Financial institutions have been dealing with the non-performing asset (NPA) crisis for many years. The spread of covid-19 has exacerbated adverse cash flow for many businesses, resulting in the non-repayment of loan and interest payments to banks and financial institutions. The majority of the bad loan pile in India is stuck with the state-owned lenders.
Following the example of other countries such as the US, Sweden, Finland, Belgium, and Indonesia, the finance minister announced the formation of India’s first bad bank at this critical juncture of the covid era. This will isolate and work to realise the high-risk assets held by banks and financial institutions to de-stress their balance sheets.
The bad bank structure will comprise two institutions, the National Asset Reconstruction Company Limited (NARCL) and the India Debt Resolution Company Limited (IDRCL). NARCL has got RBI’s nod to carry on the ARC business while IDRCL will provide professional expertise for realising the value locked in the stressed assets of various banks and financial institutions. This proposal is a welcome move for the banking sector, which has been suffering under the weight of bad loans. The successful resolution of such loans will allow banks to reduce the large provisions they have had to make, thereby boosting their earnings.
The finance minister also announced that an initial tranche of bad loans valued at INR890 billion (USD12 billion) is to be assigned by various banks to NARCL/its special purpose entity. Such debts could be assigned to NARCL under the 15:85 structure, in which NARCL would pay 15% of the price in cash up front and issue tradeable security receipts for the remaining 85% to the banks and financial institutions. If IDRCL is unable to sell these bad loans for a satisfactory price to cover the value of security receipts, the government will step in with its sovereign guarantee to ring-fence the shortfall between the amount realised and the face value of the security receipts, but subject to an overall ceiling of INR 306 billion with a validity period of five years.
The combination of the NARCL and the IDRCL is a key structural reform required to make the concept of the bad bank successful. The efforts of the two are expected to be supported by other measures and reforms, such as greater governance and supervision during original lending processes, the stringent monitoring of loans for the early detection of distress and allowing market-driven platforms to sell bad loans through improved price discovery processes.
Given that around 28 ARCs have already been set up under the SARFAESI Act and the mechanisms under the Insolvency and Bankruptcy Code, 2016 (IBC), and the debt recovery tribunals framework, the bad bank mechanism will be another stable and effective option for banks and financial institutions to deal with their portfolios of bad loans. These will be larger accounts, which existing ARCs are not expected to handle.
The aim of the scheme is to allow banks to focus on their mainstream business and credit growth, leaving the toxic asset recoveries to the professionals of the field. The two institutions, therefore, with their teams of market experts and professionals, will be expected to relieve banks and financial institutions by achieving better recovery and realisation from their toxic and bad loan portfolios.
With an aim to attract the prospective investors/buyers, while deciding whether to bring a particular bad loan account under the bad bank mechanism or IBC mechanism, bankers will need to adopt a holistic approach of study for the various key factors. These factors include the quality of the underlying assets and valuation thereof; levels of illiquidity; legal, regulatory, tax and accounting issues; asset transfer and management costs; nature of the business activity of the borrower; reasons for the stress; time since the account is under stress or NPA; current performance of that particular sector etc, and accordingly an appropriate decision should be taken by the respective bankers for a successful resolution of/realisation from such toxic assets.
A bad bank is an excellent idea, but for it to be the saviour of the banking system, it will need to be effectively implemented at each governance level and supported by sector specific reliefs and incentives to attract the prospective buyers by enhancing the marketability of stressed assets and business valuations.
Satish Anand Sharma is a principal associate and Aniket Sawant is a senior associate at SNG & Partners
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