Explained: How will India's Bad Bank Fix Country's NPA Mess?

Explained: How will India's Bad Bank Fix Country's NPA Mess?
What is a bad bank, All you need to Know
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The government has set up two new entities to acquire stressed assets from banks and then sell them in the market.

Following through with one of her key announcements in the Budget, Finance Minister Nirmala Sitharaman has announced the formation of India’s first-ever “Bad Bank”. National Asset Reconstruction Company Limited (NARCL) has already been incorporated under the Companies Act. It will acquire stressed assets worth about Rs 2 lakh crore from various commercial banks in different phases. About Rs 90,000 crore in bad loans will be transferred in the first phase. 

Another entity — India Debt Resolution Company Ltd (IDRCL), which has also been set up — will then try to sell the stressed assets in the market.

The NARCL-IDRCL structure is the new bad bank. To make it work, the government has okayed the use of Rs 30,600 crore to be used as a guarantee. It will cover the entire pool of Rs 2 lakh crore. 

As per the announcement made on Thursday, the bad bank or NARCL will pay up to 15 per cent of the agreed value for the loans in cash and the remaining 85 per cent would be government-guaranteed security receipts. 

What are non-performing assets?

A non performing asset (NPA) is a loan or advance for which the principal or interest payment remained overdue for a period of 90 days. Banks and other financial institutions are required to classify the debts owned by them into the following four categories:

a) Standard: It is a kind of performing asset which creates continuous income and repayments as and when they become due.

b) Sub-standard: Loans and advances which are non-performing assets for a period of 12 months.

c) Doubtful: The assets considered as non-performing for a period of more than 12 months

d) Loss: All those assets which cannot be recovered by the lending institutions

Out of the above four, a non-performing asset would be either a sub-standard, doubtful or a loss asset.

What is Bad Bank?

A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution. The entity holding significant nonperforming assets will sell these holdings to the bad bank at market price. By transferring such assets to the bad bank, the original institution may clear its balance sheet

Technically, a bad bank is an Asset Reconstruction Company (ARC) or an Asset Management Company (AMC) that takes over the bad loans of commercial banks, manages them and finally recovers the money over a period of time.

The bad bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans.

US-based Mellon Bank created the first bad bank in 1988, after which the concept has been implemented in other countries including Sweden, Finland, France and Germany. Countries like Malaysia created a bad bank sponsored by the government, the US launched the Troubled Asset Relief Program (TARP) in 2008, Ireland, too, had set up a National Asset Management Agency (NAMA) in 2009. But conditions in these countries were far different from what is being tried in India.

Why do we need a bad bank?

In every country, commercial banks accept deposits and extend loans. The deposits are a bank’s “liability” because that is the money it has taken from a common man, and it will have to return that money when the depositor asks for it. Moreover, in the interim, it has to pay the depositor an interest rate on those deposits.

In contrast, the loans that banks give out are their “assets” because this is where the banks earn interest and this is money that the borrower has to return to the bank. The whole business model is premised on the idea that a bank will earn more money from extending loans to borrowers than what it would have to pay back to the depositors.

Imagine, then, a scenario where a bank finds a huge loan not being repaid because, say, the firm that took the loan has failed in its business and is not a position to pay back either the interest or the principal amount.

Every bank can take a few such knocks. But what if such “bad loans” (or the loans that will not be paid back) rise alarmingly? In such a case, the bank could sink.

Now imagine a scenario where several banks in an economy face high levels of bad loans and all at the same time. That will threaten the stability of the whole economy.

In normal functioning, as the proportion of bad loans — they are typically calculated as a percentage of the total advances (loans) — rise, two things happen. One, the concerned bank becomes less profitable because it has to use some of its profits from other loans to make up for the loss on the bad loans. Two, it becomes more risk-averse. In other words, its officials hesitate from extending loans to business ventures that may remotely appear risky for the fear of aggravating an already high level of non-performing assets (or NPAs).

If a bank has high non-performing assets (NPAs), a large part of its profits would be utilized to cut losses. As a result, any bank with high NPAs is likely to become more risk averse and would be less willing to lend money to borrowers. It would become more difficult for businesses and consumers to take loans from banks, thereby impacting the overall robustness of the economy. 

Moreover, in India, a large portion of NPAs is with the government-owned public sector banks. In the past, the government had to infuse fresh capital to improve the financial health of PSBs. The government infusing fresh capital in PSBs means less money for other schemes. 

Background About Bad Bank

The idea gained currency during Rajan’s tenure as RBI Governor. The RBI had then initiated an asset quality review (AQR) of banks and found that several banks had suppressed or hidden bad loans to show a healthy balance sheet. 

However, Former Reserve Bank of India (RBI) governor Raghuram Rajan opposed the idea of a government-led bad bank and instead suggested that private sector asset reconstruction companies be strengthened to have adequate capital to make all-cash purchases of bad loans from banks.

While there are 28 private ARCs, sales of bad loans have not picked up, as the banks and the reconstruction companies differ on the fair value of these assets, so the need was felt for government-backed security receipts. 

Now, with the pandemic hitting the banking sector, the RBI fears a spike in bad loans as well as Finance Ministry is also Pushing the concept to clean the Balance Sheet of Public Sector Banks to make it more profitable to expand credit base.

