The finance minister (FM) has stated that an asset reconstruction company (ARC) and an asset management company (AMC) would be set up to consolidate and take over the existing stressed debt of the banks and then manage and dispose the assets to alternate investment funds (AIFs) and other potential investors for eventual value realisation. The ARC/AMC taking over the existing stressed debt of public sector banks (PSBs) has been described as Bad Bank (BB). The assumption is that with the BB cleansing the PSBs, the PSBs’ problems would be over. Let me explain that the BB in isolation will not prove to be a panacea for the PSBs
High NPAs of PSBs: Chronic Malady
In India there is a significant impact of bank NPAs (non-performing assets) on the country’s GDP since the country’s financial system is predominantly bank-based. Hence, it is necessary that the banks must perform well and aid in the gross domestic product (GDP) growth. This means that the banks must have manageable NPA levels which, in the worst case, should be significantly less than 5% as is seen worldwide and even for well-run private sector banks in India. However, NPAs of Indian banks, particularly the PSBs remain unmanageably high (figure-1).
NPAs of PSBs, which had shown a sudden spurt of 93.9% in FY15-16, have stayed high since then. This spurt was due to the asset quality review (AQR) introduced by the Reserve Bank of India (RBI) governor in 2015. Even before FY14-15, PSBs had consistently churned out high levels of NPAs which were camouflaged with myriads of restructuring schemes of the RBI, mercifully withdrawn in February 2018.
So, how can the BB fix the chromic malady of PSBs? A peek into the past can give us ideas. Take the example of the Industrial Development Bank of India (IDBI Bank now). Similar to BB, a special bail-out package was given to IDBI in FY04-05, when it was cleansed with the transfer of a portfolio NPAs of Rs9,000 crore (gross NPAs – Rs12,945 crore) to stressed asset stabilisation fund (SASF), a trust. The transfer value of Rs9,000 crore constituted IDBI’s investment in 20-year zero-coupon government of India bonds to be redeemed out of recoveries from these NPAs. At the end of 20 years, the redemption period could be extended by 10 more years. During the past 15 years, despite passing through unprecedented pre-2008 boom period, recovery from SASF has been about Rs5,000 crore so far, and has almost completely tapered off. This is not a problem, however. Recoveries of banks (predominantly PSBs) is among the lowest in the world (figure-2). In comparison, SASF’s recovery of 38.62% is phenomenal, though far from desirable.
Cleansing of IDBI’s NPAs was not accompanied by management revamp. So, the bank continued with business as usual and continued to receive liberal recapitalisation by the government without a murmur. As a result, the government shareholding which was 51.2% in FY03-04 rose to 98.1% in FY19-20. Yet the bank has the dubious distinction of having the highest NPAs among all the banks as on 31 March 2020.
IDBI has shown us that BB in isolation will only give a short breather and the PSBs will regress IDBI Bank-style soon if not revamped. If the country does not learn from this blunder and rectify it, it is destined to repeat it with increased intensity.
There is a fairly high correlation coefficient of 0.77 between the government ownership of banks and NPA levels. The country, therefore, cannot turn a blind eye to the government’s ultimate responsibility of PSB mismanagement and huge NPAs. This was hinted at by Dr Raghuram Rajan with the following words in his book “I Do What I do”: We will have moved significantly towards limiting interference in public sector banks when the Department of Financial Services (which oversees public sector financial firms) is finally closed down, and its banking functions taken over by bank boards and the Bank Board Bureau.
PSB mismanagement was also highlighted in Dr PJ Nayak Committee Report in May 2014 which had lamented that the government as PSB shareholder had suffered deeply negative returns over decades (due to misgovernance and incompetent boards) and had, therefore, recommended government’s exit from the bank management. According to the Report, at the organisation level, there was need for wide-ranging human resource policy changes with requisite rewards with proper vesting schedules of benefits like stock options, etc, and punishments based on performance. Precious little has been done in this direction, and the PSBs have continued the business of churning out NPAs, as usual.
