This essay was adjudged as the best entry in the Second NLUJ CSBF Essay Writing Competition, 2020-21. The article was submitted by Ahhkam Khan. The author is a student at Dr. Ram Manohar Lohiya National Law University, Lucknow.
The Covid-19 induced financial stress has exacerbated the problems with the Indian banking system, mostly caused due to pre-pandemic economic slowdown. This has led to pessimistic projections regarding impending defaults, showing a spike in the gross non-performing assets (NPA) on the banks’ balance sheets. This NPA spike has carried a wave of support for establishment of bad banks in India as a mechanism to clean up the dirty laundry of these banks. This essay, while recognising the need for asset segregation tools in the form of bad banks, highlights how the Indian NPA crisis requires more than just a balance sheet touch-up. In the first part, it studies the issues surrounding the ownership structure of these bad banks as well as the transfer price of the bad debt. Second, it analyses the performance of standalone bad banks without any other booster for the credit market; specifically, the need, if any, for recapitalisation of banks following asset segregation, even contemplating the alternatives in the absence of direct capital infusion during an economic downturn. Lastly, it concludes by providing a model framework for resolution of India’s NPA problems in the long run.
The RBI Financial Stability Report 2021 has provided a great impetus to debate revolving around the growing need to address the NPA crisis in India by projecting a rise of over 5% in the gross NPA ratio of Scheduled Commercial Banks (SCBs) in India, totalling 13.5%, which in the worst-case scenario may go as high as 14.8%.[i] This led to the finance minister proposing the establishment of bad banks during her FY22 Union budget speech. However, the call for a bad bank intervention was not entirely new. It started in 2017 with Arvind Subramaniam, the then-Chief Economic Advisor to the Government of India[ii], and only got stronger with the recommendations of the Indian Banks’ Association (IBA)[iii] and the Confederation of Indian Industries[iv] in 2020. In September 2020, Viral Acharya (ex-Deputy Governor, RBI) and Raghuram Rajan (ex-Governor, RBI) also backed a proposal to set-up several private bad banks as well as a national asset management bad bank to aggregate and manage bad loans.[v]
As an idea, this is not India’s first tryst with bad banks. In 2004, when IDBI was converting to a Bank, the government set up the Stressed Asset Stabilization Fund (SASF) as a bad bank-like structure to hive off and store IDBI’s NPAs aggregating ₹ 9,000 crores.[vi] While the project failed to achieve any major success, it may have laid down several key lessons for future policy decisions involving a similarly structured entity, mainly with respect to ownership and capital infusion, as we shall observe later in this paper.
A bad bank is an entity, which houses/stores the bad assets of a bank (sometimes called a ‘good bank’ or ‘parent bank’), thereby taking up highly risky assets with low chances of return on its sheets and allowing the parent bank to re-calibrate its lending activities with a clean balance sheet and better debt ratings. In the absence of the mismatched assets and liabilities, the good bank can inspire confidence with investors and depositors alike, and undertake its routine lending processes freely with a healthy risky appetite, in a stronger capital position with lower funding costs. In addition to the balance sheet clean-up for the parent bank, a bad bank also allows specialised management of the bad assets, which permits the parent bank to focus on core lending activities while the bad bank maximises the value of bad assets.[vii] Such structures are used as short-term fixes to a growing twin balance sheet problem and are often dissolved after meeting their objectives, as seen with the Grant Street National Bank in the US in 1990s.[viii]
While there has been much talk around the establishment of these bad banks, little literature exists beyond speculation regarding the expected model of operation for these bad banks in India. The RBI Governor, Shaktikanta Das has recently indicated that while he is open to a proposal about a bad bank, he has not received anything proposal-worthy in black and white from the Ministry of Finance.[ix] In such a complex milieu, this essay seeks to answer some important questions regarding the ownership and transfer price of bad debts, and combinational steps required for the success of the bad banks in India.
