As the problem of non-performing assets persists in a sector stressed by the pandemic, the RBI has agreed to look at a proposal for creating a bad bank. What are the arguments for and against the concept?
Recently, the Union Cabinet approved the Rs 30,600 crore guarantee to back Security Receipts issued by National Asset Reconstruction Company Limited (NARCL), the so-called ''bad bank" for acquiring stressed loan assets.
What is a 'Bad Bank' and NARCL?
In simple terms, a 'bad bank' is a financial entity set up to acquire Non-Performing Assets(NPAs) from banks and resolve them.
The bank which sells the stressed assets to the bad bank is now relieved of the burden of the bad loans and instead focuses on growing its business. The NARCL which is being set up by the lender and will be 51% owned by public sector banks, proposes to take over the fully provisioned stressed assets of about 90,000 crore INR in the first phase.
How will the NARCL operate?
The bad bank will acquire assets by making an offer to the lead bank of a group of lenders of NPAs. It will offer a certain value to the lead bank for troubled loans of over ₹500 crores, and pay 15% upfront in cash, and issue the balance as tradable security receipts. These receipts in turn would be guaranteed by the government's ₹36,600 crore backstop facility.
The bad bank will then rope in a separate asset manager being incorporated — the India Debt Resolution Company Ltd. (IDRCL) — to add value to the ailing asset, and resolve it as a ‘going concern’ or liquidate it. The guarantee can only be invoked once an asset is resolved and will cover any shortfall between the face value of the security receipts issued by the NARCL and the actual amount realized from a bad loan. The guarantee fee will be increased each year as a nudge for NARCL and the IDRCL to speed up resolution.
Why is the center providing a backstop?
Given the huge sizes of the NPAs, a backstop from the government helps lend credibility to the resolution process and provides for contingency buffer. It will also enhance the liquidity of the receipts that are tradable. Also given that there would be a pool of assets it is likely that the realization of value in many cases would exceed the acquisition cost obviating the need to draw down on the guarantee.
The Road Ahead for the Banking Industry
The government expects that the setting up of the twin entities, the NARCL and the IDRCL with adequate capital and its guarantee will incentivize quicker action on resolving stressed assets thereby helping in better value realization. In a bid to disincentivize delay in resolution the government has also proposed that the NARCL pay a guarantee fee to the center which would increase with the passage of time.
Critics of the bad Bank concept however contend that the Government's role in guaranteeing some part of the NPAs could lead to laxity on the part of bankers in assessing risk and thus creating fresh dodgy loans. A January 2020 Bank for International Settlements working paper on bad banks resolution and bank lending found that bad bank segregations are effective in cleaning up balance sheets and promoting bank lending only if they combine recapitalization with asset segregation.
To know more about Bad Banks, head over to the following links:
Bad Banks in India [Deloitte]
Bad Banks: Finding the right exit from financial crisis [McKinsey]
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