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Home >Opinion >Views >We need a good NPA market if a bad bank is to succeed

In the latest Financial Stability Report, the Reserve Bank of India (RBI) has stated that the banking sector’s gross non-performing assets (NPAs) could rise from 8.5% at the end of March 2020 to as much as 14.7% by March 2021—a two-decade high.

The financial managers of the economy have been well aware of the magnitude of that problem. Over the years, the Insolvency and Bankruptcy Code (IBC) has been proactively interpreted and modified to respond to the need to resolve sick companies, and do so expeditiously. Further, on 8 January, the ministry of corporate affairs issued a consultation paper on strengthening the resolution process of bad debt prior to a declaration of bankruptcy. All to the good.

But resolution of bad debt is only one way to address the NPA problem. A large proportion of bad debt in terms of value would be on account of big-ticket companies whose dues run into hundreds and thousands of crore, and whose financial creditors comprise a consortium of banks. Resolution of the claims of creditors of such companies, despite all the stipulated timelines, is a long-drawn and messy business. It also requires expertise in commercial and legal as well as business issues. Banks should have the option to offload the problem to specialists in business reconstruction, rather than have to take control and drive resolution. Hence, the resolution process must be complemented by a process that allows the regular offtake of NPAs in smaller tranches.

Asset reconstruction companies (ARCs) were created under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Act for precisely this purpose. They were set up as the prime vehicles for securitization of debt and hence allowed to buy NPAs with a combination of cash and securities. The securities continue to be held in the name of the bank in a trust structure created by the ARC. The percentage of securities used to pay the bank represents the share of risk that continues to be borne by the bank even after the NPA sale. To incentivize high-risk transfers, RBI has been specifying the minimum cash proportion that must be satisfied to make the bank eligible for a waiver of its provisioning requirements against NPAs. However, from 2002 to 2016, the level of the stipulated minimum cash remained relatively low. This situation reflected an inadequate transfer of risk to ARCs.

To bring transparency and effect higher levels of risk transfer, RBI issued a circular in September 2016, proposing that the sale of NPAs would be exclusively via the ‘Swiss auction mechanism’ and that the minimum cash proportion required to be eligible for a waiver of provisioning charges would be raised to 90% over two years. Currently, the bad debt market deals almost exclusively in cash, implying that the entire risk is being borne by the buyer. An economic model we have built to analyse the market suggests that this is by and large unviable from the perspective of the buyer.

As of now, the assets under management of ARCs amount to 1.5 trillion, or over 14% of the stock of NPAs. However, the growth rate of assets managed by ARCs slowed down in 2019, which is not a good sign, given the flood of NPAs expected in the post-covid economy. Further, it is noteworthy that as per a report by Crisil, in 2018-19 investors other than banks and asset reconstruction companies held 60% of the newly-issued security receipts. These would mainly be foreign portfolio investors.

Such investors are able to raise funds overseas at low interest rates. But there is also a steep risk premium associated with India, given that our sovereign rating is only slightly above junk status. Hence, one cannot rely on foreign capital for future growth. Nor can one rely on domestic sources of funds, due to the high cost of capital. Indeed, anecdotal evidence suggests that the current Swiss Auction method is actually a negotiation, with sellers having to cajole buyers to bid.

There has been talk of setting up a ‘bad bank’ to deal with the problem. The definition of a bad bank has not been spelt out, but it seems to be an ARC for which the government will provide part of the capital. While the provision of additional capital within the boundaries of fiscal propriety is welcome, such capital must be aligned to commercial considerations. Therefore, redesigning the ARC market to enable private capital to operate at reasonable levels of risk is a necessary precondition for the success of a bad bank.

And for this to happen, it is imperative that banks be willing to take on certain levels of risk, instead of transferring all of it to the buyer. This would lead to higher deal values and larger capital outlays. Our model allows us to specify a minimum risk burden, and also convert two-dimensional bids, comprising a total bid amount and a cash proportion, into a cash equivalent. Indeed, the level of risk transfer should emerge from the process of bidding, with a reasonable level specified as a starting point.

We also recommend that new sources of domestic capital be encouraged to participate in this market through a relaxation of laws, in alignment with the formalization and digitization of the monetary system. It is ironic that speculative inflows that were an important factor in creating the current crisis are being expected to resolve it. But that is precisely the implication of the current design of the NPA market.

Rohit Prasad & Yogesh B. Mathur are, respectively, professor at Management Development Institute Gurgaon, and an adviser on corporate restructuring The views expressed here are personal.

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