OWNERSHIP STRUCTURE OF BAD BANKS AND TRANSFER PRICE OF NPAs
Bad banks usually acquire NPAs at a discount price, and manage them over a period as going concern towards maximisation of realisable value. The ownership structure of bad banks has a major impact on the effectiveness of the asset segregation exercise. Since both objectives and incentives differ across the ownership spectrum from public to private ownership, ownership/funding of bad bank is a determinant for several issues ranging from the transfer price of bad debts to transparent governance.[x]
The determination of transfer price is a complex issue. Firstly, the difficulty in understanding the actual economic value of assets (primarily using discounted cash flow) is a cause of concern due to asymmetry in availability of information as well as a thin secondary market for distressed assets.[xi] Secondly, the book value with banks can depend on a number of factors like the provisioning requirements, which in itself may depend on dicey criterion of elapsed time since declaration of NPA, despite strict and harmonised accounting criteria. In such a situation, there may be a huge bid-ask spread between the book value and the realisable market value. This huge haircut from book value may disincentivize because it will lead to heavy capital shortfall. On the other hand, sale at book value might require heavy capital infusion into the bad bank, and may prove unsuccessful especially since realisable market value of the distressed asset is usually way below the book value in India[xii].
The most important factor determining the transfer price is the role of state funding. In the presence of state funding, the transfer price is usually higher than the market value, which may lead to potential losses for the bad bank, as seen in the case of SASF. Therefore, while determining the ownership structure of the bad bank, it is necessary to recognise the trade-off between private bad banks (where sale happens close to market value and banks take heavy haircuts) and public bad banks (where sale happens at higher prices but the government entails the risk of heavy potential losses).[xiii]
Empirical data suggests that private bad banks are usually more effective than public ones[xiv] and for good reasons:
- Higher incentives for the management because of the market discipline imposed by private funding[xv];
- Higher haircuts taken by parent bank lead to quicker realisation of losses, which disincentives evergreening or ‘zombie-lending’, freeing up more strapped capital.[xvi]
However, ownership structure may also be driven by factoring the size and scope of the NPA problem in the economy. At one end of the spectrum, lies the centralised system-wide bad bank, while at the other end lie a pool of bank-specific bad banks. When the NPA problem is systemic and plaguing the entire economy, centralised system-wide bad banks are considered a better solution. Since the scale of resources required for such a bad bank is massive, they are mostly public-funded.[xvii] Further, economies having low number of NPAs that form a large part of the banking system provide the ripest grounds for establishment of a bad bank[xviii], as can be seen from the bad bank established for RBS by the British Treasury.[xix] Another successful example proving this hypothesis is the Korean experience in case of Korean Asset Management Company (KAMCO).[xx] In India, a similar system could be replicated because the NPAs are mostly concentrated in a few entities/groups (e.g. RBI’s dirty dozen list) in specific sectors like infrastructure and manufacturing that form a large part of the banking system, as observed in the graph below[xxi]:
Another regulatory hurdle specific to India is the fact that fraud-hit accounts cannot be transferred below their book value to the bad bank, in light of an April 2011 RBI communication to all SCBs. While the IBA’s May 2020 bad bank proposal had suggested an amendment to this rule, by allowing for an approval mechanism based on case-to-case analysis, government insiders involved in assessing the proposal stated that this could be problematic in light of the moral hazard attached to the fraudulent account.[xxii] The RBI recently rejected Yes Bank’s proposal to set up an ARC (bad bank-like structure) citing ‘conflict of interest’ reasons because most of the distressed assets being transferred are declared fraud cases that cannot be transferred to an ARC.[xxiii] In such a situation, this rule could be an additional burden on the resolution of the NPA crisis through bad banks, making it imperative upon the government to recognise and resolve it.
STANDALONE USE OF BAD BANKS: A CASE FOR RECAPITALISATION?
