India plans to set up a so-called bad bank to deflate a post-pandemic rise in non-performing assets and help lenders clean their balance sheets. Will this be the panacea the country’s troubled banking sector needs? Mithun Varkey reports

The government of India is proposing to set up a “bad bank”, or an asset reconstruction company, to manage the rising non-performing loans problems facing Indian banks, especially the state-owned ones.

A bad bank is an asset management and reconstruction company that takes over non-performing assets of a bank, or a group of banks, to help them clean their balance sheets by removing the illiquid and high-risk assets held by the financial institutions. A bad bank helps separate good assets from bad, allowing financial institutions to raise more capital.

Finance minister Nirmala Sitharaman, in her 2021 budget speech, announced: “An asset reconstruction company and asset management company structure will be set up to take over the bad loans on public sector bank balance sheets and manage recoveries.”

With India’s high levels of non-performing assets, there have been demands for a bad bank. However, the pandemic – and the expected rise in illiquid assets as a result – seems to have forced the government’s hand.

India has been staring at a banking crisis on account of high levels of non-performing assets in the system, a situation which has worsened since the pandemic began.

The Reserve Bank of India’s (RBI) latest financial stability report published in January cautioned that “the gross non-performing assets ratio of all commercial banks in the country may increase from 7.5% in September 2020 to 13.5% by September 2021, and if the macroeconomic environment worsens into a severe stress scenario, the ratio may escalate to 14.8%”, a rate surpassing the all-time high of 14.7% reported in 1999.

Public sector banks are especially at risk, with a gross non-performing assets ratio of 9.7% in September 2020 that may increase to 16.2% by September 2021, while private sector banks are expected to see the rate rise from 4.6% to 7.9% in the same period.

“In the severe stress scenario, the gross non-performing assets ratio of state-owned banks, private banks and foreign banks may rise to 17.6%, 8.8%, and 6.5%, respectively, by September 2021,” the RBI report says.

A mechanism to clean up the system is sorely needed because the high levels of non-performing assets erode the ability of banks to raise capital due to the higher provisioning needed to meet the regulatory requirements. According to the government, stressed loans more than ₹5 billion (US$66.3 million) each are to be transferred to the bad bank, which is likely to take more than ₹2 trillion to ₹2.5 trillion of unresolved stressed assets from about 70 large accounts.

Industry practitioners have all welcomed the proposal, however the plan is not without its issues.

Cyril Shroff, the Mumbai-based managing partner of Cyril Amarchand Mangaldas, told India Business Law Journal: “The budget proposal to create a bad bank, though the government calls it an asset re-construction company, is a positive development.”

These types of “innovations”, he says, will help in resolving the non-performing assets problem, and assist in “speeding up transactions”.

“The proposal to set up a bad bank is an effective move to help public sector banks in tackling the increasing problem of non-performing assets,” adds Akil Hirani, the Mumbai-based managing partner of Majmudar & Partners. “A bad bank or asset reconstruction company set up only for public sector banks will help achieve a focused resolution of non-performing assets when public sector banks are struggling to recover loans from customers, especially SMEs [small and medium enterprises], due to the pandemic.”

Hirani says bad banks have been successful in many countries like Sweden and Malaysia. “With the right model and approach, a bad bank can prove to be quite effective.”

Niloufer Lam, a Mumbai-based partner at ZBA, also reckons the idea of a bad bank is a good one, “to assist the banks in cleaning up their balance sheets, and focusing on other aspects of banking business”.

“The loan recovery process is complex and delayed due to the overburdened judicial system,” says Lam, “and can have multiple inter-creditor issues as different lenders have different securities, and even where they have the same security, there may be inter-creditor issues. The bad bank will help speed up decision making, the authority for which will reside with one entity.”

Aditya Bhargava, a partner at Phoenix Legal, believes a bad bank as a concept can work well, “But I think the devil lies in the details and the implementation of it,” he says. “You have had bad banks being implemented in the US following the community banking crisis in the 1980s, as well as in South Korea, and they are good examples of bad banks actually working.

