Concept of Bad Bank and NPA settlement

Bad bank is where a struggling financial institution can put assets it wants off its own books to eventually sell or unwind. While countries like the United States and Sweden adopted the idea of bad banks in the 1980s, it is a relatively new concept in India. The NPAs are taken off the balance sheets of the banks and resolved and managed by the bad bank. The bad bank buys the NPAs at a discounted rate. For instance, an NPA is worth Rs. 100 so the bad bank will buy the loan at a discounted rate of 60%. A series of negotiations takes place between the bad bank and the concerned bank wherein the bad bank attempts to buy the loan at a lower rate and the bank tries to sell it at a higher rate

India has unveiled a plan to set up a bad bank, its latest attempt to tackle the mountain of defaulted debt that threatens to cripple its financial system. Since our country’s financial system is predominantly bank-based, non-performing Assets (NPA) of banks have significant impact on the country’s GDP. NPAs also generate a vicious cycle of effects on the sustainability and growth of the banking system, and if not managed properly could lead to bank’s failure.

The Central government is likely to soon approve the setting up of the country's first bad bank, which was first proposed by Union Finance Minister Nirmala Sitharaman in her Budget speech of 2020-21, reports said the proposed bad bank — National Asset Reconstruction Company Limited (NARCL) will manage the bad debt of public sector banks and other financial institutions. It is expected to have a government guarantee of about Rs. 31,000 crore.

The transfer of non-performing assets (NPAs) from banks and other financial institutions to NARCL is expected to take place by the end of fiscal year 2021-2022. The banks have already identified around 22 bad loans worth Rs. 89,000 crore to be transferred to the NARCL in the initial phase.

Proposed Model for Bad Bank has been elucidated in the budget 2021 proposed an Asset Reconstruction Company (ARC)-Asset Management Company (AMC) structure, wherein the ARC will aggregate the debt, while the AMC will act as a resolution manager. The objective of the two entities is to take over the bad/stressed loans and then manage and dispose of the assets and value realization of the same. The objective is to help clear the balance sheets of the banks and other financial institutions and maintain the health of the banking sector.

• The proposed structure envisages the setting up of a National Asset Reconstruction Company (NARC) to acquire stressed assets in an aggregated manner from lenders, which will be resolved by the National Asset Management Company (NAMC)

• A skilled and professional set-up dedicated to Stressed Asset Resolution will be ably supported by attracting institutional funding in stressed assets through strategic investors, AIFs, special situation funds, stressed asset funds, etc for participation in the resolution process.

• Further, transferring these stressed assets to bad banks will entail recovery of 15% in cash and 85% in sovereign guaranteed security receipts. This government guarantees but will carry a zero-risk weight, for a specified period of time.

• The net effect of this approach would be to build an open architecture and a vibrant market for stressed assets.

Various Mechanisms for recovery from NPA such as Lok Adalats and DRTs have been in function for almost three decades but their recovery rates are not encouraging. The government has restructured the policies, made amendments, and brought new laws such as Sick Industrial Companies (Special Provisions) Act, 1985 (SICA), The Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFESI). Debts Recovery Tribunals were established specifically for Bad Loan’s, recovery but not yield the desired result. Assets Reconstruction Companies (ARCs) were also set up as part of SARFAESI Act, 2002 as an instrumental alternative for NPA resolution in India and as on January 2021. There are 28 ARCs are in operation.

The problem with ARCs is that they lack the bandwidth to reconstruct any company under stress which is sold as going concern. ARCs purchase bad loans from various banks and proceed to recover loans on their own. In return, for selling these assets, banks get an upfront cash payment of at least 15%, and the rest in the form of security receipts, redeemable as and when the loans are recovered.

In the year 2016, the much awaited and debated Act, the Insolvency and Bankruptcy Code (IBC) was formulated which empowered the creditors to drag the wilful defaulters to National Company Law Tribunal, NCLT. Initially it was projected as the most successful tool for the recovery of bad loans through revival and resolution but in reality, the situation still remains the same and bankers are carrying the bad debt quarter by quarter.

