Banking Article, Banking Finance 2022, Banking Finance December 2022

How Bad Banks can help the crippling crisis of non-performing assets:

The banking sector in India has been affected by the rise in non-performing assets (NPAs) for a long time. This has impacted their profits, and the ongoing pandemic has only made things worse for them. As per a Times of India story, most of the NPAs are from the loans sanctioned by banks to businesses in the mid-2000s when the economy was booming. Many businesses have struggled to repay their loans after the global financial crisis in 2008 as corporate profits decreased, which increased non-performing assets.

According to India’s Financial Stability Report released by the Reserve Bank of India (RBI) in January 2021, banks’ gross non-performing assets could rise from 7.5% in September 2020 to 14.8% by September 2021 in a severe stress scenario. The Government has recognized the problem, and the Finance Minister announced the creation of a new bad bank in the Union Budget 2021 to resolve the NPA crisis and stabilize the banking sector in India. So now, the question is- What is a bad bank and can it resolve NPA problem?

What areBank NPAs?

An Asset becomes non-performing when it stops generating income for the bank. In simple terms, NPAs are loans or advances where the principal or interest payments are not paid by the borrowers for a minimum of 90 days. After 90 days of the non-repayment of interest or principal amount such loan becomes sub-standard assets. Such non-performing assets are classified in to three categories:

Sub Standard Assets: Assets that are remain NPA for the period up to 12 months.

Doubtful Assets: If the non- performing assets remain in sub-standard category for 12 months it will be further classified as Doubtful Assets.

Loss Assets: The non-performing where there is no chance of repayment/ recovery as well as there is no security available in the account.

NPAs impact on Banks:

Banks have to kept aside fund to make a provisioning of prescribed percentage to compensate for the loss due to bad assets. It affects the profitability of banks as they have lesser funds available for lending. As a result of rising NPAs of banks reduce the money supply in the economy and leading to an economic slowdown. As a result of provisioning and losses incurred by the bank capital crisis also occurs which results in capital demand from the Government and the Govt. has to infuse the capital for the credit flow in the economy.

 There are some the main reasons for the rise in banking NPA’s.

Crony capitalism:  It is the nexus between political and the business class which have led to the rise of NPAs in banks.

The Government policies: Some of the government policies viz. waiving of agricultural loans have increased NPAs of public sector banks.

Frauds of high magnitude:  There are some many frauds happened in the recent past which leads to rise in NPAs. Such as the Rs.14000 crore scam in Punjab National Bank by Nirav Modi as per the news.

The Global Finance Crisis:  The global crisis in 2008 impacted corporate’s ability to repay their bank loans which in turn impacted the banks ability to lend more money to corporates.

Bad Lending Practices: When the bank neglect basic factors like repaying capacity the accounts turns NPA in future.

Competition: There is a competition amongst the bank themselves and provide higher quantum of unsecured loan.

What is a bad Bank?

The idea of a Bad bank is first mention in Economic survey 2016-17. Public Sector Asset Rehabilitation Agency or PARA, to buy out the NPAs of high value from Indian Banks. Two Models proposed by Shri Viral Acharya; former RBI Dy. Governor in their speech on ways to Resolve Banks Stressed Assets. 1. PAMC- Private Asset Management Company, 2. NAMC- National Asset Management Company. The Indian Banks Association (IBA), have refloated an old idea of creating a bad bank to Finance Ministry and RBI, proposing equity contribution from the govt. and the banks.

Bad bank is an Asset Reconstruction Company which are specialized financial institutions that buy NPAs of banks/lenders to help clear their balance sheets. Banks sell stressed assets such as delinquent loans to bad banks at a mutually agreeable price to get rid of them and focus on normal banking services. ARCs purchase the rights of banks in loans, debentures and bonds with the main intention of recovering them over time. The banks sell their non-performing assets to ARCs, where they get 15% of the value of these assets in cash upfront as per RBI norms and the remaining 85% through security receipts (SRs) and bonds, which have a maximum maturity period of six years. When ARCs recover the bad loans, they repay the banks after deducting management fees.

As per IBA proposal The Bad Bank will be a 2-tiered structure;

Tier I: ARCs backed by Government

Tier II: ARCs run by Pubic and Private Bodies including banks.

Regulations for Asset Reconstruction Company:

  • Asset Reconstruction Company is a company registered under section 3 of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act 2002.
  • It is regulated by Reserve Bank of India as Non-Banking Financial Company (u/s 451(f) (iii) of RBI Act 1934)
  • ARCs must have minimum Net Owned Funds of Rs.100 Crore and maintain a Capital Adequacy Ratio (CAR) of 15% of RWA (Risk Weighted Assets).
  • The banks must transfer NPAs to ARCs at the net book value (the assets value minus the bank provisioning against the stressed assets).

How do ARCS get funds:

  1. Arcs purchased NPAs from banks at lower price that their actual value
  2. Banks transfer NPAs to the ARC along with their respective security (collateral)
  3. The ARCs issue Security Receipts (SRs) against these NPAs to raise funds
  4. Qualified Institutional buyers (QIBs) invest in these SRs for higher returns as they take a higher risk.
  5. ARCs use these funds received from QIBs to make upfront payment while buying NPAs.

How can a Government -backed Bad Bank Solve the NPA crisis?

The Asset Reconstruction Company India, which is owned by financial institutions such as ICICI Bank, IDBI Bank, SBI, PNB and Avenue India Resurgence Pte, is the oldest ARC in India. There are 29 ARCs in India as of March 2021, with the bulk of the assets under management AUM held by the top five ARCs. For instance, 76% of assets under management were held by the top-five ARCs as of March 2020. As per ICRA, Indian banks currently have gross NPAs of around 9.6%, with substantial NPAs of large banks being unresolved for years. The Government can resolve the banking crisis in NPAs through a Government-backed bad bank.

The Government may create a bad bank where the public sector banks are the main stakeholders. It is crucial as many Public Sector Banks (PSBs) hesitate to transfer NPAs to private ARCs, fearing an investigation by government agencies on the reason for these NPAs. PSBs would resolve bad loans through a Government-backed bad bank as they don’t fear government interference with their business transactions.

There are some reasons why a government – backed bad bank may resolve the banking NPA crisis:

  • Private ARCs seek deep discounts when purchasing NPAs from individual banks. The government- backed bad bank may help banks get a higher valuation while selling their bad loans.
  • Smaller ARCs with low capital may struggle to conduct cash deals with banks having large NPA accounts. The Government backed bad bank has the funds to purchase the large NPA accounts of banks. Otherwise banks would have to approach the NCLT (National Company Law Tribunal) Court, which is a time-consuming process with the little chance of a resolution.
  • Private ARCs may have to seek approval from many lenders while purchasing consortium loans which causes needless delay and cost overruns. The government-backed bad bank may aggregate the industry’s bad loans and ARCs could negotiate with a single entity to purchase NPAs.

The banking sector in India desperately needs a government-backed bad bank to resolve the banking NPA crisis. Banks can easily transfer bad loans to this entity at a higher valuation and focus on productive lending. Moreover, banks have suffered heavy losses by writing off bad loans. The government-backed bad bank could leverage its financial resources to purchase and resolve banking NPAs as the economy recovers from the Covid-19 pandemic.

The advantage of setting up a bad bank, is that it can help consolidate all bad loans of the banks under a single exclusive entity. It will take bad loans off the books of troubled banks, and help free capital of over Rs. 5.00 Lakh Crore that is locked in by banks as provisions against these bad loans. This will give banks the freedom to use the freed- up capital to extend more loans to customer; which in turn will help in economic growth.

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