Bad Banks – Right Way to Improve Loan Recovery?
Sangeeta Lakhi (Senior Partner, Rajani Associates)
Rahul Pandey (Senior Associate)
Rahul Pandey (Senior Associate)
Rahul Pandey (Senior Associate)
BAD BANKS: TOO MANY COOKS SPOIL THE BROTH
This is an old proverb implying that if too many cooks prepare the soup, they would certainly spoil it. One cook may be better but different instructions from many cooks would do more harm than good. The same way, too many persons involved in a particular task may confuse everyone.
Q1. An overview of the financial conditions which has given rise to idea of bad bank
A1. All around the world, promoters avail loans from banks and financial institutions to grow their business. Most of the times businesses prosper but at times, fail. Sometimes businesses suffer due to certain circumstances, such as the present pandemic. When businesses prosper, loans are serviced with no defaults; however, when businesses fail, loans and interest remain unpaid. In such circumstances, the promoters restructure their loans or declare bankruptcy.
A bank's primary function is to lend money, receive interest and have the loan repaid at the end of the term. But what happens when loans and interest remain unpaid; it is treated as a non-performing asset or NPA. NPAs place financial burden on banks and may indicate that the bank's financial health is in jeopardy. NPAs reduce cash flow, which disrupts budgets and decreases earnings. It may even reduce capital available to provide loans to another borrower. Erosion of capital due to bad debt write-offs constrains credit growth and consequently, investment and working capital finance across all sectors of the economy.
Since the Industrial Policy was announced by the Narasimham Committee in 1991, NPAs have been multiplying by the year. The Government has notified various schemes to deal with NPAs, such as corporate debt restructuring, joint lenders forum, Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, strategic debt restructuring, scheme for sustainable structuring of stressed assets and asset reconstruction companies.
Q2. What is the idea and history behind a bad bank? Have other countries successfully established a bad bank?
A2. The Government is now toying with the idea of setting up a "bad bank" to house the NPAs. The first bad bank was set up in the United States in 1980s by Mellon bank. During the 2008 crisis, various banks around the world created bad banks which deal with NPAs on an ongoing basis. Various countries such as, Sweden, Finland, France, Germany, Indonesia have implemented bad banks. The bad bank solution was successfully and widely used around Europe to deal with the bad loan crisis in the banking sectors, with each country adding their own flavour to the mix.
Malaysia established Danaharta, a bad bank and India may use this as a prime example to set up the bad bank system. Danaharta was established amidst the Asian financial crisis, as a national AMC to subdue issues arising out of rising non-performing loans. Danaharta was set-up and funded by the government while various professional experts were hired to run its operation. Malaysia also came up with various reforms to existing laws and policies to assist Danaharta achieve its purpose, which played a huge part in the economic reforms that took place in Malaysia thereafter.
Q3. Do the present times call for the need to establish a bad bank and, if established, how will a bad bank work?
A3. In India, banks have been dealing with NPAs effectively; however, they now fear that with the pandemic, they may have to increase their provisions higher since there may be increased failure in meeting obligations due to businesses being shut. The Indian Bank's Association ("IBA"), therefore, proposed to bring back bad banks to revive the Indian banking system. But, do we need another forum to deal with NPAs?
A bad bank is a bank that will house the NPAs so that the banks themselves do not carry the NPAs in their books. Bad banks usually absorb the bad assets at a discount and manage them with an aim of recovery. No doubt, it reduces the burden on banks and increases their profitability by helping them reduce margins for bad loans and focus on core lending, but it will not make the NPAs go away altogether. The losses may have to be shared between investors and taxpayers and there is a chance of a bad bank becoming a warehouse for bad loans where no recovery is seen.
Q4. What will the structure of a bad bank be like?
A4. Setting up a bad bank will encompass setting up of a government backed Asset Reconstruction Company ("ARC"), which can buy the bad loans from banks in return of security receipts. In addition to the ARC, IBA has proposed to set up an Asset Management Company ("AMC") operated by private and public bodies, including banks, turnaround professionals, amongst others, to manage the NPAs. IBA has also proposed setting up of an Alternate Investment Fund ("AIF") to aid in the trading of these security receipts in the secondary market. This may imply that a bad bank may be governed by similar regulations that govern these entities.
Q5. How can the bad bank help improve the recovery of loans?
A5. Generally, an entity in the market to acquire stressed assets may have to knock on many doors to find a perfect match. If the NPAs are housed at one place, i.e. a bad bank and supported by the Government, it may provide the entity with a one-stop-shop to sieve through its requirement. It may also make the process streamlined, straightforward and centralised, leading to better regulation.
In other words, a bad bank takes over a loan and the recovery process, which the original banks declared as a bad loan, allowing the original banks to clear their balance sheet, albeit with write-downs.
One may compare a bad bank to the Neelkanth, Lord Shiva, who in order to contain the effect of the poison that originated from the sea, consumed it. The question, therefore, arises, whether the bad bank is willing to swallow this poison?
Q6. What is the role of ARCs, AMCs and AIFs in dealing with NPAs?
A6. If a bad bank is established, one needs to ascertain whether the present ARCs, AMCs and AIFs have an appetite for NPAs, since NPAs demand a higher price than the fair market value and ARCs and AIFs only fancy stressed assets with revival viability and/or higher returns.
Q7. What will be the challenges faced in setting up and sustaining a bad bank and what are the concerns on setting it up?
A7. A challenge for a bad bank may be developing a sustainable and unique business model. There is no market where bad banks can sell the NPAs. India does not have a securitisation market. The bad bank will deal with the same ARCs, vulture funds, and investors who are dealing with the banks now. If the bad banks are not able to sell the NPAs, how long will they hold them?
Another challenge for a bad bank may be that some of the NPAs may be risky assets, such as accounts where fraudulent activities have been detected. In these cases, surely, neither the Government nor any investor will want to shell out money to acquire these NPAs, leading to a moral hazard.
Another cause for concern in setting up a bad bank is that it may lead to banks and financial institutions taking rash decisions and undue risks. This may lead to an accumulation of bad assets (which was sought to be resolved in the first place) causing further financial turpitude.
Additionally, a regulatory framework may very well need to be established before setting up a bad bank. Despite there being various bankable examples to look at when setting up a regulatory framework, the Indian economy is its own beast and may take some niche set of rules and regulations to deal with the NPAs; to keep the banking system buoyant.
Q8. Any last thoughts?
A8. NPAs are here to stay. No doubt, bad banks may not rescue Indian banks from their NPAs altogether but surely, they may provide some respite in this hard time when the whole economy is under pressure due to the pandemic. However, the Indian Government must ascertain whether it needs to set up one more forum to deal with NPAs.
The Indian Government may consider giving more powers to banks to recover NPAs, speed up judicial systems and enforce strict punishments and penalties on defaulting promoters. The Insolvency and Bankruptcy Code has put the fear of God into defaulting company promoters (not wanting to lose controlling interest in the company); however, for banks it has meant huge sacrifices, described as \'haircuts\', ranging from 50% to 60%. All-in-all, it is the banks who have suffered more than the promoters, who may have built a comfortable nest for themselves. Do we then want to impose these sufferings on a new entity or focus on better recovery of the bad loans?
(With inputs from Prem Rajani (Managing Partner, Rajani Associates)