Bad Bank

 

What is a Bad Bank

Over a period of time several of our household goods are rendered useless, but continue to occupy valuable space.  During Diwali cleaning these assets are either disposed off or dumped in a separate room which becomes the junk yard and from where these assets are disposed off gradually to salvage some value. This cleans the house and frees up space which can be used by items of better utility. Similarly, in a Bank several assets (generated form Bank’s loan) become “Non Performing” over a period of time due to various reasons. These Non Performing Assets (NPAs) become a drag on the Bank’s balance sheet and have to be offloaded so that the balance sheet continues to remain healthy. To draw an analogy to our home cleaning example, after the home is cleaned, it gives a better feeling to visitors, similarly once the Bank’s balance sheet is cleaned it gives a better feeling to visitors (investors, new customers etc.). The storage or junk room in our home is the bad bank in the banking system.

Bad bank is a separate institution, where bad loans (assets) from another Bank or banks can be offloaded so that the latter’s balance sheet gets cleaned up and it can continue its business as a healthy venture. Since the new institution is incorporated specifically for parking and dealing with bad loans, hence the euphemism “Bad Bank”. 

The concept was first floated in 1988, by the Pittsburg, US headquartered Mellon Bank. Thereafter it became standard template to deal with bad loan crises in several countries Examples are Retriva and Securum in Sweden (1992), Dexia in France (1994),  OHY Arsenal and Sponda in Finland (1998), IBRA in Indonesia (1998), Fortis and Dexia in Belgium (2009), Citi Holdings in US ( (2009), Parex in Latvia (2010) , Swedbank in Sweden (2010), UK Asset Resolution in UK (2010), Bankaktiengesellschaft (BAG), Volksbanken und Raiffeisenbanken, Bankgesellschaft Berlin, Erste Abwickelungsanstalt and FMS Wertemanagement in Germany, SAREB in Spain (2012) and Banco Espírito Santo in Portugal (2014).

 

So it’s not that the problem of bad loans is very specific to India. Wherever there is Banking, there are toxic or Non Performing Assets .

Pros and Cons of a bad bank

The idea behind setting up a bad bank is to segregate a Bank’s bad assets from good assets and place them in a specialized institution so as to redeem, salvage and recover whatever value is possible. From this point of view, one of the biggest advantages of setting up a bad bank is that it helps to consolidate and aggregate all bad loans from a number of institutions into one entity (although it is possible for each good bank to have a separate bad bank of its own). A Bank’s main business is to carry out normal banking activities ie. collecting deposits and lending to industry/services. Transfer of bad loans from its portfolio frees up Bank staff who can be deployed for fresh banking activity. Conversely, since bad bank’s main business is to resolve bad loans, here the transferred accounts receive specialized and focused treatment.

Shedding of bad loans also frees up capital of the good bank which is locked up as provisions towards these bad loans. This capital can be profitably deployed by the good bank to book fresh business 

Talking about benefits of setting up a bad bank  Sri Sunil Mehta, CEO of Indian Banks Association (IBA) summed it up succinctly (ETBFSI-08/02/2021) "The first and the foremost advantage that the national reconstruction company will provide is consolidation of the debt. The debt which is spread out in 10-20 different entities of the consortium or the multiple banking arrangement, it will be consolidated into one entity which will provide ease of resolution. In a multiple banking arrangement, there is always a difference of opinion which makes it difficult to reach a resolution plan. When a particular asset is transferred to an AMC, which has specialisation in the particular area and thus can take a more informed decision."

 

The idea of a Bad bank is however not without its share of critics, the foremost being Sri Raghuram Rajan, (former RBI Governor  who is currently Katherine Dusak Miller Distinguished Service Professor of Finance at the University of Chicago Booth School of Business). According to him a bad bank merely shifts bad assets from Government owned public sector banks (in Indian context) to a Government backed bad bank, Another school of thought holds that bailing out commercial banks may not necessarily improve their internal processes and practices which may have contributed to the assets turning toxic in the first place.

 

Indian Bad Bank

Indian Banks specially the Government owned, have been bogged down with Non performing assets for quite some time. Governments over a period of time, have tried various means to resolve the issue starting with Debt recovery tribunals and then the SARFAESI (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest  Act), 2002 which gave more teeth to the lenders. This was succeeded by the Insolvency and Bankruptcy Code (IBC),2016. The latter was expected to resolve the bad assets problem pretty quickly with minimal haircuts for lenders, but the move did not achieve the desired results. So the move to set up a bad bank may be reflective of Government’s desire to sharpen focus on resolution of toxic assets while at the same time segregating them from the lending Bank’s portfolio, thus avoiding continuous drain on Government resources in the form of frequent recapitalization of Banks.. .

 

The genesis of Bad Bank may lie in the observations made in the Economic survey 2016-17 which referred to the Twin Balance Sheet problems, overleveraged companies and banks saddled with bad loans. The survey had observed that decisive resolutions of the loans, concentrated in large companies, have eluded successive attempts at reform. The problem has consequently continued to fester: NPAs keep growing, while credit and investment keep falling. Perhaps it is time to consider a different approach – a centralised Public Sector Asset Rehabilitation Agency that could take charge of the largest, most difficult cases, and make politically tough decisions to reduce debt..

On 1^st February 2021, the finance minister while presenting the Union budget for fiscal 2021-22, proposed setting up of an Asset Recovery Company (ARC) to take over stressed assets of public sector banks. “The high level of provisioning by public sector banks of their stressed assets calls for measures to clean up the bank books. An Asset Reconstruction Company [ARC] and Asset Management Company [AMC] would be set up to consolidate and take over the existing stressed debt and then manage and dispose of the assets…for eventual value realization,”

 

For reader info, an ARC is a RBI registered specialized financial vehicles engaged in acquiring NPAs from Banks and disposing them off. This helps the Banks to shed NPAs from their balance sheets and become healthier.

