Bad Banks in India: The New-Age Alchemist

This essay was adjudged as one of the best entries in the Second NLUJ CSBF Essay Writing Competition, 2020-21 and received a Special Mention in the Competition. The article was submitted by Jino M. & Mahathi Utham. The authors are students at the National University, of Advanced Legal Studies, Kochi.

Abstract:
Owing to COVID-19 and even otherwise, financial markets across the globe are in varying states of disarray. Banks, especially in India, remain bogged down by accruing losses. As a consequence, these financial institutions issue write-down announcements which cost the industry investor confidence, leading to declines in stock prices and increased volatility.
So, in order to stabilise the banking industry, financial institutions and governments continue to probe innovative avenues that counter the impacts of large amounts of Non-Performing Assets (hereinafter, NPAs) – the primary cause for the aforementioned losses. One such promising avenue is the newly proposed ‘Bad Bank’.  In this framework, banks transfer troubled assets, temporarily ceased business lines and other operations into a new entity, anointed as the bad bank. Although this framework prima facie appears to provide reprieve to all financial institutions in NPA limbo, it raises many concerns which ought to be addressed. This essay attempts to undertake an overall assessment of the mechanism considering its previous successes in other nations and inherent merits. It also identifies challenges that government intervention and the current Insolvency regime will pose. It will finally advance suggestions to respond to these challenges effectively.

Introduction:

With the pandemic bringing the world to a standstill, the Indian economy also suffered an unprecedented blow with a staggering 23.9% contraction in the first quarter post the nation-wide lockdown.[i] As per the Reserve Bank of India’s (hereinafter, RBI) Financial Stability Report, this raised alarming concerns within the banking sector of the country, with a predicted increase in the gross NPA ratio to a whopping 13.5% in September 2021 from 7.5% in September 2020.[ii] Notably, this increase is the highest in the last 22 years.[iii]

This sudden surge prompted the government to take immediate, albeit temporary measures to ease the burden on the economy. Accordingly, the RBI on 27.03.2020 offered a three-month moratorium from all lenders to their customers,[iv] which was subsequently extended by another three months, till 31st August, 2020.[v] In the loan moratorium case[vi] with regard to these notifications by the RBI, the Supreme court rejected the plea to further extend the moratorium, but barred the banks from charging any compound or penal interest on any borrowing during the loan moratorium.

Similarly, the Insolvency & Bankruptcy Code (Amendment) Ordinance, 2020 suspended the operation of the Insolvency and Bankruptcy Code, 2016 for a period of six months,[vii] which was further extended till 25th March 2021.[viii] While the suspension of IBC and moratorium alleviates the burden on debtors in an already difficult financial atmosphere, it comes at an inevitable price, and the most profound impact will be felt by India’s struggling banks. The cause? – growing NPAs. The Indian regime as it stands has a huge gap in this regard.

The Great Indian Void:

In status quo, none of the mechanisms available to banks or lenders, be it approaching the Debt Recovery Tribunal, or initiating proceedings under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 match the efficacy of the IBC as they do not provide a time-bound decision or allow for a resolution plan that would enable an entity to be sold as a going concern to prospective bidders to repay the creditors. Consequently, once the IBC regains effect, the NCLT will be flooded with petitions, further exacerbating the strain on the tribunal. While insolvency pre-packs etc. have been mooted as options to relieve the tribunal of drawn-out legal battles, there have been no active steps to this end. But a more pressing concern is the immediate short-term nature of these remedies, the lasting effects of which cannot be expected as the pandemic recedes. In this context, setting aside the pandemic-induced financial stress, the Indian Banking industry has been witnessing mounting NPA trends since the last decade. The figure that follows is illustrative of this steep incline.

 Fig. 1: Gross NPAs of Commercial Banks (figures in crores)[ix]

As indicated, NPAs of commercial banks have jumped by 89.4% in FY2015-2016 and have remained high thereafter. This sudden surge in NPAs can be largely attributed to the RBI’s introduction of Asset Quality Review (AQR) in 2015.[x] This indicates that NPAs did not witness a sudden jump, but have always been present in the system, and were rather camouflaged.