“With the bad bank, the emphasis is more on cleaning out the balance sheets of the banks in one shot, and less on resolution. Indian banks have the second-highest non-performing assets in the world after Italian banks, and there has been a lot of emphasis, even globally, on Indian banks improving their financial ratios, their performances and regulatory capital, and less so on improving their profitability.”

Bhargava says the focus is on giving banks a fresh start with clean balance sheets. “My larger concerns are that this shouldn’t be another mechanism that is intended to kick the can down the line,” he says.

Bhargava says he is waiting for finer details on the proposal, which are likely to come out in the July-August parliamentary session. “The feedback has been mixed to positive, and we can expect some more details to emerge towards the monsoon session of the parliament, and a detailed legislation later down the line.”

A question of ownership

The government’s proposal still lacks clarity on several fronts, most notably around the nature of ownership of the bad bank, or the asset reconstruction company.

Aditya-Bhargava,-Partner,-Phoenix-Legal“Setting up of a bad bank will require an analysis of certain factors, and adopting a model that suits the requirement of the public sector banks,” says Hirani. “Firstly, the ownership of the bad bank should be clearly defined to understand the equity participation from the government and private players. Secondly, the acquisition price of assets, the timeline for the resolution of assets, and the manner in which to dispose of assets acquired by the bad bank must be determined. Thirdly, the resolution process must be in sync with the insolvency code.”

He says a mere transfer of bad loans to asset reconstruction companies will not solve the problem, as public sector banks are already controlled by the government, and transferring bad loans from one government entity to another will not achieve the purpose. “Further, identifying prospective buyers will be key to the resolution of stressed assets. In all of this, the role of the government should be minimal, and a team of professionals of integrity should be recruited to run and manage the bad bank.”

While the government hasn’t announced clear regulations on the ownership, says Bhargava, “I think that the ownership will be diversified and with a majority in the private sector, which is a good thing in the sense there will be less red tape and more emphasis on resolving these debts, so that the private sector can make some money without falling back on the taxpayers to bail them out.”

Speculation is rife. A report in The Indian Express newspaper in February quoted unnamed sources as saying the proposed bad bank will be set up by state-owned and private sector banks, and there will be no equity contribution from the government. A March report in Mint suggested that private players will own about 51% of the asset reconstruction company.

The government has said that it would be cash neutral for the lenders because their capital contribution to the bad bank would get some portion back as cash and the rest as security receipts against the transfer of the stressed assets.

Clean sheets

Another area of concern among legal practitioners is the lack of clarity around provisioning norms for the loans. Banks typically have to make higher provisions for bad assets, which directly affects the cost of lending and reduces capital available for the lenders. If the loans continue to sit on the banks’ books after transferring them to the bad bank, the banks will have to continue to make provisioning for these assets and will not provide the intended relief.

Niloufer-Lam,-Partner,-ZBA“There needs to be clear status of the loans and provisioning norms once the loans have been sold to the bad bank,” says Lam. “While much of it is implicit, it would be helpful if these were clarified.”

Bhargava says the whole intention of cleaning the balance sheets is to remove provisioning. “As long as bad loans are no longer on the balance sheet of the banks, and they have no exposure to them, there should simply be no question of provisioning,” he says. “Though it is not certain yet, I am quite positive that is how it will actually be created.”

A parliamentary panel has recommended that non-performing assets must be transferred to the bad bank at the book value of the assets, as their value may erode over time if left on the lenders’ balance sheets. The government has also not announced any decision on this as yet.

Bhargava, however, does not see any reason to transfer assets at book value. “Transferring at book value doesn’t make a lot of sense because it creates a lot of distortion in the market,” he says. “You wouldn’t buy a used car at book value. You would try to negotiate a lower price, and the same rationale applies in this case, too. It is never done in the case of distressed assets, and that is the reason they are called distressed assets. They could consider some sort of profit-sharing plan.”