Professionally-run bad banks, funded by the private lenders and supported by the government, can be an effective mechanism to deal with Non-Performing Assets (NPA).

Financial Stability Report (FSR): The RBI noted in its recent FSR that the gross NPAs of the banking sector are expected to shoot up to 9.8% of advances by March 2022, from 7.48% in March 2021. As of March 2021, the total bad loans in the banking system amounted to Rs 8.35 lakh crore. 

K V Kamath Committee: Noted that corporate sector debt worth Rs 15.52 lakh crore has come under stress after Covid-19 hit India, while another Rs 22.20 lakh crore was already under stress before the pandemic.

That is why bad banks move by the government became the need of the hour.

How will the NARCL-IDRCL work?

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 and 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.

The government guarantee will be valid for a period of five years and the condition precedent for invocation of the guarantee will be resolution or liquidation. To disincentivise delay in resolution, NARCL has to pay a guarantee fee which increases with the passage of time. 

FAQs regarding Central Government guarantee to back Security Receipts issued by National Asset Reconstruction Company Limited for acquiring of stressed loan assets

Q. What is National Asset Reconstruction Company Limited (NARCL)? Who has set it up?

Ans: NARCL has been incorporated under the Companies Act and has applied to Reserve Bank of India for license as an Asset Reconstruction Company (ARC). NARCL has been set up by banks to aggregate and consolidate stressed assets for their subsequent resolution. PSBs will maintain51% ownership inNARCL.

Q. What is India Debt Resolution Company Ltd. (IDRCL)? Who has set it up?

Ans: IDRCL is a service company/operational entity which will manage the asset and engage market professionals and turnaround experts. Public Sector Banks (PSBs) and Public FIs will hold a maximum of 49% stake and the rest will be with private sector lenders.

Q. Why is NARCL-IDRCL type structure needed when there are 28 existing ARCs?

Ans: Existing ARCs have been helpful in resolution of stressed assets especially for smaller value loans. Various available resolution mechanisms, including IBC have proved to be useful. However, considering the large stock of legacy NPAs, additional options/alternatives are needed and the NARCL-IRDCL structure announced in the Union Budget is this initiative.

Q. Why is a Government Guarantee needed?

Ans: Resolution mechanisms of this nature which deal with a backlog of NPAs typically require a backstop from Government. This imparts credibility and provides for contingency buffers. Hence, GoI Guarantee of up to Rs 30,600 crore will back Security Receipts (SRs) issued by NARCL. The guarantee will be valid for 5 years. The condition precedent for invocation of guarantee would be resolution or liquidation. The guarantee shall cover the shortfall between the face value of the SR and the actual realization. GoI’s guarantee will also enhance liquidity of SRs as such SRs are tradable.

Q. How will NARCL and IDRCL work?

Ans: The NARCL will acquire assets by making an offer to the lead bank. Once NARCL’s offer is accepted, then, IDRCL will be engaged for management and value addition.

Q. What benefit do banks get from this new structure?

Ans: It will incentivize quicker action on resolving stressed assets thereby helping in better value realization. This approach will also permit freeing up of personnel in banks to focus on increasing business and credit growth. As the holders of these stressed assets and SRs, banks will receive the gains. Further, it will bring about improvement in bank’s valuation and enhance their ability to raise market capital.

Q. Why is it being set up now?

Ans: Insolvency and Bankruptcy Code (IBC), strengthening of Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI Act) and Debt Recovery Tribunals, as well as setting up of dedicated Stressed Asset Management Verticals (SAMVs) in banks for large-value NPA accounts have brought sharper focus on recovery. In spite of these efforts, substantial amount of NPAs continue on balance sheets of banks primarily because the stock of bad loans as revealed by the Asset Quality Review is not only large but fragmented across various lenders. High levels of provisioning by banks against legacy NPAs has presented a unique opportunity for faster resolution.

Q. Is the guarantee likely to be invoked?

Ans: Government guarantee will be invoked to cover the shortfall between the amount realized from the underlying assets and the face value of SRs issued for that asset, subject to overall ceiling of ₹30,600 crore, valid for 5 years. Since there shall be a pool of assets, it is reasonable to expect that realization in many of them will be more than the acquisition cost.

Q. How will Government ensure faster and timely resolution?

Ans: The GoI guarantee will be valid for five years and condition precedent for invocation of guarantee will be resolution or liquidation. Further, to disincentivise delay in resolution, NARCL has to pay a Guarantee fee which increase with passage of time.

Q. What will be the capital structure of NARCL and how much will Government contribute?

Ans: Capitalization of NARCL would be through equity from banks and Non-Banking Financial Companies (NBFCs). it will also raise debt as required.The GoI guarantee will reduce upfront capitalization requirements.

Q. What will be NARCL’s strategy for resolution of stressed assets?

Ans: NARCL is intended to resolve stressed loan assets above ₹500 crore each amounting to about ₹ 2 lakh crore. In phase I, fully provisioned assets of about Rs. 90,000 crores are expected to be transferred to NARCL, while the remaining assets with lower provisions would be transferred in phase II.

Reference Articles: IE, PIB

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