[Editorial Analysis] Bad loans and choke points

Mains Paper 3: Economy
Prelims level: Bad bank
Mains level: Banking Sector related issues

Context:

• Despite making considerable progress over the last five years in resolving and recovering bad debts of banks, there are still around Rs 10 lakh crore worth of stressed assets hanging around in the system.

• Against this backdrop, the newly created NARCL in the public sector offers hopes for the faster cleanup of lender’s balance sheets.

What is a Bad Bank?

• A bad bank is an asset reconstruction company that buys bad loans (NPAs) from commercial banks at a discount and tries to recover the money from the defaulter by providing a systematic solution over a while.

Need for Bad Bank in India:

• Banks have difficulty in solving these cases due to a lack of expertise, coordination, capital, etc. Even the private ARCs have also failed to recover the loans.

• The level of NPAs rose alarmingly since 2016 and an overwhelming proportion of NPAs was with the PSBs. Therefore removing NPAs effectively is the need of the hour.

• The panel led by KV Kamath has said companies in sectors such as wholesale trade, retail trade, textiles, and roads are facing stress. So, setting up a bad bank is crucial to reviving these sectors.

• Bad banks are targeted banking systems with domain experts to focus particularly on NPAs.

• Bad banks can be more effective, quicker in the restructuring of the loans.

• The Financial Stability Report points that the gross NPAs of the banking sector are expected to shoot up to 13.5% of advances by September 2021, from 7.5% in September 2020, under the baseline scenario. So, the Bad banks are essential considering the Indian conditions.

Working of NARCL-IDRCL:

• Firstly NARCL purchases bad loans from banks by paying 15% as cash and the remaining 85% in the form of Security Receipts. When the IDRCL sells the assets, the NARCL paybacks 85% to the banks.

• However, in case of a failed sale or loss sale of the assets, govt will invoke its guarantee and pay the difference amount to the commercial banks.

Significance of NARCL:

• Its greatest virtue lies in the faster aggregation of distressed assets that lie scattered across several lenders.

• Its securitized receipts (SRs) carry sovereign assurance makes PSBs some sort of comfort as price discovery is not subject to later investigation. Its initial focus will be on large accounts with debts of Rs 500 crore.

• It is also expected to free the banks from the tortuous recovery process and afford them more space to focus on much-needed credit expansion.

• The NARCL is not a bank, but a specialized financial institution to help resolve the distressed assets of banks.

The Audit of Past efforts for solving Bad loans:

• Over the years, there have been several institutional and policy measures to resolve the bad debts.

• Institutional Efforts such as:

• Board for Industrial and Financial Reconstruction 1987,

• Lok Adalat,

• Debt Recovery Tribunal 1993,

• Corporate Debt Restructure 2001,

• SARFAESI ARC 2002.

• The above institutional measures have messy resolutions with 6.2% to 27% resolution rates.

• Along with institutional, RBI has launched a slew of measures during 2013-14 to resolve, reconstruct and restructure stressed assets.

• These failed to deliver the expected outcomes.

• Again RBI has come out with a prudential framework for resolution, however that too faced poor ecosystem and legal delays.

The efficacy of Private ARCs:

• Of the 28 ARCS in operations, the top 5ARCs account for 70% of assets under management (AUM) and 65% of the capital.

• However, the private sector ARCs have not done well in the sale of zombie assets.
1. Only 13% of the assets acquired are actually sold.

2. Nearly, 1/3rd of debts are rescheduled.

Analyzing the Insolvency and Bankruptcy Code:

IBC:

• The landmark legislation with a legally time-bound resolution was introduced in 2016, marked a welcome departure from early efforts.

• Its more focus is on resolution rather than recovery.

• It has instilled a sense of fear in mischievous corporate borrowers who have siphoned of funds.

• It nearly put an end to evergreening.

• Despite delays under this, they are reduced to days/weeks.

• It has succeeded in resolving a few large corporate borrowers with an average recovery rate of 45%.

• However, the main concern is elevated haircuts of up to 95%.

National Company Law Tribunal:

• It proves to be the chokepoint and backbone of IBC.
1. However, it is starved of infrastructure and 50% of NCLT were bereft of regular judges.

