The NPA Conundrum: Evaluating the Bad Bank Approach

[By Shubham Nahata]

 

The author is a student at Hidayatullah National Law University, Raipur

Introduction

One of the most drastic and disastrous impacts of the economic slowdown induced on account of COVID-19 will be seen on the balance sheets(“B/S”) of banking and financial institutions. As the availability of easy credit will become the norm in the post COVID-19 society, banking institutions will need to deal with the herculean task of resolving stressed assets on their B/S. According to the Financial Stability Report, published by the Reserve Bank of India, scheduled commercial banks (SCBs) account for almost 9.3% of Gross Non-Performing Assets (NPAs) in the economy. Almost 85% of these stressed assets can be traced to the B/S of Public Sector Banking institutions (PSBs). One of the prospective solutions on cards for resolving the banking crisis is the creation of a ‘Bad Bank’ that would take over NPAs from banking and financial institutions. Unlike traditional banking institutions, it does not engage in credit lending functions, however, it assists in the recovery of stressed assets in the financial sector.

The soundness of the credit infrastructure of an economy is largely dependent on the recovery and resolutions mechanism in place for dealing with stressed assets. This blog post maps the growth of different regulatory practices adopted overtime to deal with NPAs and analyses the viability of a Bad Bank structure based on the experiences of different jurisdictions.

Mapping the Trajectory

Different strategies have been adopted over time in order to deal with stressed assets in the banking infrastructure. It includes measures like corporate debt restructuring, recapitalisation of banks etc. in order to improve the capital adequacy and keep NPAs in control. However, the overtime rise of NPAs in an economy is a signal for the need for a robust and effective resolution and recovery infrastructure.

Neo-liberal banking reforms introduced in the first decade of the 21st century although increased the credit flow in the economy but it also led to a steep rise in bad loans as well. In order to portray the sound health of the banking industry, drastic measures like Corporate Debt Restructuring (CDR) were taken. It involved complete overhaul strategies like conversion of debt into equity, reducing interest, or extending the maturity to maintain the soundness of B/S.  One of the benefits that restructuring offered was that it exempted banks from creating provisioning for stressed assets.

However, the Reserve Bank of India (RBI) prescribed stricter norms for classifying and recognition of stressed assets in the economy after the Asset Quality Review of 2015. This led to a steep increase in the ratio of NPAs in the banking sector. In order to deal with the ‘twin balance sheet problem’, the Insolvency & Bankruptcy Code (IBC) was enacted in the year 2016 which provided an effective avenue for financial lenders to undertake the resolution of stressed assets. The Banking Regulation (Amendment) Act, 2017 also empowered the RBI to issue directions to the banks to undertake resolution process against defaulters under the IBC.

Similarly, under the framework of Joint Lenders Forum, the Reserve Bank empowered the banks to undertake measures like Corporate Debt Restructuring, Strategic Debt Restructuring and, the Scheme for Sustainable Restructuring of Stressed Assets (S4A). S4A offered an opportunity to the lenders to identify the sustainable level of debt for the borrowers and convert the unsustainable part of debt into equity instruments. However, these policies were discontinued after the RBI notified Prior Framework in March 2018.

The prior framework was struck down by the Supreme Court in Dharani Sugars and Chemicals Limited v. Union of India, for being violative of Section 35AA of the Banking Regulation Act, 1949. Hence, on June 7, 2019, the RBI notified Prudential Framework for Resolution of Stressed Assets (Prudential Framework) which prescribes an incentive-based approach for resolution of stressed assets to improve the resilience of the credit infrastructure of the economy.

Bad Bank Economics

Asset quality, capital adequacy, liquidity and, responsiveness to the market are considered to be the key indicators of the financial health of a banking enterprise. Overtime rise in the ratio of NPAs not only affects the asset quality of banking institutions but also affects its capital to asset ratio, in turn, fracturing its ability to lend swiftly in the market. Bad Bank is a special purpose vehicle constituted as an Asset Reconstruction Company (ARC) tasked with the objective of acquiring and managing stressed assets of banking and financial institutions. It acquires discounted stressed assets from banks by upfront payment of a certain proportion in cash and issuing security receipts for the rest of the amount.