Asset segregation tools like the bad bank are usually used in conjunction with state-funded measures like recapitalisation because successful models of a bad bank require transfer of NPAs to the bad banks at a price lower than the book value, as established in Part II of the essay. Thus, while such tools may have ample positive impact, they might not strengthen the bank’s capital position enough to provide sufficient impetus to profitable but risking new lending by the bank.[xxiv] On the other hand, recapitalisation alone is also ineffective since banks use the additional capital for lending only when their capitalisation covers a basic minimum profitability threshold; thus, the additional funds are utilised by the bank to clean up its balance sheets, without any incremental lending.[xxv] Thus, to both clear the bank’s balance sheets in the short run and spur lending in the long run for the benefit of the banking industry at large, a structural mechanism providing for asset segregation as well as capital infusion is necessary. To summarise, the two simultaneous processes hindering the success of asset segregation/recapitalisation individually are as follows:
- Because transfer of NPAs below book value leads to a capital shortfall, a bank may be unwilling to segregate the NPAs in the absence of additional capital infusion to make up for the shortfall due to write down;
- If assets are not segregated, they tie up additional capital that could be devoted to fresh lending activities.[xxvi]
Alternatives to recapitalisation
Even the pre-pandemic Indian economy was suffering a slowdown that had seen severe government deficit and debt levels soaring at unprecedented levels. In such a scenario, it might be imprudent to expect the government to further work up a recapitalisation exercise. This is also evident from a lacklustre government response to IBA’s proposal of setting up a bad bank and infusing ₹ 10,000 crores in capital by the government.[xxvii] Acknowledging the government’s inactive response to capital infusion, one may start looking at additional alternatives to capital infusion in the form of market capital, state sponsored guarantees, cash-neutral recapitalisation bonds[xxviii], or other forms of indirect support like zero coupon perpetual bonds[xxix]. A cursory look at the trends for state support during the banking bailout post-2008 global financial crisis leads credence to the argument that these alternatives, though much greater in volume, as can be observed from the table below[xxx], merely support the recapitalisation exercise, which has a greater direct impact as highlighted under Part II of the essay.
While commentators against may argue on the recapitalisation’s disincentives for public bankers which leads to the “Heads, I win; tails, the taxpayers lose” spirit from the old adage, protective steps may be taken by ensuring competitive allocation of capital to different PSBs based on their efforts and success in combatting the NPAs. However, this competitive allocation to neutralise the aforementioned disincentive only needs to be done over and above the basic minimum capital support to even the trailing PSBs or further look at government disinvestment through private capital infusion in the future for these trailing banks. Lastly, in spite of all these considerations, if the Indian banking industry is to look at a brighter tomorrow, direct state support in the form of recapitalisation becomes the need of the hour.
FITTING THE BAD BANK PIECE IN INDIA’S NPA SOLUTION JIGSAW: A MODEL FRAMEWORK
In light of the IDBI bad bank episode of 2004, Acharya and Rajan[xxxi] state that a bad bank cannot resolve the NPA crisis if it simply transfers the bad debts from one government-owned entity to another. The policy progression should also involve mechanisms to discourage the seller (parent bank) from providing bad loans in the first place as well as evolve incentives for greater recovery and collection for the buyer (bad bank). This is further corroborated by the fact that the Indian NPA crisis is a two-dimensional continuously growing problem as summarised by the progression of NPAs in the past three years in the following chart[xxxii]:
Thus, while the often-highlighted mainstream problem is the gross NPA level on the banks’ sheets, at the policy level, we also need to account for the accretion of new NPAs every year. This essay proposes policy solutions at three levels to tackle this issue as explained in the flowchart below:
Combatting lending malpractices
Tackling the problem of NPAs at an institutional level will require us to nip it in the bud. To that end, transformative understanding of risk and governance is necessary. Indian public sector banks (PSBs) provide for nearly 70% of the credit industry, but account for more than 90% of the bad loans in the country. This is not merely a blip on the radar but shows significant institutional failure at the level of PSBs; even with strict governance frameworks, the performance is abysmal. Reformist bankers suggest a host of measures including strengthening of bank boards by persons of merit, rather than the usual politicised boards, abolition of the Department of Financial Services (DFS) or its merger into the Bank Boards Bureau (BBB) to provide sufficient independence in the operation of banks.[xxxiii] To highlight the problems even further, private banks like HDFC have been consistent in keeping their NPA levels in check through their underwriting practices, as illustrated in the chart[xxxiv] below:
This is down to several issues, including inter alia, low interest priority sector lending, poor risk management competencies leading to a concentration of risks in a single sector/group, and lack of specialised underwriting skills.[xxxv] This requires a complete overhaul of the underwriting framework through AI digitisation for better risk understanding and credit allocation as well as skill training to the bulk of the underwriting team responsible for retail loans.[xxxvi]
Early and effective handling of stressed assets
At an event at Stanford University, former RBI Governor Urjit Patel had stated that the dismal state of Indian banking was a failure on part of regulatory supervisors.[xxxvii] He emphasised that the failure to identify stressed assets, and to minimise losses by quick restructurings had eaten up the bulk of banking capital, leading to asset slippages. To put it into perspective, in 2020, the PSBs accounted for 82% of all fraud incidents, with a lag of more than 63 months between the date of occurrence of fraud and its detection, in cases where the amount involved was greater than 100 crores.[xxxviii] This delay in identification and reporting causes a stretch in any action to recover losses; by that time, the entity no longer remains profitable as a going concern. Further, even after identification, successful restructurings are few and far in between, and the cases that reach the NCLTs through the IBC route line up in an unending queue in the overburdened tribunal.
