A Clarion Call for ‘Bad Banks’: A Scrutiny in the times of COVID-19

– Harsh Dhiraj Singh & Vaibhav Kansara

INTRODUCTION

Extraordinary times require extraordinary solutions. The saying has made a headway for the banking sector as COVID-19 gives impetus to the deteriorating Non-Performing Assets’ (NPAs) situation in the banks’ balance sheets. With the conditions worsening, the hue and cry around the long-awaited and deliberated concept of ‘bad banks’ has taken shape once again. The idea behind introducing a ‘bad bank’ is to unclog the banks by putting all their NPAs in a separate entity controlled and managed by government and banks’ association. This bad bank will work as an Asset Restructuring Company (ARC) which will buy off these NPAs at the market prices and subsequently devise a resolution mechanism for these stressed assets to find probable buyers in the market.

Constitution of the Sunil Mehta Committee in 2018, suggestions in the 2017 Economic Survey and other historical debates in the year 2004, 2015 etc. have revolved around the idea of constituting a ‘bad bank’. This phenomenon was firstly observed in 1988 when Mellon Bank in the United States formed a bad bank to clear off the NPAs of Grant Street Bank. Nevertheless, it’s still a pipe dream in India because of the various pros and cons that the concept conceptualizes when implemented in practicality.

The major limbs of debate have largely spun around the determination of rates at which these NPAs would be bought, the non-viability of the capital infusion and support by the government and lastly, the very fundamental question: how does it help to just shift NPAs from one entity to another? In this piece, the authors attempt to answer all these questions while elucidating upon the various issues posed by the growing pandemic and the response given to it by the government. The concluding section of this article will attempt at structuring a bad bank framework for India.

THE PROPOSED STRUCTURE

The structure of bad bank has been derived from ‘Project Sashakt’.  Primarily, it would function by employing three different bodies: Asset Management Company (AMC), Asset Reconstruction Company (ARC) and an Alternative Investment Fund (AIF), having separate functions of their own.  The role of these bodies comes into play after the assets of the banks are segregated into good and bad, commonly known as NPA, based on their recoverability. These bad assets are then accommodated by ARC, having 15% investment by Government, at book value relieving the burden of banks to continue their lending operations. The process of recovery would be handled by AMC and AIC via involvement of external parties. AMC, a body of professionals, would identify the right assets and auction them to get a fair value from both private and public entities while the major focus of AIF will be on raising finance through secondary market including issuance of securities in lieu of such NPAs.

COVID-19 & BAD BANKS

• The Categorization of Assets has become difficult

The model of a bad bank strives on the basic classification of a good and a bad asset. This classification runs deeper into the framework with categorization of assets that can be restructured in a shorter frame vis-à-vis those assets which require a longer restructuring time period. However, in the present scenario where the Reserve Bank of India and SEBI are coming out with a hoard of relaxations in timelines for compliance, especially moratorium on loans, the classification criteria has become rather complicated.

 A distinction between loans that a borrower has not repaid voluntarily versus those loans whose compliance timelines have extended due to such measures by RBI, has been blurred. Moreover, the anomaly that the sector faces is a substantial one: is there any ‘bad’ debt circulating in the economy for a ‘bad bank’ to be formed? This might become one of the major arguments from the defaulter’s end as the relaxations are brought forth.

It has been estimated that around 328 companies have already sought moratorium from banks. Additionally, lending to small and medium industries as well as start-ups is under immense pressure, which makes it even more difficult for the government to run a check on the ‘bad’ debts in the economy. The sector is expecting a ‘sympathetic’ approach from the government in these tough times. Nevertheless, a step as benevolent as constitution of a bad bank could be seen as disastrous because of the vague and equivocal classification of assets.

• How is it different from pre-existing restructuring bodies in India?

