Finding a Cure to the NPA Crisis — Part 2: Bad Banks and AMCs
A look at some of the proposals to solve the NPA problem. Part 2 in a two-part series on India’s NPA crisis and resolution mechanisms…
NPAs are a problem. And we need to fix it. In my previous piece, I looked at the NPA situation in India, the typical resolution and recovery mechanisms. Recently, industry participants have put forth a proposal to institute a Government-owned bad bank. So, what’s all this about?
What’s a Bad Bank and the Proposed Option?
A bad bank is an entity that isolates high-risk assets from banks for recovery. They can be of 4 broad types depending on the following two factors:
- Whether loans would be taken off the banks’ books or not
- Whether the entity handling the bad loans would be a standalone one or not.
McKinsey’s ‘Understanding the Bad Bank’ report details these four models as follows:
In 2004, IDBI Ltd. converted itself into a bank and simultaneously, a Stressed Asset Stabilization Fund (SASF) was created to house 636 stressed assets and NPAs worth over ₹9000 crores. While SASF aimed to recover these NPAs, only around ₹4000 crores was recovered by the end of 2013. While this doesn’t serve as a particularly strong precedent for how a bad bank should operate, times have changed since then. The regulatory framework around resolution has become more robust and ARCs are becoming efficient.
The proposal that’s being discussed this time around is for the Government to establish standalone bad banks that would purchase bad loans from various PSBs at a lower cost and focus on recovery.
What are the Implications of the Proposed Model?
Such a model would greatly ameliorate the financial health of banks. They would see an improvement in the cost of capital and can focus solely on their core operations. Investors and depositors would be relieved if their banks are healthier. Further, with a sole focus on resolving risky loans, bad banks would develop the expertise to execute the process better than what PSBs can do on their own.
But, loan recovery isn’t a piece of cake. If the bad bank is unable to sufficiently recover its investments, it would have to shut shop unless more capital is infused from elsewhere. Conflict of interest that develops when a State-owned bank sells bad loans to a State-owned bad bank can exacerbate price opacity. And, fears also abound of moral hazard problems as such an entity may encourage banks to take on undue risk.
Is a Bad Bank Really Necessary?
Here’s the deal. When a bank sells its NPA to an ARC, Security Receipts (SRs) are used. Through this mechanism, payment is made after the recovery of loans. Hence, there is still no guarantee of banks really securing the discounted price for the sale of their loans.
‘The outstanding SRs is ₹1.46 trillion. This represents the “non-cash” consideration received by banks against the sale of loans. The low recovery rates and the sale based on SRs (~10–12%) is not a very attractive proposition for banks. The best way to achieve true price discovery and better realisations is to open the buy-side and enable a clear path for capital to flow for purchase of NPA,’ according to CII.
A bad bank owned by the Government and PSBs is essentially a public ARC. The gains made by this entity in purchasing NPAs at a lower cost and recovering them would, eventually, accrue to the banks themselves. That makes for a more lucrative option.
But, many factors are making the bad banks option an unsavoury one for the Government. The RBI has also not favoured it.
Creation of such a bad bank would initially require a capital infusion of around ₹10000 crores from the Government. The Government has already considerably capitalised banks over the past few years, infusing equity of ₹2.65 lakh crores into State-owned banks over the last three financial years. This additional capital requirement via an ARC is a stretch. Instead, some have recommended banks to just provision for the loans and seek capitalisation directly from the Government or investors, as this offers much more transparency.
Further, multiple other routes for NPA resolution already exist, including many ARCs in the market. They seem to be quite under-utilised in this scenario, and bringing them into the folds of the NPA discussion could go a long way. And that’s exactly what the Government was mulling in December!
What was the Government’s Proposed Plan?
The Center has announced plans to set up an Asset Management Company (AMC) to tackle the NPA crisis. It would serve as a bridge between bad loans, ARCs and lenders. The AMC would consolidate NPAs from different banks and approach entities such as distressed funds (which share the similar essence of ARCs) and institutional investors for funds. The AMC would then engage ARCs for resolution of the loans.
The AMC option looks at utilising existing infrastructure and establishments in a better manner instead of reinventing the wheel. By bringing more entities together and serving as a facilitator and channel between them, a more robust market-oriented process may be seen.
Bad Bank Back on the Discussion Table?
An ET article dated 7th January 2021 has, however, indicated that the bad bank option may still be on the cards. Ahead of the 2021 Union Budget (which would be unveiled in February), the Government seems to be reconsidering the bad bank proposal and has roped in stakeholders to provide their views on the same.
Looks like we’ll have to wait it out a bit to see which path the Government takes in its battle against NPAs. Regardless, in addition to these clean-up measures, focusing on the fundamentals to cement financial health of banks should be ensured too.