However, the Insolvency Law Committee has recently proposed the introduction of an out-of-court restructuring framework in the form of a pre-pack model within the IBC, which may help incentivise early and effective handling of stressed assets.[xxxix] However, the draft framework fails to recognise the need to dilute the disqualifications for promoters under section 29A of IBC, which may thin out the already flimsy market for distressed assets, as discussed further in the essay. The government needs to appreciate the difference between a fraudulent diversion of funds and an unprofitable business issue (due to extrinsic factors like monopolisation or intrinsic factors like incompetence).[xl] In case of the latter, it should evolve a mechanism for the promoters to bid for their stressed assets. Forcing a business into liquidation because of no interested bidders (for entities like MSMEs that usually work on a niche promoter-driven business model and seldom attract outside investors) would only lead to diminution of the recovered value.
Establishing a secondary market for resolution of distressed assets
Indian distressed asset market currently pegs opportunities of over US $ 150 billion.[xli] However, the investment still lag behinds, mostly because of illiquidity in the Indian distressed assets market. The progress under IBC has not been very positive as well, mainly because of lack of transparency in pricing as well as burdensome litigation plaguing the process.[xlii]
This is another issue where a central system-wide bad bank might come to the rescue. In Korea, KAMCO was used in resolution of NPAs to eventually provide a stimulus to private players for entering the distressed assets by aiding the price discovery in the illiquid market, nullifying the first mover disadvantage due to information asymmetry between the highly informed seller and the unaware buyer.[xliii] Until mid-1999, the KAMCO invested at inflated prices; however, these prices started matching realistic levels over time, attracting private players.[xliv] It may also provide liquidity in the market by profiling NPAs as per the risk profile, so that investors may participate in assets that match their risk preferences. An idea to set up a national platform for information on stressed assets is already in the pipeline, which may also enhance liquidity by standardizing transaction data.[xlv] India may follow the well-trodden path taken by KAMCO by laying down the foundations of a promising distressed asset market for the global investors, and strengthening its banking system in the process.
The expectation that the establishment of a bad bank will be a panacea for India’s NPA woes is farfetched. Indian financial system requires structural reforms, right from the grassroots, which may be modelled on the lines of the framework suggested above. While a bad bank may bring several positives, including inter alia, easier aggregated negotiations for the sale of stressed asset, clean-up of the banks’ balance sheets, and aid in price discovery to establish a more competitive market for distressed assets, it merely loosens the noose that grips the neck of India’s banks. The uncertainty on ownership structure and transfer price of the debt still lingers, and any imported solution shall need to be customised to the Indian needs especially in the peculiarity of the Indian economic situation. Despite several opposing arguments in the fray, establishment of a bad bank coupled with adequate recapitalisation of banks may prove a temporary booster shot in the arm of the Indian economy. However, if India has to look into the light beyond the horizon, it has to recognise that institutional reforms are what will sail her through.
[i] RBI, Financial Stability Report (2021).
[ii] ‘India needs to create ‘bad bank’ quickly: Arvind Subramanian’ (Business Today, 22 February 2017) <www.businesstoday.in/sectors/banks/india-needs-to-create-bad-bank-quickly-says-arvind-subramanian/story/246859.html#:~:text=Subramanian%20has%20proposed%20setting%20up,loans%2C%20as%20of%20last%20September.>.
