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An Insight into Bad Banks



 

Stressed asset reclusion has become a pervasive way of tidying up the balance sheets of troubled banks. Private investors venture into the institutional correction of these stressed assets for a safer return supplemented by a specialized markup. These institutions, commonly referred to as Bad Banks, acquire Non-performing Assets (NPAs) at a discounted price with the aim of optimizing their recovery and capitalizing them in a given period of time. During this entire procedure, it is the Bad Bank that incurs the cost. Thus, bad banks are essentially Asset Management Companies (AMCs), which are usually part of a larger portfolio of programs targeted at restoring several commercial banks or banks with vast levels of NPAs, or perhaps the whole financial system, and reviving market liquidity as the foundation for effective capital allocation in the economy.


The inception of Bad Banks


Bad Banks as a concept first evolved out of the need to resolve the banking sector crisis in the United States of America. The Banking crisis at hand in the 1980s was a result of the plummeting real estate and oil prices, two of the greatest commodities which played a key role in the new wave of urbanization. Mellon Bank bore the brunt of this looming crisis as it was making immense losses leading to an unsustainable state of function. This led to the formation of Grant Street National Bank (hereinafter GSNB), the purpose behind this idea was to transfer all the toxic assets of the Mellon Bank to GSNB so that they could be recapitalized, leading to liquidating of GSNB once the purpose was served, thence, making it a venture formation. Post GSNB there have been several bad bank formations around the world to target the non-compiled assets of specific banking institutions or specific industries.


Need for a Bad Bank in India


Banks in India have recently collected a substantial amount of stressed assets as a result of corporate and individual borrowers' failure to repay loans. Non-performing assets (NPAs) held by Indian banks grew from Rs. 53,917 crores in September 2008 (just before the Global Financial Crisis) to Rs. 3,23,335 crore in March 2015. According to RBI's Annual Report for 2017-18, stressed assets accounted for 12.1% of overall bank loans at the end of March 2018. In this report, stressed assets comprised both gross NPAs and restructured standard advances. If gross NPAs are considered independently, they account for around 11.2 percent of advances at the end of the year.


In February 2016, Indian banks disclosed that NPAs were increasing at a rapid rate so much so that planning for them had led to an impact on the operating income. This was unforeseen as in the absence of an economic crisis the GDP was augmenting at a competitive pace. This probed questions about the economic and financial status of the country. At the onset, it seemed that RBI's Asset Quality Review (AQR) prompted the banks to tidy the books by addressing and disposing of all the previous year's losses. However, on a detailed analysis, it was found that there were other factors at hand with respect to the rising NPA situation, notwithstanding, all the adjustments that had been made by March that year, with no apparent improvement in the numbers. It was India's Twin Balance Sheet Problem.

A Twin balance sheet problem occurs when corporations expand with the objective of attaining immense growth during the boom period. They acquire massive debt which leaves them with unpaid obligations as they default on their loans leading to attenuated balance sheets. Non-Performing Assets (NPAs) being the resulting consequence of this problem, emanated from the mid-2000s when the economies of the world were booming, owing to which, corporates in India charted out new investments by launching heavily funded infrastructure-related proposals such as telecom, steel, and power generation. These investments were financed by banks leading to the largest investment and credit boom in the country.


Corporates charted out new investments by launching heavily funded infrastructure-related proposals such as telecom, steel and power generation. These investments were financed by banks leading to the largest investment and credit boom in the country. As corporations left their conservative estimates behind, all of this added up to a phenomenal amount of debt. These growth expectations, however, proved to be short-lived as structural ingenuities crept in, and procurement of land and environment-related licenses were time-consuming and more costly than anticipated. Moreover, it was during this time that the Global Financial Crisis (GFC) occurred leading the world's financial activities to a downward spiral. Forecasted long-term growth estimates were no longer viable.


Inadequacy within the existing Recovery Structures


The number of NPAs in the Indian economy is increasing at a rapid rate which does not translate itself in terms of the recovery of NPAs. In the year 2003-04, the total amount of NPA stood at Rs. 648 billion which has increased by Rs. 7900 billion, more than ten times the size. Notwithstanding the amount procured in the recovery process has been increasing over the years but in comparison to that the NPAs have soared drastically.

  • Asset Reconstruction Companies

The recovery mechanism that exists in India majorly focuses on Asset Reconstruction Companies (ARCs) which are registered with the RBI and are regulated by the SARFAESI Act, 2002. These companies are financial institutions that facilitate the recovery of bad loans. ARCs step in when instead of taking legal action, banks resolve to clean up their balance sheets. These special purpose vehicles, buy NPAs from banks at a mutually agreed discounted price through the funds that have been raised from qualified buyers in exchange for security receipts and interest in those financial assets. As efficient as the ideology seems to be, there have been multiple executional as well as structural issues with regard to carrying out the ARC mechanism efficaciously because of which ARCs have not been able to mitigate the NPA problem. Only 3-4 ARCs in the country possess an adequate amount of capital to carry out the acquisition and securitization of these bad loans. All the other ARCs have only a sliver of this capital to meet the 15% upfront payment requirement of the banks. Moreover, banks delay selling NPAs to these ARCs due to picayune price offer by the ARCs which does not cover the losses adequately for these banks. This necessitates the need for revival of the present structure or setting up of a new structure based on the cost-benefit analysis and the executional viability of the two choices, that is, whether to set up a new recovery mechanism or revamp the existing structure.