Hence, the gaping void in dealing with these troubled assets points to a more viable long-term alternative as being the need of the hour. Said system must not only tackle the flood of NPAs post the pandemic, but also provide stability to the Indian Banking industry. The proposed ‘filler’ is a Bad Bank as announced in this year’s Union Budget.

The Workings of a Bad Bank:

NPAs can create compounding adversities for any financial institution. Apart from the disparity that they create in a bank’s balance sheets, they will affect the reputation of the bank, repelling new investors and making other more robust banks reluctant to lend to them. If capital-raising takes a hit, these banks will be forced to reduce the disbursement of new loans, further impairing their business, and the country’s economy. Liquidity will reduce, interest rates will soar and other businesses will in turn be affected in the process, thereby creating more NPAs. This vicious cycle calls for the cleaning up of bad loans. Here, bad banks come into play.

Simply put, the bad bank will serve as an institution with the ability and authority to purchase the NPAs from the other banks, ensuring that the banks do not fall into the aforementioned rabbit hole. The bad bank would then undertake to resolve the NPAs and pro- ‘bad bank’-ers argue that they would be better off at recovering unpaid loans as they would comprise specialised agencies set up solely for this purpose. The proposed system is therefore a hybrid of an Asset Reconstruction Company (hereinafter, ARC) – Asset Management Company (hereinafter, AMC) model.[xi]

The ARCs will cause the bad loans to be moved from the banks by purchasing them at an upfront price. The proposed model provides for an upfront payment of 15% in cash and the rest in the form of security deposits to the bank. After the ARC successfully recovers the loan or any part of it, the remaining 85% is deposited with the now ‘good bank’.[xii]

The process is made seamless with the ARC working in tandem with the AMC. The troubled assets which were purchased by the ARC would later be transferred to the AMC, which will comprise specialists with the responsibility of resolving the loans. These AMCs are fundamental to the working of bad banks because oftentimes, an NPA would be rendered irrecoverable due to the insolvency of the debtor. In such circumstances, it is imperative that the underlying asset, or the collateral, be realised to its true value. Sometimes, large businesses may even require operational restructuring in addition to financial restructuring.

The Banking and Financial Services Secretary has suggested that the ARC-AMC bad bank model will be set up by the banks themselves and that there will be no government equity in the entity. However, the Indian Banks Association’s (hereinafter, IBA) suggestion was that a capital of ₹10,000 crore to set up these bad banks must be borne by the Government.

Challenges and Lessons:

One of the key challenges in this framework would be the extent of intervention that is required to ease lending to the economy. Determining the level of constraint in lending would as a consequence, be an issue. In this regard, a noteworthy success story is that of the Korean experience. In 1998, South Korea faced a huge crisis with NPAs aggregating to 100 trillion won. While one half was left to the respective vendors, the other was to be purchased by the NPA management fund established by the Korea Asset Management Corporation (hereinafter, KAMCO). The expeditious disposal of assets was successful with the NPAs declining from 17% in 1997 to 2.3% in 2002. The success of the NPA Fund must be attributed to the strict scrutiny on the utilisation of public funds. It was also a result not only of effective legislation but also that of management and organisation.[xiii]

Moreover, multiple structural and ownership challenges emerge, which have been met with innovatively, around the globe. Famously, the Resolution Trust Company was set up in 1989 in the US, as funds were required to repay depositors and to purchase troubled assets from insolvent institutions.[xiv] Similarly, many countries in Europe have successfully used customised variants of the bad bank model to ameliorate the bad loan crisis in their respective banking sectors. Sweden contributed one of the oldest bad banks in Europe. Different countries have adopted different bad bank structures to suit their interests and requirements. Nevertheless, the foundational objectives remain consistent, world-over, i.e., to separate and ultimately liquidate the troubled assets from the balance sheets of the banks.