[iii] ‘IBA submits proposal on ‘bad bank’ to govt, RBI’ (Financial Express, 13 May 2020) <www.financialexpress.com/industry/banking-finance/iba-submits-proposal-on-bad-bank-to-govt-rbi/1956981/>.
[iv] Shreya Nandi, ‘Multiple Bad Banks needed to solve the NPA problem: CII’ (Mint, 21 December 2020) <www.livemint.com/news/india/multiple-bad-banks-needed-to-solve-npa-problem-cii-11608484588060.html>.
[v] Viral Acharya & Raghuram Rajan, ‘Indian Banks: A Time to Reform?’ (21 Sept 2020) <http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/pdfs/indian-banks-reform.pdf>.
[vi] Vishwanath Nair, ‘Lessons from IDBI’s experience with a bad bank-like structure’ (Mint, 9 June 2016) <www.livemint.com/Industry/cM5Rb5szBMFPAyYMNiVq1N/Lessons-from-IDBIs-experiment-with-a-bad-bank.html>.
[vii] Eddie Cade, ‘Managing Banking Risks: Reducing Uncertainty to Improve Bank Performance’ (Routledge 2013) 141–42.
[viii] Heidi Moore, ‘The ‘Bad Bank’ Experience: Lessons From Mellon-Grant Street – Deal’ (WSJ, 8 September 2008) <www.wsj.com/articles/BL-DLB-3364>.
[ix] ‘RBI open to bad bank proposal: Shaktikanta Das’ (Indian Express, 17 January 2021) <https://indianexpress.com/article/business/economy/shaktikanta-das-rbi-bad-loan-npas-banking-sector-7149385/>.
[x] European Commission, AMC Blueprint, SWD (2018) 72 final <https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52018SC0072&from=EN>.
[xi] Michael Brei et al, ‘Bad bank resolutions and bank lending’ (BIS Working Paper No 837, January 2020) <www.bis.org/publ/work837.pdf>.
[xii] Srinath Sridharan, ‘Why ‘Bad Bank’ is a bad idea for India’ (Business Today, 24 December 2020) <www.businesstoday.in/opinion/columns/why-bad-bank-concept-cant-work-in-india-banking-sector-npas/story/425833.html>.
[xiii] P Baudino & H Yun, ‘Resolution of non-performing loans – policy options’ (BIS, 3 October 2017).
[xiv] A Haldane & M Kruger, ‘The resolution of international financial crises: private finance and public funds’ (2001) Bank of Canada Review 3-13.
[xv] C Goodhart & E Avgouleas, ‘Critical reflections on bank bail-ins. In The Reform of International Economic Governance’ (Routledge, 2016) 75-99.
[xvi] C Gandrud & M Hallerberg, ‘The Bad Banks in the EU: The Impact of Eurostat Rules’ (Bruegel Working Paper No 15, December 2014)
[xvii] P Baudino (n 13)
[xviii] European Commission (n 10).
[xix] HM Treasury, ‘RBS and the case for a bad bank: The Government’s review’ (1 November 2013) <https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/254540/PU1581_RBS_bad_bank_Govt_review.pdf>.
[xx] Raunaq Pungaliya, ‘NPL resolution: A Lesson from the Korean Experience’ (CAFRAL Policy Note).
[xxi] Madhu Srinivas and Deepti George, ‘The Risk Aggregator Model for Banking in India’ (Dvara Research, 8 April 2020) <www.dvara.com/research/wp-content/uploads/2020/04/The-Risk-Aggregator-Model-in-Banking-for-India.pdf>.
[xxii] Saloni Shukla, ‘Why IBA’s proposal to have govt-backed bad bank could hit a wall’ (The Economic Times, 16 May 2020) <https://economictimes.indiatimes.com/industry/banking/finance/banking/why-ibas-proposal-to-have-govt-backed-bad-bank-could-hit-a-wall/articleshow/75767087.cms>.
[xxiv] HM Treasury (n 19).
[xxv] M Brei et al, ‘Rescue packages and bank lending’ (2013) 37(2) Journal of Banking and Finance 490-505.
