The Case for a Bad Bank

 (Versions of the following article appeared in Ideas for India & Mint today, links below:

https://www.ideasforindia.in/topics/money-finance/budget-2021-22-case-for-a-bad-bank.html

https://www.livemint.com/industry/banking/how-to-make-india-s-bad-bank-workable-11613911668500.html )

The Case for a Bad Bank

One of the key announcements in the 2021-22 Union Budget was around the formation of a ‘bad bank’. As outlined in the Budget speech by Finance Minister Nirmala Sitharaman: “The high level of provisioning by public sector banks of their stressed assets calls for measures to clean up the bank books. An Asset Reconstruction Company (ARC) Limited and Asset Management Company (AMC) would be set up to consolidate and take over the existing stressed debt and then manage and dispose of the assets to Alternate Investment Funds and other potential investors for eventual value realization.”

 

Why would such an ARC be needed, when we already have an Insolvency and Bankruptcy Code (IBC) since late 2016? What should be the objectives of such an ARC, and how might it be designed? Beyond the ARC, what else is needed to reinvigorate our financial services ecosystem, so that it might start to fund our immense growth aspirations and potential?

 

Context: Understanding the problem of non-performing assets

 

The RBI’s (Reserve Bank of India) Financial Stability Report (FSR) of January 2021 suggests that the extent of gross non-performing assets (GNPA)[1] in banking may rise from 7.5% of advances[2] in September 2020 to 13.5% of advances by September 2021 as a base case, and to 14.8% of advances under a scenario of severe stress. Given the current level of banking advances, this amounts to potential GNPAs between Rs. 14.4 lakh crore and Rs. 15.7 lakh crore. This is over and above the Rs. 8.8 lakh crore of assets that have been technically written off by banks between fiscal years FY2014-15 and FY2019-20, but where recovery processes may still be underway.

 

In addition, non-bank finance companies (NBFCs) too are grappling with GNPAs. As per the RBI FSR, GNPAs of NBFCs stood at 6.3% of advances as of March 2020. Sample stress tests conducted by the RBI FSR on 200 large NBFCs suggest their GNPAs may rise to between 6.8% and 8.4% of advances, under baseline and high-stress scenarios, respectively. Extrapolating that to all NBFCs (including housing finance companies or HFCs), this translates to between Rs. 3.5 lakh crore and Rs. 4.3 lakh crore of GNPAs. 

 

It is worth noting that GNPA numbers, as of March 2020, may well be understated. While banks have undergone a formal asset quality review (AQR) by the RBI since late 2015 and have also been subjected to rigorous RBI supervision since, they have enjoyed forbearance around the recognition of some GNPA around some micro, small and medium enterprises (MSME) and certain real estate loans. 

 

In addition, NBFCs (including HFCs) have not gone through a formal AQR. While RBI supervision and scrutiny of NBFC books has indeed tightened over the years, the significantly lower proportion of GNPAs on NBFC books, as compared to banks, does raise eyebrows. Financial markets also appear to attribute less credibility to the financial books of at least a few NBFCs. 

 

Even if we ignore this uncertainty, we may be staring at a GNPA universe of between Rs. 26.7 lakh crores and Rs. 28.8 lakh crore, or between 13.7% and 14.8% of this fiscal year’s GDP (gross domestic product). These are enormous numbers that weigh down our financial services and our insolvency and bankruptcy ecosystem.

 

The case for the ‘bad bank’

 

The IBC that was passed in 2016 – along with the amendments that have been put into effect since – is an excellent piece of legislation. 

 

Data from the Insolvency and Bankruptcy Board of India (IBBI) show that as of September 2020, 4,008 cases had been admitted for resolution under the IBC. Of these, 2,066 cases had been disposed of, either through settlement, withdrawal, resolution, or liquidation. Specifically, 277 cases saw a resolution plan being adopted, yielding a recovery of 43.5% of claims across financial and operational creditors, with the process taking an average of 433 days to complete for each case. Compared to the pre-IBC days, this is certainly good progress. However, 1,942 cases were still pending for resolution, of which 1,442 cases were already over 270 days old[3]. Given that the IBC is effectively on standstill through the Covid-19 pandemic until March 2021, and given the scenarios painted earlier on the possible extent of GNPAs, there are likely many, many more cases that are waiting to be admitted.

 

While the IBC infrastructure, with the ongoing legislative tweaks, should be well capable of handling steady-state incremental stresses, the existing enormous stock of GNPAs cry out for a one-time exceptional resolution infrastructure. Trying to tackle this stock through just the IBC might take too much time and effort, with far-reaching consequences for the weak economy. 

 

Hence, there is a strong case for a one-time bespoke resolution of a chunk of the existing enormous stock of stressed assets, through the creation of a bad bank.