Although these systems were generally a success, it is apparent that a comprehensive model alone, does not aid in recovering impaired assets. It is equally the infrastructure of the Insolvency and banking regimes and efficiency of the regulatory framework which decides the time taken for recovery of assets. Within this frame of reference, there exist other specific challenges for a good-bad bank in India as well.  Firstly, the apparent ownership structure of these bad banks needs to be clarified. Such an institution would need funding as liquidity is a functional prerequisite. It can be completely backed by the government, as in the case of most aforementioned international models. However, that approach may not pan out as positively in India for the following reasons.

The Public Sector Banks (hereinafter, PSB) account for 86% of the total NPAs in the country.[xv] Hence, in furtherance of the very objective of creating the bad banks, the government would land in a price determination conflict. The government would want to recapitalise the PSBs to the highest extent possible by transferring the NPAs. At the same time bad banks would prefer to purchase the NPA at a price lower than the book value, to recover as much as possible. This may lead to bad banks purchasing the NPAs without much bargain, and without price discovery, as at the end of the day, the funds are simply being transferred from one pocket of the government to another. And since the further liquidation of assets will only be governed by the market value based on its financial prospects, the model becomes increasingly problematic. This will in turn render the bad bank into a loss-making entity for the government which sells the stressed assets at a lower market price, which could have been maximised had it taken the IBC route. Hence, the expense of bailing PSBs out of their stressed assets will be borne by the taxpayers.

Another hurdle that such a model will face, in a context where a concrete Insolvency regime already exists, is forum shopping. The promoters of companies with NPAs may carry out forum shopping to avoid subjecting themselves to IBC procedure, fearing changes in control and management. They could ensure, by any means, that the NPA resolution process is referred to the bad bank, being the alternative forum in this model. As a result, critics also suggest that the bad bank’s role should be limited to representing the banking system before the NCLT. An ancillary concern that arises is how the ARC-AMC model’s status will change the position of other existing ARCs. Will it gain complete monopoly in the industry, to the detriment of other existing private institutions? The creation of bad banks also gives rise to a moral hazard, i.e., the banks may take undue risks and indulge in reckless lending, knowing that a future financial threat may provide for a bad bank bailout. The following paragraphs attempt to put these burning questions to rest, with suggestions suitable to the Indian context.

Putting Bad Bank Alchemy to work: Suggestions

The concept of bad banks is not entirely novel or untouched in India. In the FY 04-05, a trust called the Stressed Asset Stabilisation fund (hereinafter, SASF) was created, to which net NPAs arising out of 636 stressed and non-performing cases worth Rs. 9000 crores were transferred from the Industrial Development Bank of India (hereinafter, IDBI), thereby cleansing its balance sheets. In lieu of this, the Government of India issued 20-year zero coupon bonds to IDBI, which were to be redeemed out of recoveries from the transferred NPAs. Surprisingly, even after a decade, in 2014, only Rs. 4000 crores could be recovered, per the report by the Comptroller and Auditor General of India.[xvi] That being said, recovery of a meagre 44% of the net NPA is considerably high relative to the 13.7% for India, as mentioned in the World Bank report.[xvii] Hence, bad banks could be a workable solution to tackle India’s NPA misery.

The ARCs can greatly help in aggregating the stressed assets. Once such debts are aggregated, a focused plan can be initiated in order to resolve them, and the AMCs can functionally ensure the same. By that means, the bad banks can restructure the assets, either financially, or first operationally and later auction it off to a prospective bidder and thereby recover the debt, akin to the IBC mechanism. However, this must not mean isolation of the IBC mechanism from the bad bank model.

Of Pre-packs and the IBC:

With the introduction of IBC, recovery of debts has become much more time-bound and certain, which must be adopted into a more systematic and institutionalized manner in the bad bank model as well. Akin to the IBC process,[xviii] the resolution process by the AMCs should also be made time bound.  A relatively relaxed timeline can be provided as the lender does not bear the brunt in the process and can continue doing business more efficiently, while the resolution of the debt will be undertaken independently by the bad bank.

