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Bad Bank: The challenges ahead

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With the era of the bad bank finally upon us, does this mean we are now in the endgame of the battle against bad loans? Or will this turn out to be merely a one-time clean-up exercise?

Bad Bank: The challenges ahead
The “Bad Bank” is here! After years of debates and discussions on whether setting up a “Bad Bank” or an asset management company to take over the non-performing loans (NPLs) burdening India’s banking sector would be beneficial, India has finally decided to opt for this route in its battle against bad loans.
In the latest move, the government has also offered a sovereign guarantee to help this new entity in its process of recovering the best possible value from the NPLs it takes over. So how will the newly set up National Asset Reconstruction Company Ltd (NARCL) and the India Debt Resolution Company Ltd (IDRCL) work together to tackle the NPL problem?
What will this Bad Bank do?
Let us begin with a quick snapshot of what will happen now. NARCL will first take over NPLs worth Rs 90,000 crore from banks. For NPLs over Rs 500 crore in value, the NARCL will offer the lead bank a certain value, pay 15 percent in cash upfront and then issue tradable security receipts for the balance. The IDRCL will then come into the picture to add value to the distressed asset, resolve it or liquidate it. The sovereign guarantee, worth more than Rs 30,000 crore over five years, will cover the shortfall between the value of the security receipts and the actual amount recovered from an NPL.
With open arms…
This move seems to have been welcomed by stakeholders with arms wide open, with bankers commending the government for this step and the markets giving it a thumbs up. The emergence of the need for a “Bad Bank” could be attributed to the large stock of bad assets that continues to weigh down Indian banks. The pandemic only added to the severity of this problem, with many more loans threatening to slip into the “bad” side once the pandemic-related moratoriums are lifted. At the end of the 2020-21 financial year, 7.5 percent of the total loans disbursed that year were classified as NPLs.
Although the implementation of the Insolvency and Bankruptcy Code (IBC) was a huge step in the right direction, we have seen that the IBC process can be time-intensive and that the National Company Law Tribunals (NCLTs) have become overwhelmed with a deluge of cases. With time, an alternative became necessary, and now, with the NARCL and IDRCL being set up, an avenue has been provided for stressed assets to be resolved while being kept out of the IBC route. This will certainly help ease the burden on the courts and tribunals that are currently struggling with a high volume of insolvency cases. This also takes us closer to a robust regime where lenders are not grappling with a lack of options for distressed asset resolution and therefore forced to become increasingly risk-averse on account of providing for NPLs on their books.
The added sweetener of the sovereign guarantee also safeguards against issues of vintage accumulation of security receipts payables faced by some of the existing asset reconstruction companies. It will further encourage industry participation in the resolution process.
Challenges ahead…
Although the move is a welcome one, it is not free of its own limitations and criticisms. The success of such an initiative is dependent upon many crucial factors such as fair pricing, complete segregation of risk from selling banks, investment of external capital, independent and professional management of the new entity, minimising moral hazards and adequate capitalisation of the banks post-sale of assets to invigorate fresh lending.
An undesirable outcome that the NARCL runs the risk of facing is that it may simply turn into a storage house for distressed assets after struggling to find takers for them. Care must be taken to avoid such an outcome as it would only exacerbate the problem in the long run. Moreover, in an attempt to find buyers for these stressed assets, banks must not be forced to take large haircuts as we have seen in some IBC cases.
Concerns have been raised with respect to how this bad bank will be capitalised in the longer run and what the source of the capital will be. The government’s revenue and fiscal deficit woes have been written and talked about for a while now. Questions with respect to whether the government would have been better off recapitalising the banks themselves instead of backing the bad bank have been doing the rounds. However, in my opinion, simply recapitalising the banks once again would not have been an effective solution to the problem at hand. With a bad bank taking the stressed loans off their hands, the banks can focus their resources on their core business of boosting credit growth and innovating. Although, will this be enough of a push to make banks a little less risk-averse? We will have to wait and see.
Valuation of NPLs may also pose to be a challenge in this process since most Public Sector Banks (PSBs) do not engage in independent valuations which results in the process not being transparent or market-driven. Development of detailed recovery/deleveraging plans and managing appropriate resources in areas such as restructuring and recovery, commercial real estate, IT and portfolio sales/M&A may also pose an initial statistical problem for the NARCL.
Governance concerns
Another area of concern is the governance of this entity. Further guidelines are required to provide greater clarity on exactly how this bad bank will be structured and how its functioning will be governed.
While the current structure suggests 51 percent shareholding being divided among the public sector banks, an independent governance structure would be the key to safeguard against conflict-of-interest vis a vis pricing and eligibility of NPLs for transfer.
In events where there are pricing conflicts and cases where entities backed by private corporate houses are participating in the process, sufficient checks and balances must be worked into the structure so as to ensure the highest standards of corporate governance. It is abundantly clear that for the bad banks to work as intended will require strong and impartial leadership, a high degree of financial expertise and roping in relevant professionals with the right skill set.
This move has also drawn criticism from some who say this structure could turn into a way by which the government indirectly guarantees the stressed loans of private enterprises, ultimately taking a toll on taxpayers’ money.
A helping hand to struggling sectors?
Some have opined that not enough has been done to lend a helping hand to sectors that are particularly struggling at the moment, such as telecom, aviation, tourism, etc. While we await further announcements from the government on the structure and procedures with respect to the NARCL and IDRCL, some stakeholders are hoping to see specific announcements for sectors that need a push. Perhaps certain incentives such as extensions on the guarantee period for stressed assets from these sectors can be an effective way to speed up their resolution and encourage participants to come in.
Conclusion
With the era of the bad bank finally upon us, does this mean we are now in the endgame of the battle against bad loans? Or will this turn out to be merely a one-time clean-up exercise? I am of the view that this is surely a big step in the right direction towards our goal of freeing India’s promising banking sector of the burden of these stressed loans. However, as time passes, we may also need to focus on structural reforms to the entire bankruptcy process in order to ensure that our processes are up to date and efficient.
—Haigreve Khaitan is Senior Partner at Khaitan & Co, one of India’s largest and leading full-service law firms. He has advised top global businesses and business leaders on a variety of corporate matters and worked on some of the largest M&A deals in India. The views expressed in this article are personal.
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