 

Objectives and design of a bad bank

 

While the smaller cases of stressed assets – single lender retail loans, for instance – are best handled by the lender on record, I make a case for a bad bank to aggregate larger stressed assets, with the following objectives:

 

·      To take the larger GNPAs out of the commercial banking books and bring them onto an organisation that is better resourced to specifically handle distressed debt. The skills and resources required to handle stressed assets is very different from the skills required for regular commercial lending.

 

·      As a corollary, to free up the commercial lending ecosystem, so that it can revert to its regular objective of funding India’s growth aspirations – without the millstone of managing GNPAs hanging around its neck. 

 

·      To bring the larger GNPA cases under a single ownership, so that resolution plans are not delayed and burdened by the practical difficulties of achieving a consensus among several disparate lenders.

 

The following design considerations should accompany the above objectives:

 

·      The bad bank should be managed by experienced and reputed professionals with expertise in sectoral distressed assets. 

 

·      The transfer of GNPAs from the lender on record to the bad bank has to be completed at a ‘fair price’. Admittedly, it is anything but easy to determine this a priori. Yet, the importance of arriving at such a ‘right value’ cannot be overemphasised. On the one hand, if GNPAs are transferred at too low a value, the recovery process might deliver supernormal profits to the buyers. This could be especially problematic if the eventual buyers are in the private sector. On the other hand, if the transfer value is too high, such transfers would merely shift the burden from one entity to another and kick the can down the road, leaving little space for any meaningful time-bound resolution. This was one of the many issues with the 2004 experiment with the Stressed Asset Stabilization Fund (SASF) to handle a chunk of IDBI (Industrial Development Bank of India)’s stressed assets.

 

·      Ideally, to preserve productive capacity and jobs, the new owner of the large GNPAs should be able to smoothly enlist the support of all stakeholders so that sustainable resolution is the default outcome, rather than liquidation. In many of the large, stressed assets – such as in power, infrastructure, metals and mining, construction and real estate, airlines and shipping – the government is a key stakeholder for any sustainable outcome. This makes the case for considerable government involvement in any bad bank. 

 

·      The bad bank cannot be an entity in perpetuity. As a one-time bespoke solution, it should be designed with the clear mandate to wind down by a definite timeline, of say five years. This cannot be even remotely construed as an invitation to perpetuate the cycle of bad assets creation and resolution.

 

The nuts and bolts of a ‘Neelkanth’

 

I now proceed to offer a construct of an Indian bad bank – I call it Neelkanth[4] – that could meet the objectives and design considerations discussed above. I draw heavily from the reasonably successful Malaysian experience with its stressed asset management AMC ‘Danaharta’, post the Asian crisis (Azmi and Razak 2014).

 

Structure

 

In terms of structure, I suggest that Neelkanth could be designed as a government owned ARC, capitalised the same way recapitalisation of public sector banks (PSBs) has been undertaken by the government – by issuance of special Government of India (GOI) (‘recap’) bonds. To start with, Rs. 1 lakh crore of capital could be infused into Neelkanth, against issuance of special GOI bonds to the same entity. This could support the purchase of stressed assets of up to Rs 2 lakh crores to Rs. 3 lakh crores, assuming a 33% to 50% haircut[5]on the assets.

 

People

 

Neelkanth could be headed by an inspiring and independent finance professional of strong repute. It should similarly have an investment committee and board of trustees of unimpeachable repute, experience, and credentials. On the ground, it should be managed by professional and experienced experts – including from overseas, if suitable – with a deep knowledge of distressed asset management in sectors such as infrastructure and real estate.

 

Asset purchases and the ‘fair price’

 

Neelkanth could consider all stressed assets in India’s financial sector ecosystem across banks and NBFCs, beyond a threshold size of say Rs. 1,000 crore per borrowing entity. A database of such assets across lenders could be obtained from RBI’s Central Repository of Information on Large Credits (CRILC) for banks and NBFCs.

 

Based on its own analysis and expert opinion and charged with the mandate of arriving at a ‘fair price’, Neelkanth should offer a purchase price on each these stressed assets to all financial institutions (FI) that are lenders on record. To take a specific example, Neelkanth might say offer Rs. 40 for every Rs. 100 face value of a certain power sector loan. The financial institutions that have the loan (or bond) asset on their books can accept Neelkanth’s bid and sell the asset at Rs. 40, paid for by Neelkanth in central government recap bonds. Alternatively, they can reject the offer as being too low – in which case, they would be required to mark-down the asset on their books to at least Rs. 36, or 10% below the bid price offered by Neelkanth.

 

On the flip side, consider the case that Neelkanth’s bid of Rs. 40 is accepted by the FI, and subsequently, Neelkanth goes on to recover Rs. 60 from the asset through resolution. Neelkanth would then transfer back Rs. 16, or 80% of the Rs. 20 excess over the original bid of Rs. 40, back to the original FI that sold the asset to them. Note that if Neelkanth were to recover less than Rs. 40, that loss would be solely to Neelkanth’s books – there would be no recourse to the original seller of the stressed asset.

 

Such a mechanism, which broadly mirrors the mechanism used by ‘Danaharta’ in Malaysia, would help ensure some semblance of a Goldilocks[6] ‘fair price’ in the asset transfer.