Bad banks have been institutionalised and considered a success in several countries and no doubt it may accomplishing its mission in India, provided it is implemented effectively. Secondly, wherever a Bad Bank has succeeded, it is because new money has come in. The new money will only come when there is a hassle-free acquisition. While one acquires at a price, the other has to arrange for a buyer at a price which is commercially viable. If there is no buyer at the price, each will look at the other distraught. In India, there is no separate market available where bad assets can be sold. There is no securitisation market in the Country. The bad bank will also deal with the same ARCs, Vulture Funds, and investors who are dealing with the banks now.

Though no formal structure has been announced yet, we understand basis news reports, that a National Asset Reconstruction Company Limited (NARCL) is going to be set up to take over NPAs from banks. The Promoters are likely to be power finance companies while the PSU banks will hold the remaining equity stake in the ARC. As per recent news reports, state-owned banks have shortlisted 28 loan accounts to be transferred to the NARCL with a total of Rs 82,500 crore of loans due, and further loans could also be transferred such that the AUM is over Rs 2 lakh crore.

Normally the NPA loans at the time of takeover by an ARC are valued around 30-40% of the principal amount. However, as we understand from news sources, in the case of NARCL the loans may be acquired at the current book value. The NARCL would pay 15% in cash and the balance 85% in security receipts or any other proportion as they may decide. Further, the government would provide a guarantee to the security receipts issued by the bad bank. Let’s assume that a bank sells a loan of Rs 100 to NARCL. Now, if the Bank has already made 75% provisions for the loan, then the book value of this loan is Rs 25, and 15% of Rs 25 i.e., Rs 3.75 is cash to be paid to banks. Thus, using these assumptions, for taking over say Rs 2 lakh crore of bad loans, a cash outflow of Rs 7,500 crores and issuance of SRs worth Rs 42,500 crore may be required.

Non-Performing Assets (NPAs) are the loans given by the banks which have stopped generating any income for the bank i.e., they have stopped performing. A loan becomes an NPA on the balance sheet when the principal or interest payment remained overdue for a period of 90 days. NPAs reflect the financial growth of a country’s banking system and thus, the economic conditions of the country. The problem of NPAs has been a long-standing challenge for the banking sector due to various factors inter alia, bad lending practices and blatant denial of the problem.  There are a number of reasons for India’s rising NPAs, the main being the lack of acknowledgment of the problem. Banks choose not to recognize the problem of their rising NPAs and continue to live in denial rather than facing the consequences. NPAs make the Balance Sheet heavy with loans which are not going to perform.

In case the loan doesn’t turn bad, it can add the provision to the profits of that financial period. Banks tend to avoid provisioning as it reduces the profits for the time-being. What they don’t realise is that losses will likely incur in the future nonetheless so it is better to be prepared for it rather than showing a false, healthy image of the bank in the balance sheet while in reality, the bank’s capital is lesser than what is shown.

Thus, a pricing is one of the major issues when it comes to the setting up of a bad bank. In the Budget 2021-22, a concrete idea of a bad bank for India was introduced by setting up two entities – the ARC and the AMC. While the details about ownership, control and mechanics are yet to be declared by the government, it is reported that the majority stake in the ARC will be held by the public sector and the majority stake in the AMC will be held by the private sector.

This was followed by concerted attempts to tackle the problem of mounting debts, defaults and insolvencies. The piece meal attempts included enactment of the Sick Industrial Companies (Special Provisions) Act, 1985 (SICA) and the enactment of Insolvency and Bankruptcy Code, 2016 (IBC), amongst others. Further, Asset Reconstruction Companies (ARCs) were constituted. There are 29 ARCs in India which have been disappointing in resolving the issue of NPAs.[6] The first ARC was set up in India in 2002. The concept gained further importance and concreteness after the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI Act).

