How to make good assets with a ‘Bad Bank’

While the economy is bouncing back, the banking sector, considered its lifeline, looks for an anchor for revival. Although the Budget provides a glimmer of hope, the rise of the banking sector depends on various other factors.

One of the major announcements for the sector is establishment of an Asset Reconstruction Company (ARC, also referred to as a Bad Bank) to improve bank balance-sheets. The need for cleaning up the debt from banks’ books assumes importance as it will help them raise capital and boost public confidence in the banking sector, which will in turn aid the economy in its rapid resuscitation.

The factors that may affect the successful implementation of the policy proposal can be classified into controllable and non-controllable categories. The former includes factors such as expertise and capability of the officials in charge of the new ARC, the financial design, and the structuring of the debt (for example, bifurcating the debt into categories and bundling relatively good and bad debt). The latter set includes the amount realised from the stressed assets, which in turn also depends on the revival of the sector concerned and the response of the economy.

Though the ARC can help banks reduce their NPAs (non-performing assets) and widen the capital base, it is still a makeshift solution. There is need for a lasting solution in the form of structural changes. It can be implemented in the mid-term by way of prudent lending and in the long-term by bringing in policies to make the debt market more active. This will not only help in getting rid of the twin balance-sheet problem but also bring in efficiencies by adopting market mechanism (this will also help in faster recovery of bad loans by employing the existing ARCs and avoiding the procedural delays).

ARCs in India

Whether a new ARC is required can be gauged only when the modalities of the proposed ARC are available. But ARCs certainly can help in better recovery of the assets, owing to their expertise in the area. As of July 16, 2020, there were 28 ARCs registered with the RBI; a marginal increase from 24 in November 2017. This was because the RBI, in April 2017, increased the minimum net owned funds to ₹100 crore for ARCs from ₹2 crore earlier as it viewed increased cash-based transactions.

This brings the question of increased capital requirement of ARCs. This can be achieved by consolidation among existing ARCs or by attracting more investors. As for consolidation, it can be attained by bringing together existing small ARCs (by assets under management) or by merging small ARCs with larger ones. As of March 2019, around 70 per cent of the market was concentrated in the top three ARCs (by AUM). Thus, there is a scope to increase the capital base and hence expedite the recovery of stressed assets, as they will not have to wait for the fulfilment of the need for funds.

The need for funds held by ARCs increases because according to the amendments to the RBI framework for SCs/RCs, ARCs are required to invest a minimum of 15 per cent in the security receipts (SRs) of each class issued by them till redemption (15:85 model) from the 5 per cent earlier. Consequently, the increased capital base is the need of the hour.

Another alternative to increase the capital base could be consolidation of small ARCs. This would help them bring in new business by charging competitive fees vis-a-vis the big ARCs. This will also help in efficient pricing and the competition would encourage the ARCs push for faster recovery of the stressed assets.

Attracting more investors is another way of boosting the capital base. The Department of Industrial Policy and Promotion (now Department for Promotion of Industry and Internal Trade) allowed foreign investment of up to 100 per cent in ARCs in 2016. But foreign investments in ARCs remain low. Small ARCs, by increasing their business after consolidation, can attract more foreign investments. Also, big ARCs having around 70 per cent of the market can take over the small ARCs and this will attract more foreign investment in them and, thereby, hasten resolution.

Increased investment in security receipts will also increase the liquidity of such SRs which, in turn, will attract more investment. Once the liquidity is increased, other investors (non-institutional investors) can also be sought to invest in such securities. According to the Enforcement of Security Interest and Recovery of Debts Laws and Miscellaneous Provisions (Amendment) Act, 2016, any qualified buyer can invest in SRs which includes financial institutions, insurance company, bank, state financial corporation and others.

It also includes any category of non-institutional buyers as specified by the RBI. So, high net-worth individuals and HUFs (as the current minimum allotment size of SRs is ₹10 lakh) may get an opportunity to invest in SRs as the market develops.

Government support

There has been talk about whether the government should back the new ARC. There are cases in Asia where governments have invested directly in ARCs. The Indonesian government issued recapitalisation bonds and the assets were transferred to IBRA, and Japan issued government guaranteed bonds and the funds were used to invest in RCC.

The issue with SRs is that of restricted access; only qualified buyers can invest in them and hence are less liquid. If the government issues bonds and uses the proceeds for recapitalisation, this would help in faster recovery of assets and make the bond market active.

Further, the debt-servicing requirement on ARCs can be transferred. The government can also provide guarantee as is being discussed by experts, but then the issue of liquidity and interest payments arise. Nevertheless, government support will be required as the realisation from the stressed assets will not fully clean bank balance-sheets as the amount realised will probably be less than recorded in books while transferring stressed assets to ARCs. Though the capitalisation package of ₹20,000 crore has been announced in the Budget, it needs to be seen how the amount will be utilised.

Chandra is Assistant Professor of Finance & Accounting and Khanna is a doctoral student at VGSoM, IIT Kharagpur

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