Essentially, a bad bank, in its framework and functionality, is an Asset Restructuring Company. It aims to revive these stressed banks by: firstly, infusing fresh credit to set off the liabilities in a bank’s balance sheet; secondly, finding buyers for these stressed assets in the market. A very significant question can be raised about this functionality of the proposed bad bank: why do we need it when there are already 28 such ARCs in India, doing the same task since time immemorial?

The problems that plagued the earlier models was that of asset valuation. The price at which assets were bought by the bad bank were significantly inflated and that raised a question on their efficiency. This also gives rise to a new thread of concerns about the new proposed framework for bad banks. Though it can be said that the government infusion of INR 10, 000 crore can be a booster from the framework, but it looks more of a temporary solution on the face of it. In a nutshell, the uncertain times of COVID-19 pose such unusual threat to these bad banks, that it might only backfire on the government and ultimately on the public through tax payments.

Incessant rejection of the idea in 2015, 2017 and failure of the already existing ARCs highlight the need for this new proposal to include something different from its earlier attempts. Ambiguous classification of assets, unclear compliance timelines and the same old traditional framework could only make bad banks look more ‘bad’ in these unusual times.

•  Learning from the 2008 Financial Crisis and Co-Existing Legal Mechanisms

The present financial crisis has more severe impact on the economy than GFC 2008. In GFC 2008, the monetary policies like cutting interest rates and pumping liquidity in the economy were efficiently implemented, but in the present situation, even though the interest rates have been reduced to zero by RBI the impact is disquieting. This shows unresponsiveness of the market due to uncertainty and these conditions are not conducive for functioning of bad banks, which is highly dependent on external factors i.e. parallel growth of the economy. In essence, this is a twin process: bad banks would boost the economy only if the economy is growing at a satisfactory rate. Further, due to the Global Economic slowdown it would be strenuous to find buyers for NPAs, which is the backbone of these bad banks. This, in turn, would lead to mere transfer of NPAs from one entity to another without much potential of it to be bought in future. Bad Bank would only create a façade. However, the reality behind it would be different as the bank would get a sense of security for reckless lending activities, which was never intended at first instance.

Another problem lies in its function which focuses only on dealing with the present stock of NPAs rather than reducing future NPAs, which is a major concern for the economy.

Formation of Bad Bank will substantially override the functioning of IBC, which has been found to be successful in recovery process of NPAs, with similar objectives of maximisation of value of assets and to promote availability of credit. The difference arises in the manner as Bad Banks depend on the public funds i.e. tax, and IBC looks for a resolution plan without dependency on Government funds. Hence, in case of failure, the former would do greater harm to the economy.  The creation of Bad bank would also stall IBC proceedings as once the NPAs have been transferred to Bad Bank, CIRP cannot be initiated, as it would substantially reduce the value of assets and investors would refrain from buying the same and this would increase the gestation period, and a situation of irrecoverable loss may arise where only immediate recovery could have been possible. The present pandemic has lasting impact on economy and it would be very difficult to find investors to purchase stressed assets. Hence, the whole idea of Bad Bank would fall on ground.

CONCLUSION

In essence, it needs to be understood that bad banks are nothing but a government backed Asset Reconstruction Company. The difficulties posed by classification of assets and the decisions taken to funds these stressed assets can be extended to this new model of bad banks as well. Parallel operating mechanisms like the  other existing ARCs, IBC proceedings etc. can mitigate the scope of such a bad bank.

The framework of a bad bank is suitable for any other time but not that of a pandemic. The best that this framework can do at this instance is to find suitable buyers for these stressed assets in the shorter run. The investment of INR 10, 000 crore by the government is well equipped to sustain that much load and it will also give some sense of direction to this newly formed body. In conclusion, the banking sector and the government needs to see the plain truth and designate this bad bank as a holistic ARC, rather than a ‘bank’, which would only hamper the survival of this framework in the long-term. In nutshell, with tougher times on our plate, a bad bank is still a pipe dream for the Indian economy.

This article is authored by Harsh Dhiraj Singh & Vaibhav Kansara. They are students of law at National Law University, Jodhpur.