Baba’s Explainer – Bad Bank: NARCL & IDRCL

• Boom years of late 2000s: A large part of the problem started in the latter half of 2010s, as assumptions of persistently high economic growth made several large corporates overzealous in their investment ambitions, thus over-leveraging themselves in the process.
• Role of Easy Credit by Banks: On the prospects of high economic growth financial sector, led by public sector banks, fuelled these expansion plans through easy money on credit.
• 2008 Financial Crisis: Growth (and demand) fizzled out following the global financial crisis of 2008. Despite the fire-fighting measures taken by government, the impact of the global crisis was felt in coming years. The crisis got further precipitated by Policy Paralysis of UPA-2 government (Corruption Scandals, Coalition Politics, standstill bureaucracy)
• Vicious cycle: The stress from stretched corporate balance sheets (revenue impacted due to slowdown) infected banks’ own books and underwhelmed banks own capacity for fresh lending. Former Chief Economic Adviser Arvind Subramanian had called it India’s ‘twin balance sheet problem’ in the Economic Survey for 2016-17.
• Recognition of Bad loans: Over the course of 2014-19, India’s banks were put on high alert by RBI for tighter recognition norms for bad loans for it believed that that NPAs were being under-stated.
  • NPAs in 2015-16 almost doubled over the previous year as a result. It is not as if bad decisions had suddenly happened. It’s just that the cumulative bad decisions of the past were now coming to be more accurately captured.
  • In March 2018, when bad loans on their books peaked to over ₹10 lakh crore — around 11.5% of all loans.
  • Public sector banks (PSBs) accounted for ₹8.9 trillion, or 86%, of the total NPAs. The ratio of gross NPA to advances in PSBs was 14.6%. These are levels typically associated with a banking crisis.
  • For example, in 2007-08, NPAs totalled only ₹566 billion (a little over half a trillion), or 2.26% of gross advances!
• The vicious cycle of twin balance sheet problem was interrupted to an extent by the Insolvency and Bankruptcy Code, which, along with tighter recognition norms for bad loans, helped correct the course over time.

• The RBI had, in December 2021, warned that bad loans of commercial banks could rise to anywhere between 8.1% and 9.5% under varied degrees of stress by September 2022, from 6.9% in September 2021.
• True Picture will emerge when support measures are rolled back: RBI believes that a real picture of the state of borrowers’ accounts (and consequently, the banking system in general, and the economy at large), will emerge once the policy support measures are rolled back. Had the central bank’s normal loan classification norms been followed instead of the COVID-19 relief measures, bad loans would have been higher, the RBI has argued
• Housing Finance Sector may drive NPAs in Future: RBI has also warned about large-scale loan defaults looming over housing finance companies, which have been hit by delays in completion of housing projects, cost overruns due to reverse migration of labourers, and delayed investments by buyers in the affordable housing sector as incomes shrank and jobs were lost.
• The K V Kamath Committee, which helped the RBI with designing a one-time restructuring scheme, also noted that corporate sector debt worth Rs 15.52 lakh crore has come under stress after Covid-19 hit India, while another Rs 22.20 lakh crore was already under stress before the pandemic.
• This effectively means Rs 37.72 crore (72% of the banking sector debt to industry) remains under stress. This is almost 37% of the total non-food bank credit.
• The panel led by Kamath, a veteran banker, has said companies in sectors such as retail trade, wholesale trade, roads and textiles are facing stress. Sectors that have been under stress pre-Covid include NBFCs, power, steel, real estate and construction. Setting up a bad bank is seen as crucial against this backdrop.

• In every country, commercial banks accept deposits and extend loans. Banks and other financial institutions are considered as the key drivers of economic growth, as they are the formal channels of credit.
• The deposits are a bank’s “liability” because that is the money it has taken from a common man, and it will have to return that money when the depositor asks for it.
• Moreover, in the interim, it has to pay the depositor an interest rate on those deposits.
• In contrast, the loans that banks give out are their “assets” because this is where the banks earn interest and this is money that the borrower has to return to the bank.
• The whole business model is premised on the idea that a bank will earn more money from extending loans to borrowers than what it would have to pay back to the depositors.
• A loan can turn bad when the borrower is unable to repay it back. In such case two things happen.
  • One, the concerned bank becomes less profitable because it has to use some of its profits from other loans to make up for the loss on the bad loans. Their capital got eroded as a result. Without adequate capital, bank credit cannot grow.
  • Two, it becomes more risk-averse. In other words, its officials hesitate from extending loans. Lower credit off take translates to lower capacity of economy to expand its activities i.e. lower economic growth.
• If such “bad loans” in a bank rise alarmingly, the bank could close down.
• When several banks in an economy face high levels of bad loans and all at the same time, it will threaten the stability of the whole economy.
• From the taxpayer’s perspective, the most worrisome fact was that an overwhelming proportion of bad loans was with the public sector banks (PSB), which were owned by the government and hence by the Indian public.
• To keep such PSBs in business, the government was forced to recapitalise them — that is, use taxpayers’ money to improve the financial health of PSBs so that they could carry on with the business of lending and funding economic activity.
• Despite recapitalisation, the problem of bad loans did not subside. Therefore, it was argued by many that the government needs to create a bad bank — that is, an entity where all the bad loans from all the banks can be parked.

