3 Bad Bank: A solution to India’s NPA problem or A preposterous idea?

Bad Bank: A solution to India’s NPA problem or A preposterous idea?

By: Ritwik Mahajan (IIM Visakhapatnam)

This year's budget was quite optimistic, given the fact that it touched all major pain points, especially the healthcare sector. Secondly, it was a sigh of relief for the financial sector, especially banks reeling under the pressure of low debt recovery and rising NPA (Non-Performing Asset) problem due to the overarching impact of demonetization and GST induced shocks in the market. This was further exacerbated by the exogenous shock of the Covid pandemic on an already slowing Indian Economy. The budget promised a capital Infusion of Rs. 20,000 Crores to restructure the bank debts, and a promise to set up an Asset Reconstruction Company (ARC) and an Asset Management Company (AMC). During the last month, the government promised ARC; the National Asset Reconstruction Company Limited (NARCL) got registered with an authorized capital of Rs. 100 Crores, sparking the unending debate on whether a Bad Bank is a good idea or not.

Let us dig deeper into the past to get some clarity. The idea of a Bad Bank emerged in Asia after the aftermath of the Asian Financial Crisis of 1997, affecting the ASEAN countries and the EastAsia due to credit bubbles and fixed exchange rate regimes. Their Bad Bank model was quite successful and paved way for major financial reforms and economic growth in the region.

In 2002, the SARFESI Act was passed in India to better resolve companies' insolvency and bankruptcy issues. The Act paved the way for ARCs (Indian Bad Bank Model), and many scheduled public sector banks and financial institutions came together to form the first ARC of India, ARCIL. The private players in the market also formed their ARCs. The banks and financial institutions were allowed to sell their bad debts to these ARCs. The banks wrote off the loans from

their balance sheet by selling their bad debts at considerable discounts to their incorporated ARC. These ARCs recovered much more than the cost they paid to acquire the bad debts, which led to the fructification of enormous profits for the ARCs and their promoters, aka Scheduled commercial banks (SCBs), private banks, and financial institutions.

With the service sector boom in India, substantial foreign investment flew in, and with ARCs already formed, banks lent recklessly. The firms invested in utopian ideas that failed miserably, yet banks were ready to loan them again and again. As per RBI and CIBIL calculations, “India’s

Investment – GDP ratio (nominal terms) moved up from 26% in FY04 to 35% in FY08. This was financed by the inception of the biggest credit boom in the history of India – both non-food credit and credit to the industry segment doubled in a short span of three years from FY05 to

FY08.” With the 2008 sub-prime crisis, foreign investments stagnated, and the run of firms to invest in anything and everything halted, leading to a piling up of NPAs. Even if the NPAs were sold to

ARCs to window dress the balance

sheet of banks, it did not help the cause of the economy as the pressure of these bad debts led to a regular restructuring of bank loans and capital infusion. The leakages were more prominent than the infusion. It was a classic case of indecisiveness of the public sector banks. The confidence in the financial sector was at an all-time low. The only saving grace (to some extent) for us was the booming service

economy.

In the years ensuing, the fallacies of the SARFESI Act became evident in how long it took to complete the proceedings and how inefficient it was to recover the money or turn the company

around. Usually, it costed more to carry out the proceedings than the amount it recovered. Insolvency and Bankruptcy Code (IBC) was passed in 2016 to cover these loopholes.

Covid entirely disrupted the economic activity in an already slowed-down economy. With draconian lockdowns to curb the pandemic, people had no money to pay off their dues, especially 3 sectors- infrastructure and construction, hotel and tourism, and finance and commerce. These sectors take big loans due to the huge gestation period of their products or the considerable risk associated with their activities. All this led to non-payment of loans and pressure of NPAs again increasing on the financial sector. The government acknowledged it as an extraordinary situation requiring extraordinary measures and provided a loan moratorium to all, along with Rs. 3 Lakh Crores Emergency Credit Line Guarantee Scheme (ECLGS) for the MSME sector. The government also halted the IBC for 1 year till March 2021.

Even though these measures provided short-term relief to firms and corporates, they weren’t a

solution to the increased risk of further bad debts. RBI’s Financial Stability Report of June 2021

states, “Macro stress tests indicate that the gross non-performing asset (GNPA) ratio of SCBs may increase from 7.48% in March 2021 to 9.80% by March 2022 under the baseline scenario; and to 11.22% under a severe stress scenario, although SCBs have sufficient capital, both at the aggregate and individual level, even under stress.” The government handholding has proven effective till now, and with NARCL registered, the timing couldn’t have been better. A Bad Bank

is required during these extraordinary times.

It is the right time to clean the balance sheets of the banks and corporates, which will encourage risk-taking. The fresh lending by the banks can stimulate the supply side of things to stimulate

economic recovery and growth. NARCL and other ARCs would require further government handholding and support to instill confidence in the investors and general public. As the NARCL issued security receipts are backed by government guarantees, it would positively impact the industry outlook. ARCs working on a Bad Bank-ish concept is feasible for the current scenario but is not a long-term solution to the inefficient lending system of PSBs and the lending sector in general. It can only do good with a rigorous review of credit handling processes, a systematic mechanism to assess the quality of risk, and efficient decision-making at the positions of power in a timebound manner. NARCL can help us salvage as much we can, riding on the prospective Vshaped economic recovery. However, there has to be a cutoff date for this arrangement to end. It is a temporary panacea to fill in the gaps and reconcile the fault lines in the Indian Banking System.

The terms on which the Bad Bank is being formed have to be clear and concise. It is just a transitionary tool and must be dissolved at once when the time is right. It shouldn’t become a tool

for the PSBs to shrug the dirt under the carpet until it becomes a looming mountain over our heads.

Citations:

● NARCL Incorporation: https://www.financialexpress.com/industry/narcl-incorporatedwith-authorised-capital-of-rs-100-Crores/2288879/ ● ARCs: https://cleartax.in/s/asset-reconstruction-companies-arcs ● Asian Financial Crisis:

https://en.wikipedia.org/wiki/1997_Asian_financial_crisis#:~:text=The%20Asian%20fin ancial%20crisis%20was,meltdown%20due%20to%20financial%20contagion.&text=Indo nesia%2C%20South%20Korea%2C%20and%20Thailand,most%20affected%20by%20th e%20crisis.

● NPA rise post-2008: https://economictimes.indiatimes.com/cibil/articles/the-npacrisis/becreditsavvy_show/61835992.cms ● ECLGS Scheme: https://www.financialexpress.com/industry/sme/msme-fin-eclgs-howmodi-govts-rs-3-lakh-Crores-credit-scheme-put-covid-hit-msmes-back-on-recoverytrack/2237449/

● FSR, JUNE 2021: https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=1180