How to get the Bad Bank off to a good start

Representative image by Anton Violin via Shutterstock

Following the announcement in the FY22 budget, India’s first bad bank, the National Asset Reconstruction Company Limited (NARCL) was incorporated last month. With an initial paid-up capital of Rs 74.6 crore, the entity is expected to take over bad assets worth Rs 89,000 crore. Cleaning up bank balance sheets is the first of many steps to resolve the banking system’s non-performing asset (NPA) crisis and the formation of NARCL is expected to be a significant step in that direction.

NARCL will be the latest entrant in the ecosystem of entities and regulations overseeing the buying, selling, managing and resolving bad assets. A report of the Standing Committee on Finance indicates that the proposed bad bank will be similar to an Asset Reconstruction Company (ARC) with an Asset Management Company (AMC) under it. The ARC will attempt to resolve the stressed assets, while the AMC will manage and sell bad assets. Unlike other ARCs, NARCL is expected to be better capitalised, and the government will be guaranteeing its security receipts (SRs), effectively insulating the banks from any losses that occur in the realisation of SRs. This will enable it to buy bad assets from banks at net book value (NBV), whereas other ARCs tend to offer a steep discount on the book value. More importantly, the assets to be purchased by NARCL, atleast in the first tranche, appear to be those which have been fully provided for.

Thus, purchasing the assets at NBV and the government guarantees on the SRs are expected to ensure that bank balance sheets do not take a hit. Consequently, NARCL will be better able to aggregate debt from multiple lenders and take complete control of a borrower’s debt. NARCL’s success will depend significantly on whether it has the required resources and operational framework to achieve its objectives. Let us assess this.

One, reports suggest that there would be no direct equity infusion by the government. Instead, the government will have indirect control as almost all Public Sector Banks (PSBs) are expected to hold substantial stakes in NARCL.

This is problematic as NARCL will then be owned by the very banks it buys bad assets from and can result in a circuitous flow of funds. The dual role that banks will play as investors and customers of NARCL, will make it unclear whether the institution’s objective is maximisation of residual value of assets or of its profit. The US experience with the Resolution Trust Corporation (RTC) has shown that a sudden surge in available assets for sale could have price-distortionary effects. This could prove counterproductive if NARCL’s objective is to maximise the recovery value on these assets. Further, NARCL is expected to purchase assets with ticket size of Rs 500 crore and above, especially those financed by multiple lenders. These are likely to be bespoke corporate or infrastructure related loans which have niche and fragmented markets, unlike, say, residential real estate loans. This could delay the disposal of the bad assets by NARCL and consequently the realisation of their value.

Two, RBI regulations stipulate that ARCs can purchase NPAs from sponsor banks on arm’s length basis and at market determined prices. However, NARCL will purchase these assets from banks at NBV, and not at market-determined prices, as stipulated by RBI’s ARC regulations that NARCL will be subject to, which are usually much lower, thus creating regulatory uncertainty around the validity of such transfers.

The standing committee on finance highlighted the possibility of such regulatory uncertainty and recommended that RBI issue regulations reflecting administrative clarity and economic logic while removing any ambiguity or discretion on part of banks. Experiences of other jurisdictions, such as the US, which created the RTC through the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and South Korea, which strengthened the Korea Asset Management Corporation (KAMCO) through the Act on Efficient Management of Non-performing Assets of Financial Institutions and Establishment of Korea Asset Management Corporation, indicate that a clear statutory backing, clarity of objectives and an independent and professional management are key to the success of a bad bank, components which seem absent in the current structure.

Three, the lack of an explicit sunset clause on the functioning of NARCL or the government guarantee raises potential anti-competitive concerns as banks will likely sell their bad assets above the Rs 500 crore, to only NARCL.

This situation is further exacerbated when NARCL, by purchasing the assets at NBV, will likely set the reserve price of these assets beyond the reach of other ARCs. Consequently, the development of the market for bad assets could be severely impaired and this could prove counterproductive to the primary objective of establishing NARCL.

The government’s efforts and intent to get NARCL off the ground is well-placed. However, these need to be complemented by clear thinking and articulation of the operational and strategic imperatives of NARCL. More importantly, it needs to be ensured that NARCL does not become yet another PSU with the attendant bureaucratic delays and inefficiencies.