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Insolvency

Bad Banks: Is it the Wonder Drug to India’s NPA Crisis?

By Vaishnavi Vyas and Priyanshu Agrawal

Introduction

The outcome of the Global Financial Crisis, in the mid-2000s, caused the first wave of the Indian Banking catastrophe in the form of the Twin Balance Sheet crisis. The infrastructure projects began to go sour, affecting companies’ capacity to repay loans and thereby deteriorating the balance sheet of the banks. Nevertheless, the economy stabilized and somehow continued to grow but finally it succumbed to the adverse demonetization policies, followed by Non-Banking Finance Companies (NBFC) crisis [1]and a collapse in the real estate sector. This resulted into a Four Balance Sheet crisis and a depressing economic growth. In the last 5 years, India has witnessed failures of some of the giants in the financial service sector, ranging from Punjab National Bank (PNB),[2] Infrastructure Leasing and Financial Services (IL&FS)[3], Dewan Housing Finance Corporation Limited (DHFL)[4] to Yes Bank. [5]

Adding to the misery, the final nail to the coffin is the catastrophic outbreak of the novel coronavirus (“COVID-19”) which has proven to be the black swan event of the century. As a consequence of the outbreak, the Indian economy has been experiencing a complete standstill for almost 2 months since late March, 2020 causing significant distress to the banking sector. Most of the companies have fallen prey to this pandemic and are a step away from a shutdown. This has led to a substantial rise in Non-Performing Assets (NPAs). 

In order to stabilize the economic emergency, the Reserve Bank of India (RBI) released a notification on  March 27th, 2020[6], whereby it allowed a three-month moratorium period (which has been further extended until 31st August, 2020) for repayment of term loans and other payments to mitigate hardships of companies and individuals. Further, the recently passed guidelines by the Ministry of Finance,[7] decriminalized several provisions of the Indian Companies Act making it less draconian to protect companies and their management. It also suspended initiation of any fresh insolvency proceedings[8] for a year and excluded COVID-19 related debt from the definition of default among many other changes. Although these amendments and notifications serve as a relief measure for companies under financial stress, they surely possess a huge risk of a sharp deterioration in the credit quality of already bleeding banks and trigger significant rise in NPAs.

The Government of India (GOI) has time and again, tried to solve the menace of bad loans, however this sticky problem has assumed alarming proportions. At present, the Indian banking sector is placed on an NPA time bomb, with an estimated NPA of Rs. 9 lakh crore.[9]                          Therefore, Indian Banks’ Association (IBA) has once again recommended [10] for a creation of a structure similar to a Bad Bank to solve this financial crisis.

Understanding Bad Bank vis a vis it’s Return to India

Segregating the stressed assets from the healthy and financially stable part of a bank have been conducted in various ways by taking into consideration the organizational hazards and transfer of risk. The predominant way of doing so is through the establishment of a bad bank. Primarily, the idea of a Bad bank is to clean up the pending debts of a financial institution by separating the NPA’s from the performing assets of the regular bank. While the stressed assets are offloaded into a bad bank (and further liquidated), the regular banks are recapitalized and are able to improve their normal course of business.

In India, the concept of Bad Bank has repeatedly gained limelight but has failed to be established as a mechanism to fight the economic stress. However, the present situation has been tagged as the Global Financial Crisis 2.0 by leading economists and hence the idea of creating a bad bank is seen as the last resort.

The IBA, therefore, has suggested that the GOI should invest up to 50 per cent capital [11] for the creation of a bad bank. This proposal made by the association is heavily drawn upon the recommendations made by the Sashakt Committee [12] which was established in 2018 to tackle the problem of bad loans in India. The Association thereby envisions to set up three entities, namely, an Asset Restructuring Company (ARC), a National Asset Management Company (NAMC) and an Alternative Investment Fund (AIF). After conducting due-diligence, the NAMC would make an offer to offload the toxic assets which will then be purchased by the ARC. Henceforth, the AIF would raise funds and invest them back into the securities offered by ARC. This process shall ensure that the stressed assets are being treated effectively, thereby improving the financial health of the banks. Furthermore, the IBA has proposed to keep ARC under the ownership of GOI as the same will build confidence in the banks and they will not be hesitant in selling off the stressed assets, while the AMC will be a professional body open for both public and private sector and AIF will be the secondary market for Security Receipt. It has been estimated to house around 75000 crores of NPA at book value in the Bad Bank. However, it will be crucial to see if the proposal hits a wall.

Analysis:  Is Bad Bank the Final Hope

On paper, the idea of Bad Bank looks pretty simple, however the implementation of the same is very cumbersome and perhaps one of the reasons why this idea has only been toyed with and not fully executed in India.

One of the most theoretical benefits of a bad bank is that it clears up the banks’ balance sheets and makes them financially healthy. A good-bad bank accentuates centralized decision making processes along with a flexible ownership and governance structure. Additionally, it aids the banking sector to focus on its core activity of lending, while leaving the resolution to the experts. Moreover, a proper Public-Private partnership driven ARC will ensure trust of the bankers and investors, making the entire structure more attractive.