The government seems to have recognised the malaise and has announced privatisation of two PSBs now, apart from setting up the BB. This does not obviate the need to reform all the PSBs on the lines of Dr PJ Nayak Committee recommendations before setting up BB lest the PSBs suffer the IDBI syndrome.
Determinants of Successful Bad Bank: International Experience
In the past, many countries have used BBs structured as AMCs to free the banks or other financial entities from non-performing loans (NPLs). The experience is mixed and has lessons for us. A study by Daniela Klingebiel for the World Bank in February 2000 showed that AMCs were set up to either expedite restructuring or rapid disposal of assets. Of the seven AMCs for which data were available, three were constituted as restructuring vehicles and four were set up for rapid disposal of assets. Tables 3 and 4 summarise the experiences.
The study showed that major determinants of success of the AMCs for restructuring or speedy disposal of assets were efficient legal framework, effective management and governance structure and speedy processes. Determinants of bank success post-restructuring were efficient management and adequate capitalisation.
Korean Experience
In March 1998, the total NPLs of all the Korean banks and financial institutions were 118 trillion won (27% of GDP). Of these, NPLs aggregating 100 trillion won were identified for rapid disposal, including the sticky assets of 68 trillion won. The rest were left for corporate restructuring processes. Half of the NPLs were to be disposed by the lenders themselves by selling off the securities and the remaining were to be sold to the non-performing asset management fund (NPA Fund) set up by the Korea Asset Management Corporation (KAMCO).
The rapid disposal of assets was successful with the bank NPLs declining from 17% in 1997 to 2.3% in 2002. During the same period i.e, 1997-2002, KAMCO’s NPA Fund acquired NPLs of face value of 110.2 trillion won for 39.7 trillion won (36%). The NPA Fund was adequately funded to be able to acquire the NPLs.
While the secured NPLs were purchased at 52.9% of the debt outstanding by the NPA Fund, the unsecured loans were purchased for 18.8%. In 2013, when the Fund was wound up, it had recovered 48.1 trillion won and ended up with a profit of 8.9 trillion won. The Korean banks have stayed healthy after the bail out since their NPLs had emanated from extraordinary circumstances unlike in India.
The success of KAMCO’s NPA Fund resulted from effective legislation and legal system, effective management and organisation, and Korean ecosystem characterised by strong public interest in scrutinising the use of public funds. Yet it took 14 years for the NPA Fund to resolve NPL level of 17% caused due to the economic meltdown.
Recipe for India’s BB
Based on international experience and our own experience so far, it is necessary that the creation of BB must be done along with PSB reforms sans bureaucratic / government interference as a part of a well-crafted execution plan. Further, the BB should be a special purpose vehicle to be wound up within a definite period so that a sense of urgency is induced in the BB.
The AMC may segregate NPAs for speedy disposal and restructuring by invoking fast track corporate insolvency process under Chapter IV of the Insolvency and Bankruptcy Code, 2016 with special National Company Law Tribunal (NCLT) benches and members backed by highly competent back-office so that the disposals are indeed speedy. Development of a special NCLT cadre for this process could be replicated in the entire NCLT echo system later so that speedy resolutions and disposal become a norm rather than an exception as hitherto and induce sustained discipline among the Indian corporates.
The disposal should be genuinely transparent and speedy on the lines of KAMCO’s NPA Fund. Incidentally, KAMCO's mandate was to resolve with maximisation of value. So it bought assets at a good value (it picked up only the assets, which the banks were not able to dispose rapidly).
This will entail recovery adjudication to be strengthened infinitely. Looking to the NPA levels (Rs8.99 lakh crore of gross NPAs on 31 March 2020) it is unlikely that the AIFs can acquire a significant part of the assets. This would mean delays, impairments, and eventual failure. Hence, it would be worthwhile to capitalise the AMC with adequate funds for takeover of the NPAs at book value over a period in terms of the execution plan.
Now if you talk of selling to AIFs, the gap between the book value and the AIF price will be huge, going by the fact that our NPAs are known to have very low value.
KAMCO's objective was maximisation of value, not the profit or return on the Fund. So, it picked up asset at fair value. With AIFs, such a thing is not possible.
So the KAMCO model suits India. We should not shoot from the hip and repent later!
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