Why a bad bank is good

Rohit Mehta | Updated on July 29, 2021

It is vital for restoring the banking system’s health

Talk of a bad bank has been around for the last 3-4 years. The creation of a new ARC (National ARC) and a new Asset Management Company (AMC) model was announced in last year’s Budget.

The banking system, despite resolution of major stressed assets in the last two years such as of Essar Steel, Bhushan Steel, and DHFL, is still weighed down by a sizeable NPA portfolio. The new ARC will address legacy NPAs worth ₹2-lakh crore. The 100 per cent provided NPA is the initial major criteria for proposed transfer to ARC, which will be a “win-win” proposition. Assets can be assigned at close to realisable value with upside cushion and, importantly, no incremental hit on the balance sheet of lender(s). This will also provide resolution flexibility to the new ARC. It will enable banks to focus on credit growth.

ARCs have played a significant role in resolution of stressed assets for almost two decades with assets under management of ₹4.3-lakh crore. But a significant drop in transaction has been observed over last 3-4 years due to withdrawal of provisioning protection to lenders on debt assignment (available only if 90 per cent paid in cash). ARCs’ capital constraints for large assets, price expectations mismatches, delays in debt aggregation, etc., are the main reasons for the drop in transactions. By addressing these issues and precedents, the proposed bad bank construct ticks most boxes.

RBI’s stress tests show that the bad-loan ratio will rise to 13.5 per cent by September (highest since 2000). So, the Indian Banks Association proposed to the RBI the creation of a bad bank, with initial focus on loans fully provided for and not resolved either under the IBC or other extant frameworks.

The proposed structure

A National ARC will be formed to acquire 50-60 assets, with debt exposure more than ₹500 crore each. The equity contribution for the ARC, for cash pay-out would be infused by 11 identified lenders — nine banks and two financial institutions. The National ARC would indicate the base offer price for the asset at the time of assignment and the Swiss Challenge method will be followed for compliance perspective. These assets will be transferred to the National ARC (presuming no other outbidders) at 15 per cent upfront cash for acquiring these assets at the base price. Security Receipts (SRs) would be issued for the balance 85 per cent to transferring lenders, which are expected to be partly guaranteed by the government. These securities can be traded to allow lenders to monetise the SRs in the secondary market.

The ARC through a step-down AMC mechanism will manage the assets for sale/resolution. The controlling stake of AMC shall be with private players with the aim of speeding up decision making and ensuring best feasible recovery for the asset.

Some of the issues that need attention are:

1. The resolution process must have a sunset clause that requires developing time bound strategies to resolve each category of assets. This will protect it from turning mere parking space of sticky advances and balance sheet management vehicle.

2. As major NPAs are fully provided for, pricing can be based on conservative approach but, as the process matures, new acquisitions can be based on market-driven price references for different assets/asset pools and mechanism needs to be in place.

3. Till resolution of the acquired assets, there may be a need for interim critical funding for sustaining quality of assets, and advisory support for scouting investor, for which a suitable mechanism is needed.

4. A regulatory framework and a market for distressed assets needs to be created to determine market value of these assets.

For the Indian banking system a lot rides on the success of the bad bank. But it should be a one-time exercise.

The writer is Head - Special Situation Advisory Team at Edelweiss Wealth Management

Published on July 29, 2021

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