However, a bad bank is often termed as a desperate mechanism to absorb the stock of poisoned assets because of its multiple loopholes. One of the most significant challenges is with respect to the capital structure of such banks. The capital requirement by a Bad Bank to acquire NPA is tremendous. The establishment of a bad bank was also contested by the former RBI Governor, Mr. Raghuram Rajan who believed that the same would solve nothing but will merely act as a medium of shifting loans from one pocket to another without any resolution. It is noteworthy to mention that NPAs do not vanish away with a bad bank structure, but in fact such losses have to be shared between investors and shareholders making it very risky. One of the strongest criticisms is the creation of Fire Sale externality. The NPAs are usually transferred to a Bad Bank at discounted rates, which forces it to liquidate such assets at lower prices and thereby starting a vicious cycle pushing prices even deeper. Establishment of Bad Banks will encourage banks to take undue risks and thereby further increase bad assets. Moreover, the contemporary times which are linked to the Great Depression have caused sharp deterioration in supply chain mechanisms and caused a global economic slowdown. This has majorly reduced the purchasing capacity of the people, and therefore it will be extremely difficult to sell the distressed assets to a potential buyer. The success of a Bad Bank predominantly depends on the liquidity of the NPAs, and hence unavailability of a buyer might make it inoperable. As an outcome, it will become a warehouse of bad loans without any recovery. Setting up a Bad Bank in this unprecedented time requires a well laid policy and it should not be used as an opportunity to brush the obvious dirt under the carpet.

The COVID-19 freeze is the latest blow in a multi-year economic crisis that the Indian economy is experiencing. The resolution of NPAs and restoration of the banking sector is one of the most crucial challenges that requires immediate response from multiple fronts. Globally, we are facing the greatest economic emergency. The Bad Bank is surely not a single shot solution. However, proper and swift implementation of IBC, Securitization and Reconstruction of Financial Assets & Enforcement of Security Interest Act, Banking Regulation Act, robust and strict performance criteria for the banks, along with having a stressed asset management vertical by setting up of a structure similar to Bad Bank might act as necessary evil to resolve the hanging crisis of stressed assets. There is an instant requirement of a four legged plan, which includes Restructuring, Recapitalization of the Banks, Recovery of Loans through a stimulus and lastly improving governance in the Banking sector, as repeatedly we have seen poor governance causing holes in the leaky bucket. Across the world, Bad Bank has evidenced a successful mechanism to restructure, recapitalise and recover the bad loans by liquidation. Therefore, establishing a specialized ARC-AIF-NAMC (Indian) model of Bad Bank might be a blessing in disguise to reenergize the Indian economy.

Both authors are Fourth Year law students, pursuing their degree from the NMIMS Kirit P. Mehta School of Law, Mumbai.


[1] Press Trust of India, NBFC Crisis poses more bad loans risks for Banks: Moody’s, Economic Times ( Dec. 19, 2019, 2:48 PM) https://economictimes.indiatimes.com/markets/stocks/news/nbfc-crisis-poses-more-bad-loan-risks-for-banks-moodys/articleshow/72520496.cms?from=mdr

[2] Anup Roy, PNB Scam and Banking Crisis: NPAs soared, profits plunged for banks, Business Standard, (March 30, 2018, 07:01 PM)

[3] ET Online, IL&FS: The Crisis that has India in panic mode, Economic Times, (Oct. 03, 2018, 11:37 AM) https://economictimes.indiatimes.com/industry/banking/finance/banking/everything-about-the-ilfs-crisis-that-has-india-in-panic-mode/articleshow/66026024.cms?from=mdr

[4] Rohan Venkataramakrishnan, What happened to finance firm DHFL- and what that means for the Indian Economy, The Scroll, ( June 10, 2019, 09:00 AM)

[5] Hindu Net Desk, Yes Bank Crisis Explained, The Hindu, (March 10, 2020, 04:22PM) https://www.thehindu.com/business/yes-bank-crisis-explained/article31030273.ece

[6] Reserve Bank of India, COVID-19 Regulatory Package, RBI/2019-20/186 (Issued on 27th March, 2020) https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0

[7] Vishwanath Nair, RBI extends Loan Moratorium by three months till Aug 31, Bloomberg Quint, (May 22, 2020, 07:13 PM) https://www.bloombergquint.com/business/rbi-extends-loan-moratorium-by-three-months-till-aug-31

[8] Press Trust of India, Govt. decides to suspend up to 1 year IBC provisions that trigger fresh insolvency proceedings: Report, Economic Times, (April 23, 2020, 05:35 PM) https://economictimes.indiatimes.com/news/economy/policy/govt-decides-to-suspend-up-to-1-year-ibc-provisions-that-trigger-fresh-insolvency-proceedings/articleshow/75323344.cms?from=mdr

[9] Sudden Bank recap bid, The Telegraph, (May 29, 2020, 05:05AM) https://www.telegraphindia.com/business/coronavirus-lockdown-sudden-bank-recap-bid/cid/1776722

[10] Vishwanath Nair, How the idea of a ‘Bad Bank ’made a comeback, Bloomberg Quint, (May 12, 2020, 01:33 PM) https://www.bloombergquint.com/business/how-the-idea-of-a-bad-bank-made-a-comeback

[11] Abhijeet Lele, Bad Bank may start with Rs 60-K crore NPAs; govt may put in Rs 10K crore, Business Standard, (May 12, 2020, 02:10 PM) https://www.business-standard.com/article/finance/bad-bank-may-start-with-rs-60k-crore-npas-govt-may-put-in-rs-10k-crore-120051200080_1.html

[12] Gopika Gopakumar, Bankers to revive Bad Bank concept, LiveMint, (08 May, 2020, 12:19AM) https://www.livemint.com/industry/banking/bankers-to-revive-bad-bank-concept-11588876753966.html

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