Bad Bank – A Remedy for the NPA Illness?

What is Bad Bank?

In the recent Union Budget 2021, Finance Minister Nirmala Sitharaman proposed to set up a bad bank considering ARC-AMC model to consolidate the stressed assets into a seperate entity. Will the Bad Bank be a remedy for the NPA illness?

Bad Bank – A Remedy for the NPA Illness?

Today we talk about the Union Budget’s proposal to set up an Asset Reconstruction Company (ARC) to resolve the aggravating Non Performing Asset (NPA) crisis facing the Indian Banking Sector.

Let’s start with a story.

Mellon Bank was one of the largest regional banks in the US during the 1980s. Backed by trusted pedigree, they became pioneers in the application of advanced data-processing technology to banking transactions and thoroughly reaped the benefits of first mover advantage.

As fate would have it, in 1988 Mellon Bank found itself in dire straits. They had succumbed to massive non-performing energy and real estate loans worth more than $1 Billion. Back then, provisioning of NPAs wasn’t as robust and regulated as it is in today’s time. So yes, they messed up big time.

As a result their credibility dropped to the floor, other big banks refused to lend them funds, existing investors grew skeptical and questioned the bank’s long term sustainability. Concurrently, any new investors were reluctant and unwilling to extend a helping hand.

Challenges in Raising New Capital

Mellon Bank was unable to raise fresh capital at decent interest rates and was compelled to reject new loan applications. Borrowing at sky high interest rates wasn’t a viable option, hence their hands were tied and they started losing business and market share to their competitors.

The walls were closing in on Mellon Bank, but they refused to throw in the towel. They were tenacious to the core and managed to raise new capital through preference and equity shares. Next, they decided to set up and capitalize a new independent bank called Grant Street National Bank. This wasn’t a regular bank. They did not accept any deposits from the public and had their own five-member board of directors.

The Grant Street National Bank purchased the bad loans worth $1 Billion from Mellon Bank at a deep discount for $575 million in cash and securities. With the help of an expert investment bank – Drexel Burnham Lambert, these toxic loans and the collateral underlying them were restructured and securitized. Eventually, over time all the money was successfully recovered. 

Cherry on top of the cake was that Grant Street National Bank was able to generate handsome profits in the process. The bank was dissolved in 1995 (within 7 years) after having met its objectives.

This was the very first time that a ‘good bank-bad bank’ approach had been adopted.

When Mellon Bank’s non-performing loans were transferred to a separate bank (in the above case Grant Street National Bank), it helped clean up their balance sheet, empowered them to resume lending operations, bolstered their finances and in due course stabilized earnings. To top it all, it freed the management from worrying about the defaulting loans, thereby allowing them to focus on developing the future of the institution.

Indian Banking Sector

• The Indian banking system has been through a rough patch in recent years, we’ve had several financial institutions like PNB, Yes Bank, IL&FS, etc that are in the same state as Mellon Bank once was. Balance sheets of several Public Sector Banks (PSBs) are constantly being deteriorated by toxic NPAs and the government can’t keep recapitalizing them repeatedly.
• The Covid-19 pandemic has added fuel to the fire and is expected to further exacerbate the NPA crisis, having an unfavorable effect on the credit cycle. The RBI in its recent Financial Stability Report said that the bad loan ratio of banks in India could rise to 13.5% under the baseline stress scenario. It can also double to 14.8% by September 2021, under a severe stress scenario.
• According to Reserve Bank of India (RBI) governor Shaktikanta Das- “Maintaining the health of the banking sector remains a policy priority and preservation of the stability of the financial system is an overarching goal.”
• Hence, Finance Minister Nirmala Sitharaman in her recent Union Budget 2021 speech announced a stressed asset resolution by setting up a new structure. She said – “The high level of provisioning by public sector banks of their stressed assets calls for measures to clean up the bank books. An Asset Reconstruction Company (ARC) Limited and Asset Management Company (AMC) would be set up to consolidate and take over the existing stressed debt and then manage and dispose of the assets to Alternate Investment Funds and other potential investors for eventual value realization.”

What is ARC?

An Asset Reconstruction Company (ARC) is a specialized financial institution that purchases NPAs from banks and financial institutions, normally at steep discounts. They then take special measures to recover money from the bad assets. They churn a healthy profit if they are able to recoup the money. Similar to Grant Street National Bank in the above example.

ARCs and Bad Banks though akin in their objective of isolating a bank from its toxic loans have a stark difference. A bank can simply transfer its NPAs to a bad bank, while a bank sells its NPAs to an ARC at heavy discounts.

This is how it works. The banks will transfer their toxic assets to the ARCs at net book value (i.e. value of asset minus provisions). The asset then goes to the AMCs where experienced professionals who will find suitable investors or Alternate Investment Funds and resolve the assets.

The deal between the lender and ARC won’t be 100% cash. The ARC will furnish 15% cash and 85% by way of securitized receipts. The ARC will pay the banks the residue 85% only when they are able to retrieve the money.

The ARC-AMC model will not be backed by government equity and will have to be set up by the public and private banks.

Chief Economic Adviser Krishnamurthy V Subramanian has said that – “The proposed asset reconstruction company (ARC), or the so-called bad bank, will be different from the existing ones, as it will have greater financial muscle as well as professional capacity to work out large stressed assets.”

As good as it sounds; pragmatic execution of the same will definitely be an uphill task.  Hit or miss, only time will tell how this saga plays out.