Bad Banks – A Viable Solution to Ease India’s NPA Woes?
– By Ms. Pragya Garg,
(B.B.A, LL.B. (Hons.) student at NMIMS School of Law, Mumbai)
“Bad asset and disposal of bad asset is not something which banks are equipped for at the moment, they have never been equipped and you can’t blame them for it”
~Nirmala Sitharaman, Finance Minister of India, Annual Budget Speech’21
The rampant presence of NPA in the Indian Banking sector is no hidden affair. Despite its limited potential, Bad Banks can be seen as the most viable way forward. This essay explores the history of bad loans, and the consequent need of Bad Banks arising due to the same. Furthermore, alongside presenting arguments for and against the creation of Bad Banks, the future of Bad Banks in the place of proper channels of management and guidelines is also explored. The concept of Bad Banks could be a step towards improvement of the NPAs since it would give the PSBs a tabula rasa to move forward with their day-to-day operations. This would also free the percentage of capital reserves against the lent money, thereby, giving banks the confidence to lend more money and keep the COVID-19 ridden economy afloat. But this should not be misconstrued as a free pass to keep lending increasing amounts of money to the defaulters. This essay has attempted to present a solution-oriented approach based on the perspectives of various financial experts over the years. These include improvement in the PSBs, consideration of privatisation in PSBs and placing financial experts in the valuation of a borrower’s asset rather than allowing bureaucratic controls over loan grants.
Key words: Bad banks, Non-performing Assets, Bad loans, Green Financing
Non-performing assets (NPAs) or Bad loans as they are commonly called, have always been a threat to the banking system across the world. The Indian banking system is no exception. NPAs become a detrimental factor for the growth of the banking system, thereby having an indirect effect on the overall economy. In order to build a stable and strong financial system, minimizing NPAs becomes a key priority. The Indian banking system is more often than not found to be understating their gross non-performing assets in order to boost their earnings and capital adequacy ratios. Therefore, the true picture of India’s bad loan problem may be far more serious than it’s alluded in recent times. This problem of bad loans came to the forefront for the first time in the Bancon-13 conference held in Mumbai in 2013, wherein the then Deputy Governor of Reserve Bank of India (RBI) chose to talk about ‘future of banks’ instead of the theme ‘banks of future’. He expressed his rhetorical concerns about the rising NPAs, the problem with debt recasting, poor credit appraisal and monitoring systems adopted by bankers while granting loans. This is when the discourse around the incapability of public sector banks (PSBs) in evaluating the asset quality of a borrower and creating a separate entity, an asset reconstruction company (ARC), to do so began.
Cut to 2020, the Indian Banks Association proposed to the government to set up an asset reconstruction company, commonly known as a Bad Bank, to initially buy the non-performing loans from them (since the banks are unable to realise it’s value and in order to save NPA, ends up grating more loan to the borrower), so that the bank’s balance sheets get settled. In this scenario, the Bad Bank, (whose sole purpose would be re-evaluating the borrower’s assets and recovering the loan back), would be responsible for the appropriation of the bad loans.
Recognising the need of a Bad Bank
Every bank has some customers who are unable to repay their loans which are termed as non-performing assets and presence of some amount of NPA is naturally expected by the banks as not every loan gets repaid. In India, the problem arose when the levels of ‘hidden’ NPA kept on increasing and the situation got out of hand of the bankers. ‘Hidden’ NPA implies that the banks extend loans over loans to the borrowers before the due date of the premium, so that it does not converts into a NPA. They do so to save their profitability and ultimately leads to camouflaging the real position of the bad loans. Essentially, the Indian bankers ‘extend and pretend’ which is commonly called ‘ever-greening’ abroad. They do so because i) they are poor at evaluating project finance, ii) Most of the mega-projects are financed by state-owned banks, so banks take private-equity levels of risk, for interest-rate levels of reward and iii) if they end up acknowledging NPA (as losses), it will give invitation to internal enquiry, no promotion, and maybe CBI’s involvement too, like it happened in the case of Yogesh Agarwal (former IDBI bank’s chairman). Additionally, banks end up lending huge amounts of loans to completely new, capital-intensive sectors, such as aviation and telecommunication, in which they have no prior experience to analyse the predicted growths and thus, do not realise the risks associated with the same.