  • Other Recovery Mechanisms

Already established recovery mechanisms are inefficient and inadequate to deal with the NPA problem at hand. This is due to issues with respect to the overlap in a jurisdiction that all the forums in the respective legislatures deal with. This further increases the burden on the court. Various corrective measures have been taken in terms of the judicatory authority to implement small as well as relatively larger schemes in place. The favorable mode of recovery was noted to be Lok Adalats because it's a faster and more hassle way method of recovery. In Lok Adalats the autonomy of the parties is far more due to the ease of settlement and reduced legal documentation and processes. Lok adalats also allow a more negotiated settlement between the two parties as opposed to all the other court procedures. Lok adalats had the most amount of registrations for default loan cases, this showed that people gravitated towards the settlement of loans at Lok Adalat due to the low cost and immediate settlement. Statistics showed that the recovery that took place from SARFAESI was higher from 2003-04 to 2016-17 but from the year 2013-14 the pace of the recovery started falling.

The most amount of recovery took place through SARFAESI but the level of it kept on falling every year. This was an alarming sign especially now that the court intervention was minimized in the recovery method of SARFAESI, the factor of delay through legal processes was eradicated to a certain degree which warranted levels of success but it didn't project the same over the couple of years. The least recovery was seen from Lok Adalats, which was not surprising given the occasional nature of the settlement mechanism. Additionally, Lok Adalats are favoured by the courts when the parties file an application to transfer the case to the Lok Adalat. So it does not occur as the first method of settlement among the parties as sometimes other recovery methods serve their individual and separate interests more. There is a constant fluctuation in the recovery that is observed from the DRTs as even though there is a general direction of decline, there was a dip in the years 2013-14 and 2014-15 after which DRTs improved their position.


The recent enactment of IBC 2016 has given little hope in terms of dealing with large corporate loans, albeit, it is too early to comment on its functioning of it right now. Needless to say that IBC related issues do arise day in and day out when a conflict of interest occurs among the parties, a recent example being, a question on the validity and constitutionality of the IBC Amendment Act of 2018, the issue was raised with regard to whether or not the homebuyers come under the ambit of a financial creditor under the act which was upheld by the apex court. IBC being another act that has been enacted by the government leaves room for assessment of its working and execution, as opposed to a policy reform such as Bad Bank which would not be dealing with individual borrowers but majorly with banks and corporations.


The banks as well as the government are aware of the fact that the increased amount of NPA is responsible because of ill credit management and the failure to respond to the crisis at hand in a timely manner. There is a level of recklessness when it comes to credit risk management and period assessment despite all the tools being available with the banks. Banks need to have effective operational structures for both pre and post-loan sanctioning. They need to adhere to all the minimal requirements with respect to the granting of a loan prior to sanctioning the appraisal and they need post-dispersing strategies to help them recover their losses quickly in case of a default.


Contemporary State of Affairs: NARCL and IDRCL


The proclamation made by the Finance Minister in the 2021-2022 budget with respect to corrective measures for the high level of provisioning which is made by state-owned or public sector banks, for the bad debts has been actively sought by the formation of the new bad bank in India, referred to as, National Asset Reconstruction Company (NARCL). This bad bank is a result of an alliance between public as well as private sector banks which seek to dispose of their bad debts to achieve higher financial gains. The classification of this bad bank is a bad bank spin-off wherein a license from RBI would be obtained by the promoters of NARCL.


The capital structure and financing of this bank have been bifurcated in the form of 15% upfront cash and the rest 85% in the form of state-guaranteed receipts for security which will only be invoked in case there is a loss below the ascertained minimum value. State-owned banks have a larger stake valuing at 51% as compared to the other debt management companies. The unique play in this scheme is the overseeing of supplemental operations which will be done by the India Debt Resolution Company Ltd (IDRCL) which will manage assets and assist NARCL by roping in professionals and experts for the valuation of different industry-specific assets, giving the Asset Reconstruction Company-Asset Management Company-Alternative Investment Funds (AMC-AIF) model a concrete basis of function. The result of this new policy would eventually be visible as banks would now be backed by a combination of an ARC, AMC, and AIF, which would enforce defaulted loans immediately and effectively by either forfeiting the security or through other such mechanisms, without taking the matter to the court which usually takes years to settle, in this amount of time, the money can be generated and the remedy is not as stringent.


Bad Bank-Means to the final resolution


Given the failure of the existing debt recovery mechanisms over the last couple of years and the continuous rise in the NPAs, there is a need for a total overhaul, legal as well as economic. The government's intentions and execution have been well placed by establishing laws for recovery and providing the opportunity of recourse to aggrieved lenders. However, most of these laws are built for settlement and repayment of individual loans, which would take years to revive the economy. India needs a reform that works from the top to the bottom to clean swipe the NPA problem, much like what should have been done right after the boom in the mid-2000s. This reform should work side by side with all the legislature that has been already enacted by the government. The only issue that will arise and that continues to arise in the Indian economic and legal status is the intertwining of these laws with a viable business model. The legislatures with respect to recovery are scattered everywhere leaving ill-defined boundaries for functioning between both the creditors and the debtors. The need of the hour is to streamline already existing infrastructure so that the rapid eradication of NPAs takes place in a swift two-sided move.

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