A related challenge, notes Hirani, is the RBI restriction on purchasing bad loans with at least 15% cash, which has made banks reluctant to approach asset reconstruction companies. “Therefore, an amendment or an exemption should be made to relax the requirements for the bad banks,” he says.

Lam agrees. “Either there is an amendment to avoid the cash payment, or there will need to be a capital infusion into the bad bank to fund the 15% upfront payment.”

For security receipts, RBI guidelines require a 15% provisioning. The banks have been demanding a sovereign guarantee for the provisioning and the government has indicated that it will provide the guarantee.

“Even if the 15% payment is made applicable to the bad bank, I don’t see a lot of problems in implementing it, because it is better to make an initial payment to the bank,” says Bhargava. “It is not that much of an amount, and it also creates an incentive for the bad bank to actually speed up the resolution process.”

However, that raises questions around funding these cash payments, and whether the government will have to foot the bill.

Bhargava says the mixed ownership of the bank will mean that the funds will be raised from both public and private sector entities. It is in everyone’s interest to get it done, including that of the private banks. “While the bad bank is intended to clean up public sector banks, if it is a success there is no reason not to extend it to private sector banks, or even non-banking finance companies,” he says.

There are other concerns, too, given the complicated nature of the asset transfer and resolution.

Lam says the sale of the loans to the bad bank itself is a large process to be documented. “There will be stamp duty payable on the deeds of assignment, which is a capped nominal amount in some states in India, but not all,” she says.

“The process of getting all the deeds of assignment/sale of the loans executed due to covid-19, while possible, requires more administration and process. Speed in being able to implement all this is also relevant.”

Lam says that, from a human resources perspective, key people in the banks managing these accounts should also transition to the bad bank. “The transition from each bank, in terms of the actual knowledge of each loan account/borrower issues, needs to be carefully constructed to ensure minimal disruption or delay to any existing recoveries,” she says.

Keeping it simple

In the case of a resolution, Hirani says the rights of any private sector creditors will also have to be ad-dressed so that they get a fair deal.

Bhargava agrees that a mechanism is needed for the bad bank to work with private sector creditors. “Both private sector asset reconstruction companies and bad banks are aggregators of debt, and once they reach a particular threshold, they can force a resolution without even the consent of the debtors,” he says. “That is what is missing here. If the bad bank is only buying public sector assets, then you have the risk of a holdout in the private sector. This is something that needs to be worked out in the legislation.”

Akil-Hirani,-Managing-partner,-Majmudar-&-PartnersAs a workaround, Bhargava says the bad bank can tie up with a private sector lender and push a borrower into insolvency under the Insolvency and Bankruptcy Code.

Another concern is about how much teeth the bad bank would have, or whether it would end up being just another asset reconstruction company, of which there are about 15 in India.

In accordance with the regulatory framework, asset reconstruction companies can change the borrower’s management team, take over its management, or take certain steps and actions as long as the asset reconstruction company controls 60% of the outstanding debt, or has the consent of 75% of the lenders in number.

“I haven’t seen these sorts of details emerge [in the case of the bad bank] and that is something which I find curious,” says Bhargava. “If the bad bank is going to be just another asset reconstruction company without any special privileges or powers in terms of forcing resolution on the borrowers, then it is not going to be very useful,” says Bhargava.

While there is a need for clarity, what is also needed is simplicity in legislation. The key is not to com-plicate things, says Bhargava. “As far as possible what we need is a basic, simple and straightforward law, which does not conflict with other existing legislation.

“If there is a bad bank that is set up to purchase banks, then once the assets are transferred it should follow the RBI regulations and not complicate the process by bringing it in conflict with other regulators,” he says.

Although the bad assets of public sector banks have not been very popular with investors – largely because of the complicated decision-making process in these banks – a bad bank can help tap value that is locked away in assets, especially in core industrial sectors, and give a fresh lease of life to the beleaguered banking sector.