[By Karma Shah and Diya Vaya]
The authors are third year students at the Gujarat National Law University.
Introduction
Our nation is facing a massive issue of Non-Performing Assets (hereinafter “NPAs”). Put simply, an NPA is any bank asset or receivable that has stopped making payments to the bank and has remained unpaid for a specified amount of time. The Reserve Bank of India (hereinafter “RBI”), in its Master Circular, dated 30th August, 2001, has given an extensive definition of NPAs, which aids Indian banks in identifying and treating NPAs. In this definition, the RBI has specified the period after which assets stop giving returns as a meagre 90 days.
NPAs are a threat to the Indian economy, as due to the strict prudential norms set by the RBI with respect to NPAs, banks have virtually stopped lending. This has led to the downfall of economic growth. An increase in NPAs leads to several unfavourable outcomes for the economy as a whole. These include, but are not limited to first, lower profit margins for banks and an increase in rates by banks for achieving a higher profit margin, second, reduction of liquidity in the organised financial sector, third, increased work-load on the judiciary, leading to an increased social cost to the society and lastly, stressed balance sheets of banks, less return to investors, and other such tangential issues.
To combat this threat to the nation’s economy, Ms. Nirmala Sitharaman (hereinafter “the finance minister”) proposed the introduction and setting up of ‘bad banks’ in the 2020-2021 Union Budget. Moreover, most recently, i.e., on 16th September 2021, the finance minister laid down the framework for the National Asset Reconstruction Company Ltd. (hereinafter “NARC”), India’s first ‘bad bank’. This blog aims to, first, explain the meaning of bad banks and their crucial need in the contemporary Indian economy. Second, examine the recent framework establishing bad banks laid down by the finance minister, and third, analyze the impact on the banks and the national economy.
Bad Banks – Meaning and Function
Bad banks are those institutions that, simply put, buy the NPAs and bad loans of banks and other financial institutions in exchange for cash and/or securities. The first-ever bad bank set up in the world was by Mellon Bank in the USA. In practice, a bad bank plays the role of asset reconstruction. It buys the NPAs, bad loans, and other risky assets from various financial institutions, specifically banks. The bad bank then manages and recovers these over time. Hence, contrary to a conventional bank, their core and primary function is the recovery of NPAs and bad loans.
Banks essentially isolate and divide their assets into two separate categories. One category contains the illiquid assets, including the NPAs, risky securities, non-strategic assets from businesses that are no longer beneficial to the bank, non-performing loans, and other high-risk or troubled assets. The second category contains the good and beneficial assets that perform well and represent the bank’s core business. A bad bank, a corporate structure, takes the NPAs and bad loans of such banks and provides cash and/or government securities in return. This allows the bank to clear their balance sheets, infuse themselves with liquidity, and helps them focus on their core business instead of trying and recovering the NPAs.
The Critical Need for Bad Banks in the Indian Economy
The Covid-19 pandemic has led to an unprecedented negative impact on our economy. Cash flow has reduced, leading to issues of loan repayments, tax payments, and interest payments. Furthermore, NPAs have been blocking the progress of our economy since the last decade. In such a desperate financial scenario, the need of introducing bad banks in the Indian Economy was critically felt due to the following reasons:
First, primarily to resolve the NPA crisis. NPAs have been a constant obstacle preventing the Indian economy from unleashing its true potential. NPAs have started to drastically increase in Indian Banks since 2013, forming almost 10% of the loans provided by the banks. As per RBI, NPAs of all the scheduled commercial banks have increased from 2.35% in 2011 to 8.21% in 2021, amounting to an increase of almost 250% in a decade. Moreover, due to the onset of Covid-19, RBI has presented a warning in its July 2021 Financial Stability Report that the gross NPA ratio may increase to 9.80 percent by March 2022 under the baseline scenario; and to 11.22 percent under a severe stress scenario. India has the third-highest gross NPA ratio. When a bank has a high NPA ratio, it spends a high percentage of its profits covering consequential losses incurred due to the high NPAs. This creates a situation of decelerating the cash flow in the economy, reducing the lending frequency of the banks and ultimately affecting the economy as a whole. . In this scenario, NARC is a much-needed expert entity required to fuel the economy’s growth, provide capital to banks and resolve the financial crisis.
Second, to provide support to the Insolvency and Bankruptcy regime (hereinafter “IBC”). The IBC was enacted with the objective of debt recovery and reducing the NPAs in the economy, among others. However, it did not perform as per expectations. Furthermore, it is argued that the IBC and associated debt recovery mechanisms are still at a nascent stage in India. For IBC to resolve all issues of NPAs plaguing our economy it requires greater judicial capacity, manpower and time. This can be provided by the bad bank, which creates a separate entity for quicker and more efficient one-time resolution and debt recovery. Now, banks need not worry about debts and can focus on strengthening the economy. Furthermore, the appreciable role played by bad-banks in other countries is the greatest testimony of its potential to resolve the issue of NPA’s in India and accelerate economic growth. Hence, a bad bank is necessary to tackle the issue of the large stock of NPAs in the economy as a one-time solution.
Impact of the recent framework on Banks and Indian Economy
On September 16, 2021, the finance minister set up the framework for NARC wherein the Union Cabinet approved a government guarantee worth rupees 30,600 crores of security receipts to be issued by the NARC.
It is critical that the banks calculate the value of such NPAs to be transferred to NARC, as most banks would have already written off these assets in their books. Whatever the price discovery mechanism may be, it is highly unlikely that the valuation would result in a price of more than 20% of these NPAs. Assuming that a bank is transferring an NPA worth 100 crores to NARC, as discussed above, the bank would be getting a maximum of 20% (20 crores). Out of this, only 15% (3 crores) would be given as upfront cash, and the remaining 85% (17 crores) would be given in the form of government securities. The government securities are provided for 5 years, and if the amount is not realized by NARC during that period, it will have to pay the banks in cash once these securities are invoked at the end of the period. Further, it is pertinent to note that banks are already investing in NARC, wherein it is proposed that 51% will be owned by PSBs, and the rest by the private sector. Hence, banks are receiving little to negligible financial benefit since they are only receiving back the amount in cash they will invest in NARC.
However, this would provide banks with a prospect to clean up their balance sheets, as NARC would buy off their NPAs and bad loans. This would drastically improve their book value since NPAs form approximately 10% of the total loans of these banks. Since banks wouldn’t have to worry about offsetting their losses from NPAs anymore, they would be able to increase their lending capacity, infusing liquidity in the market and holistically benefitting the national economy. Hence, in the long run, the bad bank, NARC, is bound to be beneficial to the Indian banking sector and the national economy.
Conclusion
The framework set forth by the finance minister for NARC will accelerate the growth of the entire Indian banking sector by absorbing NPAs from the banks, leading to freeing up of capital, increase in lending capacity and infusion of liquidity in the market. The success of this step hinges on the recovery of NPAs by the bad banks and various other factors. However, the Indian bad bank is an expert entity primarily set up to deal with the issue of NPAs quickly and efficiently and is backed by the government as well. Hence, bad banks have a credible shot at successfully resolving the issue.