A model can be devised wherein the AMCs themselves, can propose a fully crafted resolution plan and present it to the NCLTs under the IBC as insolvency prepacks, upon which the tribunal can directly adjudicate, thereby saving time spent on procedure and litigation. But primarily, such proposals require creating policy frameworks, amendments and an understanding between the debtor and the financial institutions. A pre-pack can be construed as an innovative hybrid corporate rescue route that incorporates both out-of-court settlements and formal judicial insolvency proceedings under the IBC.[xix]

Though a clear statutory definition for a pre-pack is absent, several jurisdictions have identified its scope and have evolved their own pre-pack arrangement with different nomenclature viz., a pre-pack sale in the UK, scheme of arrangement in Singapore, pre-arranged insolvency resolution in the USA etc.[xx] As the name suggests, a pre-pack is a restructuring or insolvency plan, that is agreed upon by the Corporate Debtor and Creditors prior to the initiation of insolvency. Thereafter, it is approved and expedited by the court.[xxi] Hence, in such an arrangement, a pre-agreed business sale is envisaged by the insolvency practitioner which does not require prior authorisation by the court or the creditors.

Pre-packaged insolvency resolution is not entirely alien to the lawmakers in India either. There have been multiple prior deliberations on the same[xxii] and even invitation of comments on its inclusion within the IBC regime.[xxiii] In the model that the authors suggest, the AMCs could be bestowed with the power to devise a prepackaged restructuring plan for the Corporate debtor. This is all the more desirable to be incorporated within this model, because once the NPA is purchased, the creditors are no longer involved with the debt, thereby eliminating the need for constituting a Committee of Creditors and taking their concerns into account, as required under the IBC.[xxiv]

Moreover, the AMC being composed of experts, would have the requisite expertise to devise such pre-packs without further procedural hassles, and which once sanctioned by the courts, can be directly implemented. Thus, eliminating lengthy litigation, simplifying the recovery process and ensuring that the Bad Banks themselves do not metamorphosize into a warehouse of NPAs. However, appropriate amendments to the IBC to incorporate the bad bank mechanism within it will be a prerequisite for a harmonized regulatory framework.

To be or not to be: Aggregators

Another oft quoted suggestion is for the bad banks is to simply act as an aggregator of bad loans, wherein the role of the AMC should be minimal and the work ought to be primarily of the ARC to aggregate the bad loans. Post this, the normal IBC route could be adopted and a Corporate Insolvency Resolution Process (CIRP), as under Chapter II of the Code.[xxv] Herein, the AMC may assume the responsibility to segregate NPAs, based on a notified pecuniary threshold, health of the Corporate debtor among other determinants, and classify those that qualify for speedy disposal by invoking the mechanism under Chapter IV of the Code for fast-track insolvency process. Special National Company Law Tribunal benches may be constituted for this exclusive purpose in select jurisdictions to ensure that the process is indeed fast-tracked. Since a preliminary segregation and report can be devised by the AMCs themselves, it would assist the tribunal in the speedy disposal of the matter.

Good Governance: 

More significantly, while devising an alternate model to address the NPA woes of the country, we must not shut our eyes towards the inherent problem in the system that persists. As priorly discussed, IDBI while being transformed into a bank from a DFI in 2004,[xxvi] a SASF, along the lines of a bad bank was created and much of its existing NPAs were cleared off. However, 16 years down the lane, as on 31st March, 2020, IDBI still tops the gross NPA ratio among the scheduled Public and Private Sector Banks in India with a ratio of a staggering 27.53%.[xxvii] This paints a clear picture that bad banks alone cannot be a solution to India’s NPA woes. It needs to be complemented with good governance in banking and elimination of mismanagement.

