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Prime Minister Narendra Modi recently lauded the role of the private sector in national progress. Some were reminded of his 2014 call for “minimum government, maximum governance". The budget announcement of a ‘bad bank’ offers a useful lens to examine how the rhetoric plays out in policy formulation. But first, a brief history of India’s distressed debt markets, covering both bankruptcy law as well as the market for non-performing assets (NPAs).

India enacted a bankruptcy law, the Insolvency and Bankruptcy Code, as late as 2016. Asset Reconstruction Companies (ARCs) engaged in the acquisition of NPAs, though, were created earlier via the SARFESI Act in 2002. The aim of the NPA market was to move bad debt off the balance sheets of banks, but at commercially appropriate values. Permitting ARCs to partly pay for NPAs in the form of securities allowed banks to use the revival prospects of debtor firms to increase deal values. But there was a balance to be struck, as high levels of securitization reflected inadequate transfer of risk out of banks’ books. From 2002 to 2016, transactions had a high proportion of securitization. Indeed, over 2002-2007, with cash proportions as low as 7%, ARCs could earn a positive net return purely on the basis of management fees, without any value addition by way of securitization or asset reconstruction. In 2006, the Reserve Bank of India (RBI) stipulated a minimum cash proportion of just 5%.

Why would such deals be acceptable to banks? Amid a weak bankruptcy landscape, banks had to settle for low deal values. At such values, they would prefer to hold securities on which they could hope for high future returns, rather than receive cash.

Cash proportions increased after 2008, with high economic growth increasing bankruptcy proceeds. In 2014, RBI officially raised its guidance on the cash proportion to 15%. This pushed ARCs to bolster their returns through securitization and asset reconstruction. However, opportunities for this were limited. Thus, market activity was slow, except for a major growth spurt over 2013-14 to 2014-15, triggered by a combination of low stipulated cash proportions and high accounting gains with respect to the avoidance of provisioning for fresh NPAs. To increase transparency and effect greater risk transfer, in September 2016, RBI proposed that NPA sales be exclusively via the ‘Swiss auction mechanism’ (bilateral negotiations were common earlier), and that a deal’s minimum cash component for the NPA to be eligible for a waiver of provisioning charges would be raised to 90% over two years. Current market deals are almost exclusively in cash.

At such high levels of cash, the market becomes unviable for all but the choicest assets, and even then, only if ARCs can partner with global funds that access capital at rock-bottom interest rates. A report by a rating agency states that in 2018-19, the holdings of such investors in newly-issued security receipts rose sharply.

The proposed 15:85 split between cash and securities to be used by the proposed public bad bank (in effect a public sector ARC) in purchasing NPAs from banks would take the market to the other extreme. It is a U-turn from a 15-year trend of incentivizing higher cash proportions. That this reversal could be seen as another example of executive action that infringes upon RBI’s autonomy seems to have escaped notice. The proposal lacks the academic rigour and transparency that characterize most RBI recommendations.

Further, a necessary condition for ‘minimum government, maximum governance’ is that the government should deploy public capital only if private capital is unwilling to enter, or if there are strategic assets involved. At a 15:85 split between cash and securities, a simple economic model would suffice to show that private ARCs would have readily entered the market and generated high prices for NPAs.

Lastly, the most fundamental function of a minimalist government is to ensure that value discovery takes place through a well-designed market mechanism that offers a level playing field to all market players. There have been reports that India’s NPA market will continue to be run via Swiss auctions, implying that private ARCs will be able to counter-bid any offer made by the public ARC. However, the availability of a government guarantee on securities held by the public ARC, together with the RBI stipulation that private ARCs must provide 90% of the NPA deal value in cash for banks to avail of provisioning relaxations, wipes out any prospect of a level playing field.

A significant feature of the market is that a single corporate debtor is serviced by a consortium of banks, often more than 10 for larger accounts. The possibility of aggregating the debt of large corporate debtors held by various banks is being held out as the key differentiator of the public ARC. This aggregation enables control over the debtor and hence would be attractive to private ARCs or other investors. The unstated assumption of this argument is that since most banks are publicly-owned, the ARC can deal with a single entity and thereby avoid the transaction costs of bargaining with multiple entities. While there are associated costs of bank autonomy, this argument has some merit.

Can we achieve the aggregation of NPAs while reducing the use of public money and adhering to the spirit of a minimalist government? Yes, we can. Watch this space for an exciting new auction design for NPAs.

This is the first of a two-part series. These are the authors’ personal views.

Rohit Prasad & Yogesh B. Mathur are, respectively, professor, MDI Gurgaon, and senior adviser-restructuring, Grant Thornton


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