• Technically, a bad bank is an asset reconstruction company (ARC) or an asset management company that takes over the bad loans of commercial banks, manages them and finally recovers the money over a period of time.
• The bad bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans in
• The takeover of bad loans is normally below the book value of the loan (provides certain margin to ARC). The bad bank subsequently tries to recover as much as possible using its expertise in stressed asset resolution.
• The bad bank concept is in some ways similar to an ARC but is funded by the government initially, with banks and other investors co-investing in due course. The presence of the government is seen as a means to speed up the clean-up process.
• US-based Mellon Bank created the first bad bank in 1988.

• Banks’ Burden is Reduced: The burden of recovering those loans is reduced for other banks. While commercial banks resume lending, the so-called bad bank, or a bank of bad loans, would try to sell these “assets” in the market.
• Specialisation leads to faster recovery: Speed of recovery will be better as Bad Bank’s main work is recovery and they are specialised in that.
• Positive Impact on Financial Sector: Bad Bank will help improve the banking sector’s health and fasten the recovery aspects of ailing by putting back frozen assets back into economic circulation.
• Increased Profitability of Banks: Bad Bank increases profitability of other banks as they can focus more on lending, acquiring more customers and upgrading technology without spending too much time on recovery or resolution of bad loans
• Complements Previous Measures: Despite a series of measures by the RBI for better recognition and provisioning against NPAs, as well as massive doses of capitalisation of public sector banks by the government, the problem of NPAs continues in the banking sector, especially among the weaker banks.  Having a Bad Bank will complement other measures taken by RBI & government to clean up banking sector.
• Helps solve economic aftershocks of Pandemic: As the Covid-related stress pans out in the coming months, proponents of the concept feel that a professionally-run bad bank, funded by the private lenders and supported the government, can be an effective mechanism to deal with NPAs.
• Feasibile: Bad banks can make profits as they usually keep high margin before acquiring the bad loans. The concept of Bad Bank has been implemented in other countries including Sweden, Finland, France and Germany.

• Shifting of Problem: Former RBI Governor Raghuram Rajan had opposed the idea of setting up a bad bank in which banks hold a majority stake. He was of the opinion that bad bank idea as merely shifting loans from one government pocket (the public sector banks) to another (the bad bank).
• Reckless Lending: Other banks may not concentrate on the quality of loans as they always an option of shifting bad loans to ARC/ Bad Bank. This leads to doling out loans without proper diligence leading to reckless lending
• Efficacy Debate: Bad banks may not acquire critical loans which are difficult to recover and only concentrate on easily recoverable loans. As a result, troubled Commercial banks continue to face the issue of bad loans. There is also the fear that it ends up as another case of throwing good money after bad.
• Profitability of Banks: High margin of Bad banks may curtail the profits of other banks which can in turn impact their lending capabilities.
• Moral Issues: Due to pressure bad banks may employ some unethical ways to recover loans. Another issue is that other banks may not show the actual position of loan accounts by doing window dressing.

• Following up the 2021 Union Budget announcement, government has incorporated “National Asset Reconstruction Company Limited” (NARCL) under the Companies Act.
  • It will acquire stressed assets worth about Rs 2 lakh crore from various commercial banks in different phases.
  • Public Sector Banks (PSBs) will maintain 51% ownership in NARCL.
• Another entity — India Debt Resolution Company Ltd (IDRCL), which has also been set up — will then try to sell the stressed assets in the market.
  • PSBs and Public Financial Institutes (FIs) will hold a maximum of 49% stake in IDRCL. The remaining 51% stake will be with private-sector lenders.
• The NARCL-IDRCL structure is the new bad bank.
• To make it work, the government has provided Rs 30,600 crore to be used as a guarantee. Government guarantee, valid for five years, helps in improving the value of security receipts, their liquidity and tradability.

• NARCL and IDRCL will have an exclusive arrangement that will be as per the scope defined in the ‘Debt Management Agreement’ to be executed between these two entities. This arrangement will be on a ‘Principal-Agent’ basis and final approvals and ownership for the resolution shall lie with NARCL as the Principal
• The NARCL will first purchase bad loans from banks. It will pay 15% of the agreed price in cash and the remaining 85% will be in the form of “Security Receipts” guaranteed by the government.
  • Although the government is giving guarantee on the SRs, it has not contributed to the equity of the bad bank.
• When the assets are sold, with the help of IDRCL, the commercial banks will be paid back the rest.
• The government guarantee will essentially cover the gap between the face value of the security receipts and realised value of the assets when eventually sold to the prospective buyers. It is for this purpose Rs 30,600 crore has been provided by the government.

Concerns

• RBI has raised concerns over the lack of clarity on the regulatory oversight of an asset management company (AMC) that was proposed to be set up under the overarching structure of the NARCL.
• The RBI has asked while it will have a regulatory/supervisory role over the NARCL, whom is this AMC accountable to?.
• This, coupled with some other operational issues, has delayed the transfer of large bad loans of about Rs 50,000 crore to the NARCL in the first phase from the initially targeted deadline of March 2022.
• As the NARCL concept is new to India, once regulatory clarity is established, it will pave the way for the setting up of similar entities in future