Inherently, banking regulations bring continuous struggle for the bankers as it decreases their freedom to function. But in 2015, the RBI recognised the problem of increasing NPAs and announced a Strategic Debt Reconstructing Scheme under its “Framework for Revitalizing Distressed Assets in the Economy – Guidelines on Joint Lenders’ Forum (JLF) and Corrective Action Plan (CAP)” wherein it suggested change of management as a part of reconstruction of stressed assets, implying transfer of shares from the promoters to the banks. This scheme was designed to assist the banks to make necessary changes in the management of the stressed asset accounts to revive the loan amount with enhanced capabilities by change in the ownership. Unfortunately, this reconstruction had an opposite effect which helped the banks to hide the true extent of their NPAs on their balance sheets and worsened their condition. This scheme worked in the favour of the banks as well as the borrowers, as now the banks did not have to declare NPAs and acknowledge the associated losses, and the companies could access more loans and stay afloat.
In 2018, under Urijit Patel’s (the then RBI Governor) supervision, the RBI instituted the Insolvency and Bankruptcy Code (IBC) which removed all leeway for the banks, where they used to go easy on big and influential clients. The new regulation removed the banks discretion of dealing with the case-to-case method in case of loan defaulters with a rule of starting a resolution in one day delay of repayment. This rule brought tension amongst the promoters as they could lose the company in case of a default. It also created an incentive for lenders as they could come up with turnaround plans to save the asset from becoming a NPA. Thus, early recognition of stressed assets was predicted, resulting in lesser NPAs. But again in 2019, the RBI changed the provision by introducing a thirty-day review period and later the Supreme Court struck down the 2018 resolution, attributing ‘depleting economic implications’ as the cause.
Mr. Patel in 2018, just after his resignation from RBI, mentioned in his book “Overdraft”, statements from government officials all of which proposed an undisputable preference for out of IBC settlement. He writes “If resolution outside the IBC is the preferred mode, then is the code a fifth wheel at best?”. He also cautioned that “Shortcuts or, worse, sweeping problems under the carpet is unlikely to work; it will only delay the unlocking of capital, hold back growth and come in the way of financing future investment efficiently”.
In the end of 2018, for a plethora of reasons, the Indian economy’s growth rate started declining, and with the spread of COVID-19, India faced a massive economic shutdown. Therefore, the government in agreement with the RBI decided that these extraordinary times demand extraordinary measures. An ordinance was introduced in the IBC regulations in 2020 which prohibited the initiation of insolvency for defaults arising from 25th March to 25th September, 2020 (extendable up to one year) and discharged a company’s director or a partner’s liability during this period. Other reliefs were also provided such as EMI moratorium passed by RBI of extension and relaxation to ease the state governments financial crisis. The RBI, on the advice of the Kamath committee report had given instructions to the banks on restructuring the existing loans. The government also came up with a three-lakh crore provision of a government guaranteed debt to MSMEs for them to survive in this crisis. The RBI in its Financial Stability Report (FSR) of January 2021, has stated that once normalcy returns, the bank’s gross NPA levels might rise to 13.5% by September 2021, from 7.5% in September 2020.
Therefore, the banks requested the creation of a Bad Bank because within a particular bank, the confidence and ability to take necessary steps against the defaulters is absent. However, if they write off the loans in their balance sheets, in comparison to showing NPAs, they would survive. And of course, the companies would be able to survive as i) They will be saved from the scrutiny process in defaulting a loan which is quite scary and risky, ii) they would be afloat with funds.
Arguments for and against the creation of a Bad Bank
The argument for and against establishing a Bad Bank is backed by two contending views. Mr. K. Subramanian, the Chief Economic Advisor, expressed his thoughts against the creation of a Bad Bank stating that there are already 28 ARCs in operation and the banks have been unable to sell their NPAs to them. It is because i) a bad loan will not get sold on its full price, they get sold on a discounted price, for example if the loan was of Rs.1,000 crore, it will most probably fetch Rs. 500 crore or Rs. 300 crores depending on the market. Bankers get scared of accepting such huge discounts as they might be accused of causing such huge losses to the banks and in worse-case scenario, be accused to cause national loss as Coal Secretary HC Gupta went to jail for the same, and ii) banks do not have the right training or expertise to recover the money from such regular loan defaulters. In this context, creating one more entity will not be beneficial, until it is owned by the government with private banks, who are willing to join. This argument stands true and consequently, it is being advised to create a government-owned Bad Bank which will not only be more capital intensive but also not impact the fiscal numbers, as in the case of recapitalising the state-owned bank. But again, in 2004, when bad loans of IDBI were bought by a government fund, neither the fund recovered sufficient value from it, nor did IDBI got back on its feet. One of the major arguments against the Bad Bank is by the former RBI governor, Raghuram Rajan, that taking out money from one pocket of the government (PSBs owned by government) and putting it in another Bad Bank (partially owned by government) might not yield any solutions. He called it ‘shifting the burden’ rather than actually solving the problem. However, it has been observed that this is not exactly what the Bad Bank would do. Instead, this separate entity would have financial experts who would only deal with recovering loans and thus have a much higher chance of success.