Addressing the moral hazard:

With the safety net of a bad bank, the moral hazard of a less focused due diligence by banks must be checked. Appropriate regulations by the RBI must be brought in consonance with the amendments introducing the bad bank system. A metric may be introduced to assess the banks on their efficiency in the creation of NPAs, similar to a credit-rating system and on this basis, the takeover of NPAs by bad banks can be further incentivised. 

Moreover, the same metric can be used by the government to decide whether to opt for further capital infusion directly to the bank when needed. Institution of Bad Banks may greatly reduce the need for the capital infusion directly to the banks as the banks will not need to write-off of bad loans merely to abide by the RBI’s asset quality mandates anymore, as they can be transferred to the ARCs. The amount can instead be infused for the working of the bad banks, which should ideally yield a better result as it focuses on resolving such bad debts, rather than compensating for them.

Minimizing the toll on the Exchequer:

Additionally, with regard to the conflict in price determination arising out of the organisational structure of these bad banks, it is imperative that measures are taken to minimise the cost to the taxpayers. The government must devise appropriate checks to establish that any sharing of financial liability between the financial system and the state does not impose an undue cost on the taxpayer. There must be a standard to determine the haircut and an overly generous support to the banks must be avoided. This would also help address the aforementioned moral hazard.

A model based on Malaysia’s Danaharta,[xxviii] would be successful in providing for the ARC to bid at a predetermined haircut of the net NPA, the acceptance of which would lead to the ARC paying the bidded amount upfront and taking over the liability, and the rejection of which would leave the Bank to follow the IBC route independently.

If the bid were accepted, an additional incentive could be awarded to the banks, viz., any excess recovery by the AMC can be given back to the bank, thereby making the bad bank model more lucrative.

Conclusion:

Through a review of success stories, possible obstacles and an insolvency angle, this essay has proposed a comprehensive model to deal with undervalued assets during a systemic financial crisis. To that end, our proposal does not profess to solve the problem of illiquidity. Its sole objective is to assuage principally sound banks from sudden death. Accordingly, the aim of a bad bank must never become profit-making, as that would inevitably lead to politics and price manipulation in buying of the NPAs from the banks. On principle, it must only look to help commercial banks clean up their bad loans so as to ensure that the banking system in the country remains stress-free and stable.  In sum, bad banks can solve the woes of the economy if its alchemist properties are put to appropriate and timely use.


[i] Priscilla Jebaraj, GDP contracts by record 23.9% in Q1, The Hindu (Aug. 31, 2020), India’s GDP contracts by record 23.9% in Q1 – The Hindu.

[ii] Chapter II, Financial Stability Report, Reserve Bank of India (Jan. 2021), 6CHAP2JAN21783500073F0A40159E3E0A7CFAF1A1F7.PDF (rbi.org.in).

[iii] Id.

[iv] COVID-19 – Regulatory Package, RBI/2019-20/186, Reserve Bank of India (Mar. 27, 2020), NOTI186B27003E9DB3D4FB49BDDF955F4289D68.PDF (rbi.org.in).

[v] COVID-19 – Regulatory Package, RBI/2019-20/244, Reserve Bank of India (May 23, 2020), Reserve Bank of India – Notifications (rbi.org.in).

[vi] Small Scale Industrial Manufactures Association (Regd.) v. Union of India and others, (LL 2021 SC 175).

[vii] The Insolvency and Bankruptcy Code (Amendment) Ordinance, 2020, 741059f0d8777f311ec76332ced1e9cf.pdf (ibbi.gov.in).

[viii] MCA, Notification (Dec. 22, 2020), df55d4f612f270d6c637ee4b3c8131c8.pdf (ibbi.gov.in)

[ix] Bank Group-wise Classification of Loan Assets of Scheduled Commercial Banks, RBI Report, Reserve Bank of India, https://dbie.rbi.org.in/DBIE/statistics.rbi?action=RL&f=365&sd=37

[x] Joice John, Arghya Kusum Mitra, et al., Asset Quality and Monetary Transmission in India, Reserve Bank of India Occasional Papers Vol. 37, No. 1&2, 2016,  02AQM02052018497C8F678B464E2CAA89D46CE2FDFEEA.PDF (rbi.org.in).

