Are bad banks really good?

Along with NARCL, India Debt Resolution Company Ltd (IDRCL), has also been set up, it will then try to sell the stressed assets in the market. (Representative image)

By Sandesh Dholakia

A few days back, in one of her key announcements Finance Minister Nirmala Sitharaman made good on one of her promises from the Budget 21-22 and announced the formation of India’s first-ever “Bad Bank”. National Asset Reconstruction Company (NARCL) which has already been incorporated as a company and received cabinet approval will acquire stressed assets worth Rs. 2 lakh crores from various banks in order to recover them. Along with NARCL, India Debt Resolution Company Ltd (IDRCL), has also been set up, it will then try to sell the stressed assets in the market. This NARCL-IDRCL structure is the new “Bad Bank of India.”

But why do we really need a Bad Bank ?

Insolvency and Bankruptcy Code (IBC), Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI Act), Debt Recovery Tribunals as well as setting up of dedicated Stressed Asset Management Verticals (SAMVs) in banks for large-value NPA accounts have brought much-needed focus on the recovery of non-performing assets. In spite of such efforts, a substantial amount of NPAs continues on the balance sheets of banks primarily because the stock of bad loans as revealed by the Asset Quality Review is not only large but fragmented across various lenders.

The situation becomes even duller when we benchmark India with other leading G-20 nations. As per World Bank data, the share of NPA to gross loans in Indian banking is significantly higher compared to all other leading G-20 nations with an exception of the Russian Federation. Large unresolved NPAs over a sustained period of time have proven detrimental to policymaking and economic growth for many economies in the past.

How will the new Bad Bank structure function ?

NARCL proposes to acquire Rs. 2 Lakh crores of (gross value) assets. As per the Secretary DFS, blended net realizable value of these assets is likely to be ~18% i.e. Rs. 36,000 crores (Rs. 30,000 crores post-tax). 15% of the net realizable value will be in the form of cash and rest through security receipts(SR).

GOI guarantee on SRs will be good between net realizable value and actual realized value. In a normal Asset Reconstruction Company (ARC) transaction, cash realization is recorded upfront and flow to profits and SRs are subject to MTM. Due to uncertainty on recovery, these SRs are illiquid hence locked capital for banks. Under the scheme, SRs are guaranteed by GOI so it will provide liquidity to SR and free up capital on immediate basis post conclusion of sale.

Let’s understand through an example : –

Let’s say a loan of Rs. 10,000 was written-off by a bank –

The book value of asset in bank’s balance sheet is zero

If the bad bank determines the recoverable value at 30% or Rs. 3,000 then:

Bad bank will have to pay 15% of Rs. 3,000 = Rs. 450 (or 4.5% of original loan value) – this will be paid in cash by bad-bank, which may source funds from banks themselves as equity. From accounting perspective, banks will report Rs. 450 as profit from recoveries of written off loans that gets added to net worth.

For the balance 85% of Rs 3,000 = Rs. 2,550 – bad bank will issue securitisation receipts (SRs) which will be partly guaranteed by government and partly non-guaranteed. For the guaranteed part, banks will recognise the value as investment but that will not require any capital for 5yrs as there is Govt. guarantee. For non-guaranteed part, banks might not recognise value until actual recovery is made.

What does the Global Experience say about Bad Banks?

Way forward for Bad Bank of India –

Aggregation of stressed assets at one entity’s hand is undoubtedly expected to speed up the process for finding interested buyers, transfer of assets, restructuring of debt etc. but more than anything else the quality of such asset will matter the most. Historically we have seen proven examples of formation of Bad Banks working, most of it were in the cases where not only a law was passed but the enforcement of it was done properly. A plenty of it also relied on the evolving socio-economic and political conditions of the country.

As India recovers from its hardest ever economic hit due to Covid-19 the challenges going to be faced by the Bad Bank are not going to be easy but if tackled properly this could provide a much-needed moment of renaissance to the entire Indian Banking Sector.

(The author is founder & CEO at Case Ace and Asia-Pacific chairman at International Finance Students’ Association. Views expressed are personal.)