• Hriday Vora

Breaking Bad



NPA SITUATION:

The burning question – What is NPA?

An asset with a bank becomes a non-performing asset (NPA) if, as per the current RBI regulations, interest and/or principal on a loan remains unpaid for 90 days. Depending upon the nature of the security available / recoverability, banks are required to make provisions for these NPAs ranging from 15 to 100%. The sharp increase in NPAs over the years can be largely attributed to (1) A sustained economic slowdown for over a decade now (2) Unscrupulous lending by banks & Financial Institutions without proper assessment of actual funding requirements and its end use (3) Lack of monitoring (4) Somewhat ineffective legal system & insolvency process. This has resulted in the evaporation of lakhs of crores of public money over a period of time. The graph below gives an idea of the growing NPA menace in the Indian Banking System.

As evident, there has been a steady surge in the gross NPAs over the past 9 years. The gross NPAs crossed the Rs 10 lakh crore mark for a brief period in March 2018. For FY19, the absolute gross NPAs stood at Rs 9.36 Lakh crores (around 5% of the GDP).

Still not boggled by the huge numbers?

To put the gravity of the issue into a better perspective, as per CRISIL estimates, India will permanently lose 4% of its GDP as a result of COVID-19. Scared of doing the math? At Rs 200 Lakh crore of GDP, India stands to lose Rs 8 Lakh crore permanently. The actual impact on loan recovery will be known post the end of the 6-month loan moratorium in September 2020, and the results are less likely to be encouraging.

BAD BANK CONCEPT EXPLAINED:

Apart from the implementation of stringent loan monitoring mechanism and agile recovery process, there is another option which could give the banks a partial relief – A Bad Bank.

When a lot of junk we don’t need (old furniture, old car, age-old computer, etc.) gets accumulated in our homes, we have two choices – Sell them at a discount, write off the losses, and start with a clean slate. If we don’t, we incur expenditure on maintenance and storage which is at times higher than the fair value of the asset. The bad bank idea is somewhat equivalent to the first choice.

Let’s consider an example- XYZ Bank had given a loan of Rs 1000 crores to a company – PQR Ltd for a tenure of 10 years. Now, after 2 years, it is found that the company is not able to pay the balance loan of say 800 crores and it turns into NPA. In this situation, XYZ has two options – (a) sell this Loan to a bad bank at an agreed value which could essentially be at discount, or (b) let the loan continue in its balance sheet, while making the necessary attempts to recover it.

You might think, why would banks bother to sell their NPLs at discounts and incur losses? Well, if they don’t:

  1. Significant management bandwidth, which otherwise is supposed to be used to do core business, will get choked in managing the stressed assets.

  2. Banks would have to make provisions until either the loan is recovered, or a complete loss is recognized. This would have a domino effect on the net profits of the banks, their ability to grow further, their market valuation, among others. This could also impact the prospects of further capital raising by the banks.

  3. Higher NPAs in the bank’s balance sheet would mean a higher perceived risk by the market, lower credit ratings, and hence, the banks would have to pay higher interest for its fixed income instruments (Bonds/Fixed Deposits/Certificates of Deposits, etc.), leading to a higher cost of funding.

Put simply, A bad bank is supposed to relieve the banks from this tedious process of loan resolution and recovery, and give the management adequate bandwidth to carry on business as usual.

BAD BANK ADVANTAGES:

A. Less Provisioning/Enhanced Liquidity: Since the NPA account would be transferred to the bad bank, the selling bank wouldn’t need to set aside further reserves over and above already set aside/write back if already fully provided. Hence, the sale proceeds could be further profitably deployed.

B. Focus: By parking NPAs with a bad bank, instead of focusing on recovery, banks can actually focus on their core business, while the bad bank, with its expertise, can tread on the path of asset resolution and asset sale to maximize the recovery.

C. Speed of recovery: The bad bank, which would be created as a specialized agency to deal with toxic assets, could hire specialized personnel to manage those assets. This would help ensure a speedy resolution of assets with minimal losses.

D. Ratings: With bad loans off the books, rating agencies such as CRISIL, CARE, ICRA would upgrade their ratings of the banks, resulting in a decreased perceived risk. This would in turn help them raise funds at lower costs.

BAD BANK DISADVANTAGES:

A. Incentive for banks to continue with Reckless lending: If banks become aware that there will always be a bad bank to take over and manage their toxic assets, then they will tend to be less careful while granting loans. A potential solution could be capping the amount of bad loans sold at a fixed % of total NPAs for every bank, based on its size and total advances.

B. Faulty concentration: The bad bank set up might not take up critical accounts where loan recoveries are a challenge. They might concentrate on acquiring those accounts, where recoveries could be made easily in comparison.

C. Fire sale externality: The regular bank usually transfers the toxic assets to the bad bank at a discounted value. This lowers the market value of similar assets held by other banks. This forces the other banks to liquidate similar assets at lower prices, thereby starting a vicious cycle which further pushes the prices of the assets below their fair value. This is known as the fire sale externality.

D. Political interference: Since toxic assets would be held by a bad bank, it may be prone to political interference, based on the ownership structure. Unless effective mechanisms are put in place to deal with the issue whereby ownership and management will have to be strictly independent of each other, this risk will remain.

SO WHY IS A BAD BANK STILL A THEORETICAL CONCEPT?

Let's do a Reality Check. In theory, setting up a bad bank might appear easy, but the reality is different. An important issue to deal with is - who will provide the initial capital and working funds? the Government? Banks themselves? Specialized distressed funds? Or a combination of these? If combination, is there any conflict of interest among the stakeholders? The answer is difficult but not impossible. Capital could be brought in by the government, and working funds could be mobilized from the public for which the government would have to give assurance of the safety of public money.

A major bone of contention between the lenders and the bad bank would be the valuation of bad assets. Then the question would be if the bad bank realizes less than the price paid to the bank, whether the selling bank would be held responsible to make good those losses. If the answer is yes, then the purpose is defeated. Therefore, once an asset is bought by the bad bank at a mutually agreed valuation, there should be no way that the selling bank is associated with the asset. The last potential barrier could be the selling bank demanding cash upfront for the value agreed upon. It may not accept consideration in the form of long-tenor illiquid security receipts as they might have no secondary market for trading.

Therefore, for the bad bank concept to reach the actualization stage, some of the key fundamental issues listed above would need to be addressed.

Having said this, the only long-term solution to prevent the public money from evaporating into thin air is for the banks themselves to adopt careful lending practices with stringent monitoring and recovery policies. But till the time this is in place, for the short term, a bad bank could be put to use to mop up the mess created by banks.



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