Bad Banks are tasked with the responsibility to uniformly carry out resolution and recovery steps in respect of stressed assets and increase the return on such assets. Generally, such a form of entity is funded by the government and banking institutions in order to carry out its activities. Bad Bank structure for resolution of NPA can be effective as compared to the recapitalisation of banks, as the latter increases the burden on the taxpayers to provide for weak recovery infrastructure for banking institutions. 

Global Experience

Different jurisdictions around the globe have found recourse in a Bad Bank framework in order to deal with the problem of mounting stressed assets in the banking industry. Sweden during the financial crisis of 1992, formed a state-owned company (‘Securum’) tasked with the objective of acquiring stressed assets from its banking institutions. Securum was successful in resolving banking crisis in the economy and was able to return a substantial amount of government funding.

Similarly, the Korean Asset Management Corporation of South Korea was formed in order to deal with stressed assets lying with banking and financial institutions. It was successful in reducing the ratio of NPAs in the economy from 17% in 1998 to 2.2% in 2002. It also introduced and developed the market for asset-based securities which attracted investments from both domestic and foreign investors.

After the global financial crisis of 2008, the United States of America also formulated a Public-Private Investment Program (PPIP) which focussed on removal of toxic assets from the B/S of financial institutions. PPIP was initially funded by the Treasury to the tune of $22 billion and it also attracted funding from private sector players. It was mainly tasked with the responsibility to create a market for mortgage bases securities and facilitate its price discovery. By 2014, PPIP was successful in returning $18.6 billion of Treasury’s investment and it also contributed a net positive return of $3.9 billion in excess of the original equity capital.

Experiences around the world are a testimony to the fact that asset management and reconstruction companies backed by state funding can be offered as a prospective solution for cleaning the B/S of banking and financial institutions. Hence, a State-backed Bad Bank in India can provide much-needed security and open avenues for private involvement in the process. However, it needs to be kept in mind that there is no straightjacket formula for the resolution of stressed assets and it is largely dependent upon the nature of the market and the government policies assisting the same.

Evaluating the Proposal

  1. Addressing Information asymmetries ­– A central agency tasked with the responsibility of management and recovery of stressed assets can address information asymmetries in the credit market and can streamline and collate information with respect to stressed assets in the economy. It helps in the creation of a central repository dedicated to asset-based securities, fostering rapid growth and development of its market.
  2. 2. Efficient Resolution & Recovery – As a Bad Bank enjoys complete control over the assets, it can take quick and efficient decisions under the resolution process. Unlike previous regimes where permission of different lenders was required to approve a resolution plan, a Bad Bank, on the other hand, streamlines the process by according control to a unified entity.
  3. Focus on Core Banking Activities – One of the primary benefits of a central asset management agency is that it deleverages the B/S of banks and financial institutions. Hence, it can be an important tool in destressing their B/S, allowing them to focus more on core banking activities.
  4. Attracting Private Investments – A centralised agency backed by the state has the potential to attract private investment and develop a market for stressed assets. South Korean Asset Management Corporation not only reduced NPAs of financial institutions but was also successful in developing a market for asset-based securities which improved the resilience of recovery mechanisms for banks in the future.
  5. Shifting Responsibility – One of the most prominent arguments against the creation of a Bad Bank is that it only shifts the responsibility from the shoulders of banks to an asset management agency. It cannot be considered as a complete solution to the NPA problem as it merely deleverages the banks in order to maintain their financial health. Hence, floating a Bad Bank proposal without proper and adequate regulations for monitoring credit growth in the economy is a wasteful effort.

Conclusion

A centralised agency dedicated to the recovery of stressed assets in the economy can provide much-needed relief to the banking and financial institutions and can ensure better recovery through a uniform channel. However, it is necessary to note that a recovery mechanism should be supplanted with proper credit appraisal and monitoring measures in order to ensure the sound development of the credit market in the future.

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