BY ADITI SINGH, GRADUATE FROM SYMBIOSIS LAW SCHOOL, PUNE

Indian banks especially the public sector banks are heavily burdened with bad loans and an ongoing pandemic is further making the crisis worse. For banks to effectively operate, it’s imperative that they continue lending loans and advances which are categorised as a standard asset or a non-performing asset (‘NPA‘). In an event when the borrower defaults in payment of interest or principal amount of loans and advances made by the bank for more than 90 days, the asset which was earlier categorized as a standard asset is then converted to an NPA.

According to the Financial Stability Report the Gross NPA ratio of Scheduled Commercial Banks may rise from 8.5% in March 2020 to 12.5% by March 2021 under the baseline scenario however the same may be escalated to 14.7% under a very severely stressed scenario. Banks suffer enormous losses in provisioning for already existing NPAs, due to the Covid-19 pandemic, the world has been facing economic slowdown which has forced the Reserve Bank of India (‘RBI’) to allow a moratorium period and the government to suspend resolution procedure under Insolvency and Bankruptcy Code which will further burden the already burdened banks with NPAs.

Asset Reconstruction Companies away from Efficient Resolution of NPAs

There are Asset Reconstruction Companies (‘ARC’) registered with the RBI and regulated under the SARFAESI Act, 2002 that purchase NPAs from the banks at a discounted price and then focus on realising such financial assistance. In order to secure finances, ARCs under section 7 of SARFAESI Act, 2002 are authorised to issue security receipts to qualified buyers evidencing the purchase or acquisition by the holder thereof, of an undivided right, title or interest in the financial asset involved in securitisation. However, ARCs have not been able to provide relief to the stressed banking sector. ARCs have been poorly capitalised to purchase NPAs from the banks and to make 15% of upfront payment as required. Even if ARCs have capital to purchase NPAs the price offered by them after haircut is far too less for banks to agree upon which is why the banks delay and avoid to put NPAs for auction. Delay by the banks in selling NPAs to ARCs leaves restrictive space for ARCs to realise the stressed assets, ultimately defeating the entire purpose behind ARCs existence. Looking at the near future, Indian Banks’ Association has proposed to set up a ‘Bad Bank’ for the recovery of banking sector from the financial distress.

How will Bad Bank resolve NPAs? How will it work differently from already existing ARCs? Who will fund the Bad Bank in India? These are some of the questions that come hand in hand with the discussion of establishing Bad Bank.

The Bad Bank Approach

A Bad Bank essentially is an ARC which aims at reducing NPAs from the books of banks thereby reducing the load of stressed assets upon the banks. The banks will first segregate their assets and then transfer their stressed assets to the Bad Bank. The Bad Bank will then focus on realizing those stressed assets.

Experiences of United States of America, Ireland, Germany, Sweden, Malaysia suggests various significant features behind success of Bad Bank. Mellon Bank of USA was the first bank to use the Bad Bank approach to resolve stressed assets. Further, The United States established, the Resolution Trust Corporation in the year 1989 funded by government and a few private investors. Thereafter, in the year 1992 Sweden incorporated Securum, a state sponsored company to resolves stressed assets, which successfully resolved ailing assets and was closed in the year 1997. Some of the major factors behind its success were state intervention, well framed laws and policies, transparency and political unity.

Another significant model is Danaharta, established by the Malaysian government in the year 1998, a government funded asset management company with finite life to resolve stressed assets and recapitalisation. Malaysian government focused on strengthening its laws to support the effective operation of Danaharta. Malaysian government also stressed upon involving experts around the world which contributed immensely towards its success. However, there is no correct model for Bad Bank but intervention of state in ownership of Bad Bank needs to be carefully determined before establishing Bad Bank in India.