[xi] Finshot, Budgets and Bad Banks (Feb. 05, 2021)Budget and Bad Banks (finshots.in).

[xii] Id.

[xiii] Rajendra Ganatra, Bad Bank Remedy or Malady (Feb. 08, 2021), https://www.moneylife.in/article/bad-bank-remedy-or-malady/62878.html#:~:text=The%20rapid%20disposal%20of%20assets,1997%20to%202.3%25%20in%202002.&text=The%20NPA%20Fund%20was%20adequately,loans%20were%20purchased%20for%2018.8%25.  

[xiv] George Soros, Wall Street Journal opinion ‘We Can Do Better than a ‘‘Bad Bank’’’, http://online.wsj.com/article/SB123371182830346215.html.

[xv] Bank wise and Bank Group wise Non Performing Assets, Gross Advances, and Gross NPA ratios of Scheduled Commercial Banks, RBI Report, Reserve Bank of India, http://dbie.rbi.org.in/DBIE/statistics.rbi?action=RL&f=365&sd=37

[xvi] PTI, Bad Bank not a good idea, https://economictimes.indiatimes.com/industry/banking/finance/banking/bad-bank-not-a-good-idea-unless-key-issues-are-addressed-uday-kotak/articleshow/76259324.cms?from=mdr 

[xvii] Sumathi Gopal, NPA’s—A-Comparative-Analysis-on-Banks Financial-Institutions-and-its-Implications, Thesis, (Jun. 2010), http://www.dypatil.edu/schools/management/wp-content/uploads/2015/05/NPA%E2%80%99s%E2%80%94A-Comparative-Analysis-on-Banks-_-Financial-Institutions-and-its-Implications-Sumathi-Gopal.pdf

[xviii] Insolvency & Bankruptcy Code, 2016.

[xix] Bo Xie, Comparative Insolvency Law: The Pre-pack Approach in Corporate Rescue (2016).

[xx] Debby Lim, Singapore’s First “Pre-Packaged” Scheme Of Arrangement (May 03, 2018), https://www.mondaq.com/corporate-and-company-law/698526/singapore39s-first-pre-packaged-scheme-of-arrangement.

[xxi] MCA, Notice (Jan. 08, 2021), 34f5c5b6fb00a97dc4ab752a798d9ce3.pdf (ibbi.gov.in).

[xxii] MCA, Monthly Newsletter (Nov. 2018), NovemberMCANewsletter_19122019.pdf;  MCA (2019), Notice (Apr. 16, 2019), Notice for inviting public comments on Code.pdf (ibbi.gov.in).

[xxiii] 34f5c5b6fb00a97dc4ab752a798d9ce3.pdf (ibbi.gov.in)

[xxiv] Aditya Shendye, Non Performing Assets and Recovery Mechanisms, http://www.legalserviceindia.com/legal/article-3771-non-performing-assets-and-the-recovery-mechanisms.html.

[xxv] Chapter II, Insolvency & Bankruptcy Code, 2016.

[xxvi] IDBI Bank, IDBI Bank History, https://www.idbibank.in/idbi-bank-history.asp#:~:text=It%20was%20regarded%20as%20a,was%20transformed%20into%20a%20Bank.&text=October%2001%2C%202004.,Western%20Bank%20with%20IDBI%20Ltd.

[xxvii] Bank wise and Bank Group wise Non Performing Assets, Gross Advances, and Gross NPA ratios of Scheduled Commercial Banks, RBI Report, Reserve Bank of India, http://dbie.rbi.org.in/DBIE/statistics.rbi?action=RL&f=365&sd=37.  

[xxviii] Anand Adhikari, Cleaning The Bad Loans Mess (May 07, 2017), https://www.businesstoday.in/magazine/cover-story/cleaning-the-bad-loans-mess/story/250235.html.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s