Why a bad bank needs a sunset clause

Syllabus: General Studies Paper 3

Context:

Recently, the Reserve Bank of India gave license to National Asset Reconstruction Company Limited (NARCL), popularly known as a bad bank.

About National Asset Reconstruction Company Limited (NARCL)

• The plan is to create a bad bank to house bad loans of ₹500 crore and above, in a structure that will contain an asset reconstruction company (ARC) and an asset management company (AMC) to manage and recover dud assets.
• The new entity is being created in collaboration with both public and private sector banks.
• The proposed bad bank will have a public sector character and majority ownership is likely to rest with state-owned banks.
• The objective of the bad bank is to establish a liquid market for Non-Performing Assets (NPAs) so that banks will be able to sell their NPAs at a reasonable price. 
• The biggest advantage of NARCL would be an aggregation of identified NPAs (non-performing assets). 
• NARCL, through its service company/operational entity India Debt Resolution Company Ltd (IDRCL), will manage the resolutions of these NPAs.
• The NARCL will acquire these stressed assets through 15 per cent cash and 85 per cent security receipts (SRs) in a phased manner. ₹90,000 crore of the asset will be managed in the first phase.
• A government guarantee will back the SRs for a maximum amount of ₹30,600 crore, and the guarantee will be valid for a resolution period of five years.

Initiatives for NPAs recovery in India

• Debt recovery tribunals under the Recovery of Debts Due to Banks and Financial Institutions (RDDBFI) Act in 1993
• Asset reconstruction companies (ARCs) as a part of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI Act) in 2002, and 
• The Insolvency and Bankruptcy Code (IBC) in 2016.

Need for a Bad bank

• Currently, the Indian banking system has one of the highest gross non-performing assets (GNPA) to total asset ratio globally. 
  • Post-covid stress scenarios estimated by the RBI pegs it at an aggregate GNPA ratio in the range of 12.5- 14.7 per cent.
• Lack of liquidity: The secondary market of the Security Receipts (SRs) issued by the existing ARCs is quite illiquid. 
  • There is a dominance of the selling-bank in holding SRs, resulting in a limited demand for SR by other qualified investors.
  • The main reason for the limited demand is the average low debt recovery rate of only 27.8 per cent, with the most recent 2019-20 showing a debt recovery rate of 26.7 per cent.
• The NARCL is essentially an ARC with only two distinguishing features
  • (i) NARCL is intended for dealing in big sized tickets, and 
  • (ii) NARCL has a partial government guarantee.

Challenges for Bad Bank

• International examples show that the effectiveness of ARCs hinges on: 
  • (i) a focused mandate for setting up the ARCs, 
  • (ii) limited lifespan of the ARC, 
  • (iii) market-based resolution of NPAs.
• No fixed life span: NARCL has a focused mandate as stated in its proposal to acquire ₹2 lakh crore worth of stressed assets, but the absence of a clause about the lifespan of NARCL may lead to a moral hazard problem. 
  • Evergreening of Bad loans: Public sector banks (PSBs), who own 51 per cent stake in NARCL, may continue buying their own stressed assets through NARCL leading to the propagation and evergreening of bad loans.
• The government guarantee of ₹30,600 crore is insufficient in providing liquidity and creating a market for the NPAs.

Way forward:

• Specific mandate for the bad bank: A bad bank must have a specific, narrow mandate with clearly defined goals. Transferring NPLs to a bad bank is not a solution in itself. There must be a clear resolution strategy. 
• Sunset clause: Government should address the lifespan issue of NARCL in the form of a sunset clause; a bad bank for perpetuity will pose long-term risks to the financial stability of a country, like Huarong in China.
• There should be a fair and transparent mechanism while setting the haircut on the stressed assets by the NARCL.
  • A haircut, in this context, refers to the shortfall in recovery of the creditors in comparison to their claims submitted before the insolvency professional, as part of the insolvency resolution process of a borrower.
• Minimizing exposure to bad loans: Indian banks remain exposed to these bad loans even after they are transferred to asset reconstruction companies (ARCs). 
  • To address this problem, RBI has tightened bank provisioning while liberalising foreign portfolio investment norms. 
  • Policymakers must ensure that the creation of the NARCL does not reverse this trend.
• Removing multiple ARCs: The resolution of bad loans should happen through a market mechanism and not through a multitude of bad banks. 
  • In India, the Narasimham Committee (1998) had envisaged a single ARC as a bad bank. 
  • Yet, the SARFAESI Act, 2002 created multiple, privately owned ARCs. 
  • ARCs should be allowed to purchase stressed assets from mutual funds, insurance companies, and bond investors. 
• The pricing mechanism should ensure that the net asset value (NAV) of the SRs is fairly priced, which will boost the participation and liquidity in the SR market.

While setting up a bad bank in the form of NARCL is a step in the right direction towards financial sector reforms; NARCL is just a palliative; it is neither a cure nor does it prohibit bad loans. Unless there is a strong political will to recognise bad loans and support legal infrastructure to address wilful defaulters, setting up a bad bank may become a moot point.

The Hindu Link:https://www.thehindubusinessline.com/opinion/why-a-bad-bank-needs-a-sunset-clause/article37424464.ece

Question- A bad bank cannot be the panacea to the issue of Non Performing Assets in the banking sector. Comment.