2. Over 13000 crore involving distressed debt of Rs 9.2 lakh crore are languishing with the NCLT.

• As per reports, the distressed assets that are fully provided for may be taken over by NARCL at 20%.
1. This low cost of acquisition would suffer from anchor effect and bias.
2. The anchoring effect is defined as the tendency to make decisions based on the first available information.
3. The 3-stage process to mitigate anchor bias: (Daniel Kahneman)

• Acknowledge the bias,
• Seek more and new sources of information,

• Drop your anchor based on new sources of information.

• The issue of lack of adequate infra coupled with the poor quality of its decisions has proved to be the IBC’s Achilles’ heel.

What NARC learns from past efforts mainly IBC?

• It should uphold the principle of bringing behavioral change in errant and willful defaulters by forbidding them to take back distressed assets. If not the credit culture would suffer.

• It should have a sunset clause of 3-5 years to avoid the perpetuation of moral hazard and also encourage expeditious resolution.

• The anchoring bias needs to be mitigated by better extrinsic value discovery.

• It should avoid selling to other ARCs.

Benefits of a Bad Bank:

• A high level of NPAs makes lending difficult for banks, as they have to keep supplementary capital under the Basel Accord which reduces its capital base and the resulting losses erode depositor confidence.

• Bad banks by way of absorbing NPAs, will ease the provisioning requirement by the banks and help them to get on with business as usual.

• Also, the creation of a bad bank allows the better segregation of a bank’s good assets from its bad assets which increases investors’ confidence and helps banks to grow financially.

• Speed of recovery will be better as Bad Bank’s main work is recovery and they are specialized in that.

• Bad Bank will help improve the banking sector’s health and fasten the recovery aspects of ailing by putting frozen assets back into economic circulation.

• It increases the profitability of commercial banks as they can focus more on lending, acquiring more customers, and upgrading technology without spending too much time on recovery or resolution of bad loans

• It can make profits as they usually keep a high margin before acquiring the bad loans.

Demerits/Challenges of a Bad bank:

• Some domain experts had opposed the idea of setting up a bad bank in which banks hold a majority stake because it merely shifts loans from one government pocket (the public sector banks) to another (the bad bank).

• Also, the commercial banks may not concentrate on the quality of loans as they always have an option of shifting bad loans to Bad Bank which results in reckless lending

• The main concern is that Bad banks may not acquire critical loans which are difficult to recover and only concentrate on easily recoverable loans. As a result, troubled Commercial banks continue to face the issue of bad loans

• A high margin of Bad banks will curtail the profits of commercial banks which in turn, impact their lending capabilities.

• There is a major moral concern whereby bad banks will employ some unethical ways to recover loans.

• The govt stake in the Bad bank is criticized for political influence in decision-making. Especially when the majority of the NPAs are associated with the Public Sector Unit.

• The larger systemic issues will not be addressed because A bad bank does not focus on the structural weaknesses in public sector banks such as management etc.

Will a Bad Bank resolve the issue?

• From a stressed bank’s perspective, Bad will help them because it will get rid of all its toxic assets in one go.

• After its total payment of NPA from the bad bank, it can start lending again.

• Despite a series of measures by the RBI for better recognition and provisioning against NPAs, as well as massive doses of capitalization of public sector banks by the government, the problem of NPAs continues in the banking sector, especially among the weaker banks.

• Having a Bad Bank will complement other measures taken by RBI and the government to clean up the banking sector.

• Proponents of the concept feel that a professionally run bad bank, funded by private lenders and supported by the government, can be an effective mechanism to deal with NPAs.

• Many other countries had set up institutional mechanisms such as the Troubled Asset Relief Programme (TARP) in the US to deal with a problem of stress in the financial system in the wake of the 2008 financial crisis.

Conclusions:

• The NARC is the need of the hour and a welcome move to resolve and recover the delayed and deserted bad loans of the Indian banking sector.

• However, without reducing the problem of NPA India cannot become a trillion-dollar economy. Despite its potential benefits, the concept of a bad bank has its own limitations.

• Therefore, the need of the hour is to strengthen the fundamentals of the economy in the first place and emphasize better banking practices to prevent the accumulation of NPAs.

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Prelims Questions:

Q.1) With reference to cybercrime, consider the following statements:

1. Cybercrimes have gone up by almost 500% in India during the global pandemic.

2. Information Technology Act, 2000 is the primary law in India dealing with cybercrime and electronic commerce.

Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Answer: C

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