ARC-AMC structure

Thereafter Indian Banks Association (IBA) took the initiative and approached RBI seeking a license to set up the ARC or bad bank. The bad bank, christened National Asset Reconstruction Company Ltd. (NARCL) was incorporated in July 2021. NARCL has been lead sponsored by Canara Bank (12% share) with equity participation by State Bank of India,  Bank of Baroda, Indian Bank , Union Bank of India ,(all 4 with 9.9% each) Bank of India , Punjab National Bank ( both with 9% each) Bank of Maharashtra (5%), Indian Overseas Bank (3%) , UCO Bank (4.4%), and Punjab & Sind Bank (2%). Private sector is represented by ICICI Bank, IDBI Bank (5% each), Axis Bank and HDFC Bank  (3% each)

 

To assist NARCL, public and private banks have come together to set up India Debt Resolution Company Ltd. (IDRCL) that would manage the acquired toxic assets. The company was incorporated in September 2021. Here the majority stake ie 51 % shall be with Private sector Banks, while 49 % shall be held by Public sector Banks.

 

Bad bank scheme envisages segregation of asset acquisition and resolution. While NARCL will acquire NPAs from banks, IDRCL will handle the debt resolution process under an exclusive arrangement with NARCL on a Principal-Agent basis. Ownership and final approval authority shall lie with NARCL.

 

In total, 38 stressed accounts with an aggregate outstanding of Rs. 82,845 crores have been identified to be transferred to NARCL out of which 15 accounts with an aggregate outstanding of  Rs 50,335 crores shall be dealt with in the first phase. The cut off point for identification is minimum secured outstanding exposure of Rs. 500 crore..

 

How will the Indian bad bank work

Loans extended by a Bank (assets in its balance sheet) may turn toxic due to various reasons viz. overall distress in the economy, enterprise’s product not getting market response or simply dishonest conduct of the promoter. Once the Bank fails to recover its dues, the account is classified as Non Performing asset (principal or interest becoming overdue for more than 90 days ) and the Bank has to set aside some profits / capital to provide for the likely loss from the asset. This is called provisioning.

 

NARCL ie the bad bank, shall acquire the identified toxic assets by making a binding offer to the concerned banks. The latter, following the Swiss Challenge method, shall invite offers from other ARCs with NARCL’s offer as the anchor. If any offer received from an ARC is better than the original offer of NARCL, then the latter shall be given an opportunity to match the same. The asset in question shall be transferred to the highest bidder.

 

Under the scheme, NARCL shall pay 15 % of the bid amount in cash while the residual 85 % shall be though issue of Security receipts (SRs) in favour of concerned lenders. SRs are financial instruments that represent undivided right, title or interest in the asset. The said SRs shall be guaranteed by Govt of India to the extent of Rs. 30,600 crore under a backstop arrangement covering the gap between face value of SRs and value realized from sale of assets to the eventual buyer. The Govt guarantee shall be valid for a period of five years. While NARCL shall bid under the 15:85 scheme, other ARCs will have to bid on all cash basis. The SRs are tradable in market through transfer / assignment in favour of Qualified Institutional buyers (QIBs) as defined under Section 2(1)(u) of the SARFAESI Act), 2002.

Here it may be pertinent to note that India already has 28 ARCs which are engaged in resolution of stressed assets, but still Government / Reserve Bank thought it fit to go for a fresh ARC/AMC structure. This was probably done, since the existing ARCs have been found to be ill equipped to manage and resolve large stressed assets

Once the toxic assets / accounts are transferred to NARCL, a trust is set up for each account individually which shall issue the respective SRs. So the asset shall be carried in NARCL’s balance sheet , while IDRCL which shall be functioning only as a debt resolution service company

 

NARCL is expected to make a profit if it is able to realize a sale price which is higher than the amount it paid to the original lenders. However generating profits is generally not the main aim for setting up a bad bank. As explained earlier, a bad bank’s primary objective is to remove toxic assets from the balance sheet of commercial banks, freeing their capital buffer which can enable them to restart normal lending activity.

The Bottom line

Allowing the toxic assets to continue in Bank’s Balance sheet, impairs its ability to operate as a profitable entity, as its capital gets bogged down by toxic assets and it is not able to mobilise fresh capital. Option of letting the bank write off these toxic assets (against capital provision) and then recapitalizing the balance sheet , may put a massive strain on public exchequer, which will  have to be tapped for future capital infusion into Government Banks.

Therefore segregating the assets into a bad bank is a good idea, where it can receive specialized and focused treatment while freeing the commercial banks for normal credit activity. But the key element which may determine success or failure of this move, may be whether the transactions are treated as mere accounting entries or a sincere effort is made to maximize realizations from the bad debts. Towards this end, it should be kept in mind that varyingly different skill sets are required for lending process and asset resolution and consequently different organizational set ups are required for a good bank and a bad bank.

 

Bad bank’s first year of operations shall be crucial as processes get formulated for expeditious resolution of wide variety of assets spread all over the country. Long term aim shall be to resolve all the toxic assets over a certain period of time say 5 to 7 years and then wind up the bad bank itself. The bad bank cannot be a permanent feature of the economic ecosystem because that shall pre suppose that big ticket assets will continue to become ‘Non performing’ in the books of lenders and there will be continuous inflow of ‘business’ for the bad bank. This cannot be a good sign for robust credit governance and delivery.