[xxvi] Shekhar Iyer et al, ‘A Strategy for Resolving Europe’s Problem Loans’ (IMF Staff Discussion Note 15/19, September 2015) <www.imf.org/external/pubs/ft/sdn/2015/sdn1519.pdf>.
[xxvii] Shreya Nandi & Shayan Ghosh, ‘Centre not to infuse equity into bad bank’ (Mint, 3 February 2021) <www.livemint.com/industry/banking/centre-not-to-infuse-equity-into-bad-bank-11612310881388.html>.
[xxviii] ‘Reforms needed to back bank recpaitalisation’ (Mint, 16 October 2017) <www.livemint.com/Opinion/1HPaESu6reDVRWDron7obL/Reforms-needed-to-back-bank-recapitalisation.html>.
[xxix] T Sabri Oncu, ‘Bad bank proposal for India’ (EPW, 11 March 2017) <www.networkideas.org/wp-content/uploads/2017/03/Bad_Bank_Proposal.pdf>.
[xxx] Luca Martini et al, ‘Bad banks: Finding the right exit from the financial crisis’ (Mckinsey Working Papers on Risk No 12, August 2009) <www.mckinsey.com/~/media/McKinsey/dotcom/client_service/Risk/Working%20papers/12_Bad_Banks_Finding_the_right_exit_from_the_financial_crisis.ashx>.
[xxxi] Viral Acharya & Raghuram Rajan (n 5).
[xxxii] Hari Hara Mishra, ‘How bad bank model of ARC, AMC would work to manage NPAs’ (Business Today, 8 March 2021) <www.businesstoday.in/opinion/columns/how-bad-bank-model-of-arc-amc-would-work-to-manage-npas/story/433303.html>.
[xxxiii] Saloni Shukla, ‘What Modi govt can do to save PSU banks’ (The Economic Times, 24 July 2019) <https://economictimes.indiatimes.com/industry/banking/finance/banking/what-modi-govt-can-do-to-save-psu-banks/articleshow/70355779.cms?from=mdr>.
[xxxiv] Madhu Srinivas and Deepti George (n 21).
[xxxv] Deepti George, ‘An alternative to privatization of public sector banks’ (Mint, 23 April 2018) <www.livemint.com/Opinion/uNFFjr8ijNfTC42uB6t9LI/An-alternative-to-privatization-of-public-sector-banks.html>.
[xxxvi] Indian Government, Economic Survey (2019-20) <www.indiabudget.gov.in/economicsurvey/doc/echapter_vol2.pdf>.
[xxxvii] ‘Urjit Patel admits RBI was slow to take timely measures for bad loan mess’ (BusinessLine, 4 July 2019) <www.thehindubusinessline.com/money-and-banking/a-mess-urjit-patel-admits-rbi-was-slow-to-take-timely-measures-for-bad-loan-mess/article28281774.ece>.
[xxxviii] RBI, Annual Report (2019-20).
[xxxix] Ministry of Corporate Affairs, ‘Report of the Sub-Committee of the Insolvency Law Committee on
Pre-packaged Insolvency Resolution Process’ (October 2020) <www.ibbi.gov.in/uploads/whatsnew/34f5c5b6fb00a97dc4ab752a798d9ce3.pdf>.
[xl] Rohit Jain, ‘IBC: What Would It Take For Pre-Packs To Work?’ (Bloomberg Quint, 3 February 2021) <www.bloombergquint.com/law-and-policy/ibc-what-would-it-take-for-pre-packs-to-work>.
[xli] Radhika Merwin, ‘Covid impacts sale of distressed assets’ (BusinessLine, 8 October 2020) <www.thehindubusinessline.com/news/national/covid-impacts-sale-of-distressed-assets/article32801525.ece>.
[xliii] Dong He, ‘The Role of KAMCO in Resolving Nonperforming Loans in the Republic of Korea’ (IMF Working Paper 04/172, September 2004) <www.imf.org/external/pubs/ft/wp/2004/wp04172.pdf>.
[xlv] Suresh Iyengar, ‘IBBI arm seeks e-platform for stressed asset sale’ (BusinessLine, 15 February 2021) <www.thehindubusinessline.com/news/ibbi-arm-seeks-e-platform-for-stressed-asset-sale/article33838494.ece>.