 

Resolution and Timelines

 

Neelkanth could also offer policy recommendations that aim to address chronic issues in severely stressed sectors (for example, power, real estate, construction, telecom, airlines, and shipping) and pave the way for sustainable all-round economic recovery and growth – beyond just cleaning up the financial services ecosystem. Acting on such recommendations may also allow Neelkanth to bring about timely resolutions that preserve the underlying assets and jobs, rather than having to resort to liquidation.

 

Government ownership of Neelkanth – alongside the commitment to transfer back a substantial chunk of the surplus recovery to the original FI – would also reduce the moral hazard associated with bringing into effect policy changes that improve recovery and resolution prospects. 

 

Beyond bad bank: Management and governance reforms

 

A one-time resolution through a Neelkanth would be incomplete, unless accompanied by serious governance and management reforms to ensure that we do not slip back to repeating the cycle of ‘lend, extend, pretend, and finally bailout’. Without adequate reforms, we would be running the risk of throwing good taxpayer money after bad.

 

Governance reforms

 

The past few years have put the spotlight on the considerable weakness in every aspect of governance checks and balances, with respect to our financial services ecosystem. These governance issues are ownership-neutral – they permeate both public sector and private sector entities. 

 

While there is work underway, much more needs to be done to call to account – and reform – critical governance pillars such as risk management in FIs, independent research analysts, auditors, boards, rating agencies, and regulatory supervisors. We cannot afford to repeat the mistakes that led to episodes such as egregious financial sector frauds and losses involving IL&FS (Infrastructure Leasing and Financial Services), Yes Bank, PMC (Punjab and Maharashtra Co-operative), DHFL (Dewan Housing Finance Corporation), and others.

 

Professional management autonomy for public sector banking

 

Beyond governance issues, PSBs – accounting for 60% of banking in India – also need special attention. The RBI’s FSR reckons that PSB GNPAs could rise to 16.2% of advances as a baseline – more than double the 7.9% of advances of private sector banks. 

 

While it is tempting to beat up PSBs as chronically inefficient, they do not enjoy a level playing field for the following reasons: 

·      They are set up under the State Bank of India (SBI) Act or bank nationalisation acts, rather than under the Companies Act. 

·      They are controlled by the mandarins of the Department of Financial Services (DFS) – and hence subject to interference in their day-to-day banking operations, ranging from “phone-banking”[7]  to more recent nudges towards Mudra[8]  loans. 

·      Their professional decisions are subject to scrutiny by the dreaded 3 Cs – CBI (Central Bureau of Investigation), CVC (Central Vigilance Commission) and CAG (Comptroller and Auditor General) – something their private sector counterparts do not have to lose sleep over. 

·      The compensation for their middle and senior management is capped by government pay scales and are substantially lower than their private sector counterparts.

 

The P. J. Nayak committee (2014) laid out a roadmap for addressing each of these issues and more. The substance of these recommendations needs to be implemented now. 

 

PSBs have to be provided professional autonomy, and a level playing field with their private sector counterparts. While social obligations are part of every banking operation in India (for example, the requirement for priority sector lending), the government should start to address social objectives using explicit fiscal instruments and transfers, rather than obliquely leveraging commercial organisations and their shareholder money for this purpose.

 

Further Reading

·      Azmi, Ruzita and Adilah Abd Razak (2014), “The Role of Danaharta in Managing and Rehabilitating Financially Troubled Companies in Malaysia – Part One”, International Corporate Rescue, 11(6).

 

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[1] Gross non-performing assets are the sum of all loan assets of an entity that are classified as non-performing on the entity’s balance sheet, as per RBI guidelines.

[2] Funds provided by a bank to an entity for a specific purpose, repayable after a short period of time, are known as advances.

[3] Under the IBC, initially, the resolution process was to be completed in a period of 270 days after which liquidation is to be invoked. In September 2019, this timeline was raised to 330 days.

[4] Neelkanth is a name given to the Hindu God Shiva, which translates to ‘the blue-throated one’. In Hindu mythology, Neelkanth was the name given to Lord Shiva when his throat turned blue after consuming poison from the sea. The poison is meant to symbolise vices and negativities that Lord Shiva controlled and made ineffective.

[5] In banking and finance, haircut refers to the lower-than-market value placed on an asset being used as collateral for a loan.

[6] A ‘Goldilocks economy’ is described an ‘ideal state’ for an economy, where the economy is neither expanding nor contracting by too much.- suggest this be modified or dropped please. The reference to Goldilocks in the article above is to a “just right” price for the asset, rather than anything to do with the state of any economy.

[7] In the past, New Delhi allegedly asked PSBs to lend to favoured corporate groups.

[8] Micro Units Development and Refinance Agency Bank (or Mudra Bank) is a public sector financial institution which provides loans at low rates to microfinance institutions and non-banking financial institutions which then provide credit to MSMEs.