chicagobooth.edu/-/media/faculty/raghuram-rajan/research/papers/paper-on-banking-sector-reforms-rr-va-final.pdf
  8. International Monetary Fund, ‘Financial Soundness Indicators
    http://data.imf.org/regular.aspx?key=61404590
  9. Dong He, The Role of KAMCO in Resolving Nonperforming Loans in the Republic of Korea, International Monetary Fund WP 04/172 (2004) http://www.imf.org/external/pubs/ft/wp/2004/wp04172.pdf
  10. Anish Mashruwala, Neelasha Nemani, Can 'bad bank' save our stressed economy?, Economic Times (March, 2021) https://economictimes.indiatimes.com/small-biz/money/bad-bank-need-of-the-hour/articleshow/81478979.cms?
  11. Are bad banks effective options to tackle non-performing assets arising out of COVID-19?, Deloitte,
    https://www2.deloitte.com/in/en/pages/finance/topics/forensic/bad-banks.html
  12. Anish Mashruwala, Neelasha Nemani, Can 'bad bank' save our stressed economy?, Economic Times (March, 2021) https://economictimes.indiatimes.com/small-biz/money/bad-bank-need-of-the-hour/articleshow/81478979.cms?
  13. Srinath Sridharan, Why 'Bad Bank' is a bad idea for India,
    https://www.businesstoday.in/opinion/columns/why-bad-bank-concept-cant-work-in-india-banking-sector-npas/story/425833.html
  14. Mehta panel submits 5-point plan to fight NPAs, Business Today,
    https://www.thehindubusinessline.com/money-and-banking/mehta-panel-submits-5-point-plan-to-fight-npas/article24314726.ece
  15. Viral V Acharya, Raghuram G Rajan, Indian Banks: A Time to Reform?, https://faculty.chicagobooth.edu/-/media/faculty/raghuram-rajan/research/papers/paper-on-banking-sector-reforms-rr-va-final.pdf
  16. Mishra SP, Srivatsava HV, Corporate Governance: An empirical Analysis of Ownership and Performance in Indian banks, Indian Journal of Corporate Governance, (2010)
  17. Stephanie Medina Cas, Irena Peresa, What Makes a Good ‘Bad Bank’? The Irish, Spanish and German Experience, https://ec.europa.eu/info/sites/info/files/dp036_en.pdf
  18. Parker Hannifin India Pvt. Ltd. v. Prowess International Pvt. Ltd., 2017 SCC NCLT 11998
  19. John Hawkins, Bank restructuring in South-East Asia, https://www.bis.org/publ/plcy06h.pdf
  20. Heidi N. Moore, Lehman Brothers and a Brief History of ‘Bad Banks’, The Wall Street Journal, https://www.wsj.com/articles/BL-DLB-3333 

     

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