The IBC was enacted to overcome the failures of the SICA and other preceding enactments. Experience had shown that insolvency laws were failing due to judicial over-intervention and due to the scheme of the acts, as per which management vested with the Board of Directors and not the creditors. Pursuant to these challenges, the role of judiciary was limited and the power to approve the resolution plan was left to the committee of creditors. National Company Law Tribunal (NCLT) And National Company Law Appellate Tribunal (NCLAT) had limited powers of review within the limited fold of Section 32 and Section 61(3) of the IBC. But the NCLT and NCLAT have constantly tried to water down the provisions pertaining to limited judicial intervention and have often over-turned the decision of the Creditors, whose commercial wisdom ought not be questioned as per the scheme of the IBC. The principle of the primacy of the commercial wisdom of the COC has been upheld by various courts in a line of cases including the recent case of Kalpraj Dharamshi and Another v. Kotak Investment Advisors Limited and Another, REED 2021 SC 03545. But the NCLT and NCLAT more often than not, deviate from the dictums of the Supreme Court. Further, during the pandemic, the government suspended the code on 24th March 2020 by amending the code. Instead of a blanket suspension, the government could have raised the threshold for the applicability of the IBC to the defaulters, as Section 4 vests the government to extend the threshold (which is otherwise 1 lakh), to higher amount. Raising the threshold would have ensured that lesser number of defaulters could have been subjected to CIRP.

It is clear that India needs stricter enforcement of the IBC, which will be more effective in handling the NPA crisis than newer banks, to hold the NPAs in that very system itself. In this regard, instead of setting up another debt recover institution; there is a need to focus on structural reforms.  Instead of setting up new institutions, there is a need to revive and manage the already existing ones. The RBI and the government have time and again implemented many laws and regulations which have been incapable of resolving the NPAs. Reserve Bank of India in its Financial Stability Report for January 2021 has estimated that considering the current market and economic scenario, the banks Gross Non-Performing Assets may rise sharply to 13.5% by September 2021 and may also escalate to 14.8% which is nearly double of GNPA for FY 2019-20 which stood at 7.5%. Also out of all the banks, State-Run Banks are being the worst-affected with their GNPA expected to increase to 16.2% by September 2021 as compared to their GNPAs at 9.7% in September 2020. The loads of NPA accumulating in the economy are a major concern for the financial framework and for the general economy overall since rising NPAs will make trouble upon the banks to meet their higher capital necessity to conquer the effect made by the bad credits.

IBC Channel the IBC requires a Corporate Insolvency Resolution Process (CIRP) which allow the company to come out of the state of insolvency. The CIRP is to be completed in 180 days, which can be extended by another 90 days to a maximum of 270 days. CIRP under IBC can be initiated even if default is wilful, i.e., when the borrower has the capacity to pay but chooses not to

While IBC is a sound channel to solve the NPAs, it has its own shortcomings. A way to solve the problem without overwhelming NCLT is to set up a functional out-of-court restructuring process, which can be tried without taking the matter to the NCLT.  The NCLT should be used as a last resort. The banking policies ought to be re-shaped on the tenant of prevention before cure and such a policy switch will be more fruitful than investing in bad banks, which do not have the capacity to reform the system radically.

The governments have been trying to find the remedy to the problem of bad loans through enacting legislations and setting up institutions. But none of these attempts has shown substantial results.

The idea of a bad bank, which took the most concrete shape and form, in so far as India is concerned, is another such institution that is purportedly being set up to solve the problem of NPAs.

There is a need to bring in structural and fundamental reforms, so as to ensure that the problem of NPAs is nipped in the bug. The piece meal approach has not been successful in the past and the bad banks are bound to add up to the already existing multiplicity of authorities and the government expenditure, unless the banking sector is transformed in a more substantial way.

Further, the process of decision-making by the Committee of Creditors will be smooth as the Bad Bank will have in most cases the voting power as required for the decision. Thus, the Bad Bank will be better placed to use the IBC and this will improve outcomes from IBC processes.