The structure of the Bad Bank will be the main area which will distinguish it from the already existing ARCs in India. Indian Banks Association has proposed three stages of Bad Bank which includes an Asset Reconstruction Company (‘ARC‘) which will house the NPAs, an Asset Management Company (‘AMC’), and an Alternate Investment Fund (‘AIF’). The ARC will be owned by the Government of India, the AMC will be a professional body with participation from public and private sector, and the AIF is where a secondary market can be created for security receipts. The association recommended that the capital of Rs. 10,000 for Bad Bank to start operating shall be funded by the government.

The idea of Bad Bank has been avoided for a long time in India. However, looking at the enormous number of distressed assets it becomes significant to find a way to resolve them. The role of ARCs and IBC has been significant yet not sufficient to resolve enormous number of NPAs. Bad Bank which is essentially an ARC has the potential to get financial sector ready to release funds. Some of the significant factors that will help the Bad Bank to effectively operate and resolve the enormous amount of bad loans in India are as follows:

Structure of the Bad Bank

The structure is the significant feature that will distinguish it from ARCs. Amid Covid-19, it is unreasonable to expect state owned Bad Bank, even otherwise Bad Bank requires minimum state intervention. However, Experiences around the world are a testimony that the state cannot be entirely excluded from the ownership structure of Bad Bank.

The suitable structure for Bad Bank would be a Public-Private Partnership (‘PPP‘) to maximise recovery. Size of NPAs in public sector banks is such that the Government cannot be entirely excluded from the ownership but can stand as a minority stake holder so that the bank has the commercial freedom and transparency to avoid red-tapism while resolving the stress of bad loans.

Adequate guidelines and Framework: For Bad Bank to resolve NPAs effectively there must be adequate guidelines and frameworks from the very beginning, firstly, to determine the value at which assets shall be transferred and secondly, to determine how these NPAs shall be resolved. The major issue ARCs have been facing is to reach an agreement on the value at which banks can sell off the NPAs. Moreover, in the case of ARCs, the RBI launched guidelines on sale of stressed asset by banks in 2016 much after the enactment of SARFAESI Act.

Banks have been selling NPAs to ARCs either by an auction or bilateral negotiations. However, auction cannot be a suitable way for Bad Banks to acquire NPAs as it will further complex the entire time bound procedure the Bad Bank needs to follow.

One of the key aspects of having PPP structure is the profit sharing link between the owners of the Bad Bank. Framework may include links of profit sharing between the owners of the Bad Bank so that once the bad asset has been resolved by the Bad Bank the profit will accrue to the owners of Bad Banks i.e. the banks, the original institution itself. If the banks have a profit sharing link then they would not shy away from transferring assets to Bad Bank without any unnecessary delay.

Timeline: Timeline in which the assets need to be resolved by the Bad Bank is crucial to the entire resolution process and must be strict. Bad Bank should be able to resolve the acquired NPAs within 5 years which can be extended up to 7 years in special circumstances. The extension must not give any leverage otherwise it can start a vicious cycle of bad loans all over again.

No Barriers to foreign skills and capital: The valuation mismatch between ARCs and bank is because ARCs have been under capitalised due to stringent policies for foreign investors to invest in ARCs which were relaxed only in 2016. This has been the major cause for ARCs limited role in resolving NPAs. The same shall not be done with the Bad Bank, foreign investors must allowed to invest in the Bad Bank from the very beginning so that the Bad Bank does not remain under capitalised.

Along with the investors, Bad Bank shall also include experts from all around the globe to deal with complex NPAs. Also, in an event when it takes time to resolve NPAs, it’s the experts who can use their expertise to deal with the assets meanwhile a suitable buyer can be found.

Having a Bad Bank will let the banks continue the lending however, it will bring its own challenges but this seems be to be the best suited time for its incorporation for the recovery of the banking sector. It’s also significant to not completely rely on a successful model of a foreign nation as India will need its Bad Bank to meet its own challenges. Since, the resolution procedure stands suspended in such circumstances banks specially the Public sector banks need to have confidence to keep up the lending. In such circumstances it’s important to segregate distressed assets and let them be realised by the experts.