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What is India's Bad Bank? How Might the NARCL Help Banks Combat the NPA Crisis?

Jun 29, 2021 11:48 AM 5 min read

The much-discussed “bad bank” may finally materialise as early as this week.

First proposed by the Indian Banks’ Association (IBA), the National Asset Reconstruction Company Ltd. (NARCL) and the India Debt Management Company Ltd. (IDMCL), which will manage the sour loans, are expected to become legal entities by June-end.

The entire project is expected to take on a quarter of the banking sector’s bad loans and stressed debt, which would be a share worth $27bn.

The Forever Crisis

Everybody knows that Indian banks and NBFCs have a bad loans problem. Lenders have as much as ₹2.25Lcr ($30.8bn) of unresolved bad assets. And the coronavirus-driven recession has only aggravated the crisis.

According to the RBI, Non-Performing Assets (NPAs) could nearly double to 13.5% of total advances by September-end - one of the highest levels among major economies.


Bad Bank Basics

What if you could gather all bad loans from multiple banks into a single and separate entity i.e. A “bad bank”?

So what remains of these multiple banks would be the...“good bank” part. Ergo, these good banks could release provisions held against NPAs, find it easier to raise capital from investors and grow and expand and issue fresh and - you get it.

As for the newly-minted bad bank, its sole focus would be on winding down the ring-fenced loans - either by restructuring them, resolving them or selling them. It would be designed akin to an Asset Reconstruction Company (ARC). And these bad assets could be bought by specialist institutional investors such as hedge funds or PE firms at a deep discount, who would further sell them at a premium once the underlying performance improves and earn a profit.

Thus, everyone’s happy and Indian banking can look forward to a fresh start.

Well, at least that’s the theory. What do real-life implementations of the idea have to say?


Affirmations from Abroad

The first bad bank was created by US-based Mellon Bank in 1988 to hold its “toxic assets”. In this case, a new institution called Grant Street National Bank (GSNB) was created to hold Mellon’s illiquid assets. GSNB purchased Mellon’s bad loans at a 53% discount and was dissolved in 1995 after meeting its objectives. However, unlike the IBA proposal, GSNB was a private-sector experiment with no capital from the government.

The concept has been experimented with under government aegis - successfully, too - in many countries including the US, Finland, Sweden and Germany. The US set up an ARC named Resolution Trust Corporation, which operated between 1989 and 1995. Stockholm responded to a banking crisis by setting up Securum, which had disposed of 98% of its bad assets by the time it was dissolved in 1997.

But there are some worrying examples too…


Warnings from Abroad

Take China. In the wake of the 1997 Asian financial crisis, it created China Huarong Asset Management Co. It was supposed to handle the bad assets of the country's four big state-owned commercial banks and had an initial tenure of 10 years. This was later extended indefinitely.

By 2016, bad bank fever was gripping the Middle Kingdom. One such entity was set up in each province, then two. By the end of the decade, there were 59 bad banks in the world's second-largest economy.

  1. Research has shown that the proliferation of such state-backed ARCs incentivised a culture of moral hazard and dubious deals wherein NPAs were hidden or resold to third parties at inflated prices. Take Huarong. Over time, its mandate was broadened to such an extent that it became an investment bank rather than a bad bank, lending liberally to everything from risky real estate ventures and high-yield cross-border undertakings. This created an ironic situation where the bad bank developed bad loans of its own!


The NARCL Cometh

Coming to India, its bad bank experiment is rumoured to take off this week. An announcement was expected by the Finance Minister during her press briefing today, but observers were left wanting.

As per news reports, the Government is in favour of NARCL but is reluctant to directly infuse capital in it. However, it may offer ₹31,000cr ($4.2bn) in guarantees on the entity’s security receipts for five years. (This is in contrast to the IBA’s earlier proposal for setting up a state-run entity with an initial capital infusion of ₹10,000cr ($1.37bn).)

This might mean that the Government may refrain from holding equity in the bad bank (although it would indirectly hold a stake via public lenders: the Government has over 70% ownership in 10 PSBs and over 90% in three).

All PSBs are reportedly in talks to purchase a stake in NARCL while Canara Bank has sought the RBI's approval to be the lead sponsor of the bad bank. Meanwhile, private banks are expected to hold equity stakes in IDMCL. State-owned lenders have reportedly already shortlisted 28 loan accounts to be transferred to NARCL.

The exact MO is yet to be notified by the Finance Ministry, but NARCL could take over the bad loans from banks by paying 15% in cash and 85% as state-backed security receipts. And learning from the Huarong debacle, NARCL could keep its debt-to-equity ratio at 1:1.


Mischief Managed?

There are some obvious problems with the concept of bad banks. They can entice moral hazard, can inflate the prices of distressed assets, and have to make do with the limited secondary market for illiquid assets. To use Raghuram Rajan's words, a bad bank “would solve nothing”. (For an explanation of the pros and cons of a bad bank, read this.)

That said, the IBA’s desperation is hardly unwarranted. If the current level of NPAs holds till the end of FY22, it would be the worst bad loan quagmire faced by the banking sector since 1999.

A bad bank could be a quick and successful fix for some of Indian banking's ailments. The lessons from abroad are quite straightforward. NARCL should have a finite tenure and well-defined (and narrow) goals. Government funding - and even involvement - in this venture should ideally be kept at a minimum to inspire the notion that it is a market solution for market problems. A bad bank being a temporary fix, long-term solutions to bad loans like ARC regulatory and bankruptcy reforms need to receive renewed attention to take over NARCL’s mandate once it is dissolved.

For now, Indian banks will likely heave a much-needed sigh of relief that at least some of their burden will be relieved. Now, at least some focus can be diverted from the NPA crisis to credit growth.


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