Home >Opinion >Views >A new auction design for a bad bank to achieve its goals

In our previous piece (‘The bad bank proposal and process of value discovery’, Mint, 10 March), we scrutinized the government proposal for a bad bank in the light of the rhetoric of “minimum government, maximum governance", and found that it fell short of the principles of: 1) enabling fair value discovery by creating a level playing field for all market players; and 2) not crowding out private investment.

Recall, the proposed public asset reconstruction company (ARC) will deploy a 15-85 split between cash and securities in its purchase of non-performing assets (NPAs). Therefore, it will end up with 15% cash and 85% securities, the value of which will be protected by a government guarantee.

A necessary condition for success is the presence of a sound value-discovery process for NPAs. Written down book values, recently suggested by the Parliamentary Panel on Finance, are accounting conveniences and do not represent market value. This is especially true for large accounts and fresh NPAs. But, as explained in the previous piece, merely inviting counter-bids from private ARCs is not sufficient to yield a sound market process. Of critical importance is the creation of a level playing field for all market players, which, given the unequal treatment of public and private ARCs, doesn’t currently exist.

One silver lining of the public ARC’s proposed structure is that for consortium-led debt financing, with multiple banks in the fray, it would fare well in aggregating debt for each large borrower. This would enable control over the distressed firm while avoiding multiple rounds of negotiation with various entities. Our solution would retain the advantages of the present scheme while fixing its drawbacks. It has the following features:

Drop the government guarantee: This unavoidably skews the market in favour of the public ARC. In its place, the government should support the public ARC by subsidizing 15-20% of the cash component of every deal. This subsidy will counter-balance the ability of private ARCs to raise foreign capital at low rates of interest.

Expand the addressable market for ARCs: As suggested in RBI’s draft circular of August 2020, private ARCs should also be allowed to bid for distressed assets that have not yet been deemed NPAs, referred to as SMAs.

Raise the minimum cash proportion to 35%: Economic analysis shows that the problem with a 15% cash proportion is that it encourages deals at inflated values, which would artificially bolster the books of banks only to be followed by future write-downs. Also, while the securities are being under-written by the government, holding 85% of an NPA as securities represents an inadequate transfer of risk out of the government-public-sector bank combine. The market can offer deal values in alignment with the fair value of NPAs at much higher levels of cash, reflecting higher risk transfer.

Equalize and rationalize accounting gains: Gains in the form of avoidance of provisioning should be available in an identical fashion for transactions of the public ARC as well as private ARCs. In addition, accounting gains should not get triggered in a binary fashion with no gains below and 100% gains above the stipulated minimum. Instead, there should be a sliding scale of gain—i.e., a 35% cash proportion should imply the accrual of 35% of the accounting gains, and so on. This would incentivize higher levels of risk transfer.

Introduce a two-dimensional bidding process: There should be two-dimensional bids consisting of a proposed deal value, and a proposed cash proportion that is greater than or equal to the stipulated minimum. This two-dimensional bid should be converted into a cash equivalent by using an appropriate adjustment factor for the security receipts component.

Replace the Swiss Challenge with a combinatorial auction: A new regulation should be passed which mandates that for every account with more than five creditors, the availability of more than 50% of the debtor’s outstanding amount for auction will automatically trigger an auction of the account’s NPAs held by all banks. This is similar in spirit to the IBC rules prescribing an absolute majority of 66% for a decision on a resolution plan. The decision to sell NPAs warrants a lower threshold than the decision to transfer ownership. All these NPAs should be sold simultaneously through a combinatorial auction. In combinatorial auctions, bidders are allowed to bid for combinations of objects. For instance, in a spectrum auction, a bidder, instead of bidding separately for each circle, can also be given an additional option of bidding for certain combinations of circles with significant complementarities (for instance, Delhi and Haryana). This auction format is useful when there are high levels of synergy between the objects being auctioned. The option of bidding for individual objects continues to exist.

It’s true that the total number of packages a bidder could choose is large. For instance, with 10 banks, the total would work out to 1,023. In the case of an NPA auction, the packages on offer could be restricted to combinations of NPA holdings that enable a 66% stake in the corporate debtor. Carefully designed combinatorial auctions have been successfully used for US spectrum sales.

Minimizing the deployment of public capital and enabling fair value discovery must be the lodestar of a government that walks the talk on minimalism. The principles outlined above offer a way to operationalize the government’s intentions.

Rohit Prasad and Yogesh B. Mathur are, respectively, professor, MDI Gurgaon, and senior adviser, restructuring, Grant Thornton . These are the authors’ personal views.

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