Will the proposed Bad Bank cure India’s banking sector? Here’s how it may shape up

The lockdown restrictions were relatively higher in South and some parts of central region,” said Rajat Kumar Singh-business head of MicroBanking and Rural Banking, Ujjivan Small Finance Bank.

By Nitin Jain

In Feb 2021, RBI announced a structure for a proposed bad bank, “What you call a bad bank is not really that; an ARC-type entity will be set up to take over bad loans from the books of public sector banks and it will try to resolve just like any other ARC,” RBI Governor Shatikanta Das had said.

Proposed Structure of Bad Bank

Though no formal structure has been announced yet, we understand basis news reports, that a National Asset Reconstruction Company Limited (NARCL) is going to be set up to take over NPAs from banks. The Promoters are likely to be power finance companies while the PSU banks will hold the remaining equity stake in the ARC. As per recent news reports, state-owned banks have shortlisted 28 loan accounts to be transferred to the NARCL with a total of Rs 82,500 crore of loans due, and further loans could also be transferred such that the AUM is over Rs 2 lakh crore. The list of borrowers includes big names such as Videocon Oil Ventures Limited (VOVL), Amtek Auto, Reliance Naval, Jaypee Infratech, Castex Technologies, GTL, Visa Steel, Wind World, Lavasa Corporation, Ruchi Worldwide, Consolidated Construction.

Normally the NPA loans at the time of takeover by an ARC are valued around 30-40% of the principal amount. However, as we understand from news sources, in the case of NARCL the loans may be acquired at the current book value. The NARCL would pay 15% in cash and the balance 85% in security receipts or any other proportion as they may decide. Further, the government would provide a guarantee to the security receipts issued by the bad bank. Let’s assume that a bank sells a loan of Rs 100 to NARCL. Now, if the Bank has already made 75% provisions for the loan, then the book value of this loan is Rs 25, and 15% of Rs 25  i.e. Rs 3.75 is cash to be paid to banks. Thus, using these assumptions, for taking over say Rs 2 lakh crore of bad loans, a cash outflow of Rs 7,500 crores and issuance of SRs worth Rs 42,500 crore may be required. (Please note that these assumptions have been taken for the purpose of explaining this concept only and are not indicative or confirmatory in any nature).

Pros and Cons of the Proposed Bad Bank Structure

Pros
-Cleans the balance sheet of the banks.
-Will provide immediate relief to the banking system which will now be facing fresh NPA on account of disruption due to Covid.
-Banks will become capitalized and ready for fresh lending.
-Faster decision making by one body (NARCL) v/s Consortium of banks.
-A secondary market can be created for the SRs which have a sovereign backing, that would provide further liquidity to the banks.

Con
The actual recovery of these loans may be lower than the book value of the loans transferred, thereby could lead to erosion of capital at NARCL over the medium and long term.
-If NARCL will need to take decisive, focused steps to recover these loans, otherwise the process may not be successful.
-The process entails transferring the bad loans at current date, and recovery or resolution to happen in future.
-May lead to aggressive fresh lending by Banks.

Taking control of management of these companies from the Promoters. The RBI had demonstrated effective management of DHFL, by taking over the board and appointing an administrator to manage the company and find a resolution.However, a Bad Bank, or even a network of bad banks, will not make the losses disappear. The losses, or non-performing loans, transferred to a bad bank will still exist. The process may allow better recovery of these loans in future. It will be important for the banks to review their lending policies and put in place a robust risk management system.  Further, it would be crucial to see how NARCL will manage these bad assets. I believe that one will require specialized expertise for recovery of these bad assets such as:

-Interim Crisis Management in these Companies – restructuring, reducing costs, identifying surplus assets and to sell these assets to generate liquidity, and providing transparent and clear communications to all stakeholders.
-Classification of bad loans by sector. The Government already has significant expertise in the Road/ Highways and Power Sector via its Undertakings. However, expertise may need to be built in other sectors via sector experts to facilitate day-to-day management of the operations of the company and to find a viable resolution to preserve value.
-Provisioning policies of NARCL will need to be reviewed such that they are in accordance with the tenor/ maturity of the SRs issued.
-NARCL will need to take a decision as to the route to be taken for recovery from the bad loan. Some potential routes could be: 

1. 1. Initiating corporate insolvency process on the Company
   2. Engaging an investment banker to pursue mergers and acquisitions transaction for the said asset.
   3. Undertake a compromise or settlement u/s 230 of Companies Act.

Though the ‘Bad Bank’ appears to be a sweet pill for the banking sector to get rid of their immediate problems, it would be a tough task ahead for the proposed NARCL to preserve the tax- payers’ monies over the medium and longer term.

(Nitin Jain is a veteran corporate and investment banker having worked in banks like Standard Chartered Bank and Bank of America. He is a Restructuring Expert and is also an Insolvency Professional registered with IBBI. The views expressed in the above article are the author’s personal views.)