Bad Bank: Turning Bad to Good

Icfai Bytes

5 years ago

Introduction

Bad debt is a global bane for the lending sector. The pandemic stress in 2020 and 2021 has added to the woes. Money lent by a bank needs to come back with interest through periodic payments. When this is defaulted perpetually, the loans involved become nonperforming assets (NPA). In India, the gross NPA ratio is expected to touch 13.5% during the current fiscal. About 75% of the unsuccessful businesses fail due mismanagement of funds. For instance, working capital loans are diverted to other exigencies. This disturbs the repayment schedule and turns the debt bad. NPA erodes banks’ credibility.

The Bad Bank

Though bank can take legal recourse against defaulters, it is not feasible always. This is where an asset reconstruction company (ARC) becomes relevant. An ARC is a specialist institution that buys the debtors of the bank at a mutually agreed value and initiates their recovery. ARCs are registered and regulated under the relevant statute (SARFAESI Act, 2002). The Capital requirement of ARC’s are met through private equity or public funding. As of July 16, 2020, there are 28 ARCs operating in India.

The National Asset Reconstruction Company (NARC) set up by public sector lenders, popularly called “The Bad Bank”, is the recent addition. NARC was to be launched by 31st March 2021. However till the time of uploading this article (4th May 2021) there is no official announcement on this. The initial equity capital of around Rs.7000 cores will be shared by the participant institutions, public sector banks and state-run NBFCs. The government backing makes NARC the first among equals.

Competency

The bad bank splits the assets into good and bad and focus on the recovery of bad loans. The recovery process involves buy outs, revamping the operations, takeover of the management or converting the debt into shares. The competency lies in selecting the right approach, as a faulty approach translates to losses.

Challenges

Bad bank too faces challenges. Here are some:-Loss incurred when the recovery process fails: ARC’s purchase the bad debts with a view to recover them. If the recovery fails due to some reason, the institution lands up in loss.
Wrong judgement of bad debts: Sometimes ARC could have purchased temporarily strained assets, which could have been revived otherwise , could be disposed at a low price.
Escape of accountability by lenders: Once bad loans are taken over by the ARC, the accountability of lending banks is likely to come down and banks may engage in reckless lending.
Excessive purchase price due to faulty negotiations. Sometimes ARC may have paid higher price for NPA, than it deserves.

Opportunities

Asset management business has great potential. The revenue generated from asset management is the main source of income for ARCs. In view of the risk involved, this is often a specialist’s domain. However opportunities exist by way of investment in capital and entering into partnerships. Reserve Bank of India (RBI) has allowed private equity and FDIs in ARCs. This enables high net worth individuals (HNIs) and venture capitalists (VCs) to access bad assets. Private players can also participate in the trust for asset management created by the bad bank.

Learner’s opportunity

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Discussion Questions

Do you think pressure on the banks to lend more is creating bad debts? Why?
What are the opportunities to the asset management companies on account of the bad bank?