Most of the PSBs are managed by bureaucrats rather than financial experts, who may not have the best interest of the lender’s profitability. This is why privatisation of PSBs is advised. But again, to believe that a government is not capable of running its own sector efficiently enough is a major problem. That is why while designing a Bad Bank, this confidence in PSBs management is crucial. Thus, this time, the government and the RBI have come up with a different design of Bad Banks, inspired from successful models of countries like Germany and Sweden. It is to be owned by state-owned banks and private banks, without any intrusion of the government. There may be a sovereign guarantee by the government to meet the fundamental requirements of RBI regulations. Also, it is important to understand that from a long time now, the PSBs are not able to solve the NPA crisis by themselves, therefore creating a separate specialised entity (Bad Bank) would ease their job and get them back to their day-to-day operations.
It is crucial to note at this point that the Bad Bank will focus only on retrieving the loans as much they can, so that the PSBs can have a clean slate. “Creation of a Bad Bank has become the need of the hour. The national public sector ‘Bad Bank’ could serve as a vehicle to aggregate loans, create management teams for distressed firms, and possibly buy and hold distressed assets in a sector like power till demand returns. It could provide fall-back prices for loans sold by PSBs” mentions R. Rajan and V. V Acharya in their paper. Due to the fact that private players could recover and aggregate loans in sectors where the intervention of the government is not needed, they also advocated for privatisation of PSBs. While the public sector of Bad Banks had the ability to aggregate loans, buy and hold distressed assets before demand in the sector returns and also create management for companies in distress. For example, when the Delhi Vidyut Board was privatised in 2002, three new companies were created with clean balance sheets and now all of them are reporting profits. With a clean balance sheet, banks would also be able to lend money confidently and soon the Indian economy will be in thriving conditions wherein it would be able to meet the pressing needs of the economy of recovery and high growth. It is also postulated that Bad Bank will revive the credit flow of the economy as when it would buy the bad loans from the banks, it will free-up the capital kept as reserves against loans according to RBI regulations. Therefore, a Bad Bank would be able to improve bank lending not by increasing the reserves but by improving the percentage of capital buffers as reserves.
The Road Ahead
It is important to understand that unless the processes which gave rise to these excessive NPAs which are too large to be handled by the banks, just by shifting them to the Bad Bank might give them an incentive to restart the whole process and end up getting trapped again in the same vicious cycle of non-payment. Therefore, a simultaneous reform in the system is required which generates NPAs in the first place. Also, in the model of a Bad Bank, some hand holding if not ownership, will be useful both in terms of giving confidence to the banks as well as giving market participants confidence that this is something which is worth taking seriously. Also, privatisation of PSBs could be considered in the upcoming years as in private sector banks, asset valuation while granting a loan is done on the basis of their asset holding and is done by financial experts. Therefore, it is done in a much efficient manner and they end up granting less loans in comparison to PSBs. While in PSBs, loans are often granted on the brand value and not the real time asset value, which automatically has a higher chance of converting into bad loans. Therefore, until there is serious management and evaluation improvement in the PSBs, the problem of such huge amounts of bad loans will not end. The design of the Bad Bank and the right kind of first-generation management would decide the success rate of the Bad Banks.
But as far as creation of a Bad Bank is concerned, it could be the only option available in the current scenario. It is so because with the revised norms under IBC, prohibition of the process of ever-greening and restructuring of loans, making borrower’s loan rating agencies more robust, the idea of Bad Bank may not be the best suitable option but could certainly be a way forward to rectify the past mistakes of granting loans and reviving the economy.
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