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Shaping India's Bad Bank

Business Today |
Sundaresh Bhat, Partner
Business Restructuring Services

09 July 2021

Government and RBI are working to make the National Asset Reconstruction Company a reality. Here’s why we must learn from global experience

After the East Asian currency crisis in 1996-97, Malaysia set up two asset management companies (AMCs) — one for buying bad loans from banks and another for injecting fresh capital into weak banks. Both were shut down after seven years. Around the same time, South Korea set up Korea Asset Management Corporation for five years to buy bank loans. It made huge profits by turning around the assets. China, in contrast, opted for four government-led AMCs. One of them, China Huarong Asset Management Co, is seeking a bailout.

Can these different models guide Indian government, regulators and bankers as they gear up to tackle the fresh round of non-performing assets (NPAs) that are building up as a result of businesses getting hit by successive Covid waves? The Indian financial system, which entered the Covid crisis with 8 per cent gross NPAs, seems to be pinning a lot of hope on the central government’s move to build a platform — National Asset Reconstruction Company Ltd. (NARCL) — for transferring bad loans of mostly public sector banks (PSBs).

In a parallel move, the Reserve Bank of India (RBI) has initiated the first big overhaul of ARC regulations in 20 years. An ARC buys bad loans from banks at a discount. Also, the Insolvency and Bankruptcy Code (IBC) is being reformed to allow pre-packs for MSMEs. This could be extended to large companies in the near future. A pre-pack involves debt resolution outside IBC with judicial approval. “An overhaul of the ARC framework was long overdue. ARCs allow loan restructuring outside the IBC framework. One is an alternative to another,” says Ashwin Bishnoi, Partner at Khaitan & Co, a corporate law firm.

Hinting at coordinated action with the government, a recent RBI paper stressed the need to focus more on ARCs in view of asset quality deterioration due to Covid-19. “The introduction of government-backed ARC (NARCL) for addressing NPAs of PSBs may also shape operations of existing ARCs,” it said. Experts expect massive asset quality deterioration in MSME, services, retail (especially unsecured loans) and business banking. This will badly affect bank lending and economic growth.

Here is what the new regulatory framework for bad loans may look like.

Government-Backed ARC-AMC

Finance Minister Nirmala Sitharaman talked about setting up a Bad Bank, under the ARC-AMC (Asset Management Company) structure, in her 2021-22 Budget speech. This puzzled experts as IBC was thought of as fairly effective in resolving bad loans. But the government was worried about delays and low realisation from assets under IBC. Also, the loans were sold at massive discounts. In some cases, the assets were liquidated. There were also complaints about lack of coordination among PSBs. “PSBs often fight each other in the committee of creditors,” says a corporate lawyer.

The proposed NARCL will buy bad loans from banks, mostly PSBs. A step-down AMC will work on restructuring, turnaround and resolution. The government is keen to attract alternative investment funds (AIFs) run by private equity and other investors and will provide assurance against security receipts (SRs) issued to banks. PSBs will hold 51 per cent stake in NARCL. Canara Bank will take the highest 12 per cent stake. Private sector banks, too, will join. The investment will be between Rs 5,000 crore and Rs 8,000 crore depending upon the initial asset purchase plan.

“The government will get a lot of bargaining power. The idea is to attract international investors too,” says Jay Jhaveri, Partner, Bhuta Shah & Co LLP, a chartered accountancy firm. Global distressed asset investors will prefer the faster AMC system over IBC. For instance, the Essar Steel resolution under IBC took 865 days. The prescribed time period is 270 days.

Meanwhile, PSBs have identified over Rs 2 lakh crore stressed loans that they plan to transfer to NARCL. “These are a mix of NCLT cases, old NPAs and written-off loans,” says a banker. At present, their book value will not be more than Rs 50,000 crore. In the first phase, close to two dozen companies with loans of Rs 90,000 crore will be shifted to NARCL. Regulations allow it to accept only loans that have been fully provided for.

Critics, however, say PSBs are paying from own pocket (as shareholders) to buy their own bad loans (as shareholders of NARCL). According to ARC regulations, NARCL will pay banks 15 per cent cash. The remaining 85 per cent payment will be in the form of government-guaranteed SRs. The SR redemption period will be five to eight years. “The government guarantee will be invoked only after SR losses cross a threshold,” says a banker. Credit rating agencies rate SRs on the basis of value that can be realised. In case of a downgrade, the holder has to book mark-to-market losses. However, some ARCs are not in favour of a government guarantee for what is essentially a commercial transaction. “The NARCL structure has to be a one-time affair. Why should the government give guarantees? They are indirectly guaranteeing bad loans of private enterprises,” says Siby Antony, former Chairman, Edelweiss ARC.

The government is aware of the criticism but is more concerned about cleaning up PSB books. “It wants to get good value from PSBs by way of disinvestment. A clean-up will push up their value,” says a consultant.

However, the big challenge will be on the resolution side, where private ARCs are already struggling. “Many NPAs likely to be transferred to NARCL have no value. Why not take them through the IBC process?” asks a consultant. NARCL will need professional management and an independent board to manage resolutions, say experts.

Then there is the issue of RBI prohibiting banks from selling bad loans classified as fraudulent to ARCs. Assets with even a small element of fraud will not be transferred to NARCL. Some experts are also concerned about lack of clarity in valuations. The idea is to transfer bad loans that have been fully provided for at book value. The real value could be higher or lower. “PSBs are not doing independent valuations. This is not a transparent or market-driven sale,” says an official of a private ARC. “Clarity is missing in valuation. For instance, banks have different securities which, if invoked, will get them a much higher price than what they will get in an ARC-AMC set-up,” says a market player.

haveri of Bhuta Shah & Co LLP suggests a way out. “They could look at proxies such as resolutions in the same sector. For example, the average recovery rate in the steel sector is 35-45 per cent. They could also look at cash flows post-resolution or a hybrid model that includes discounted cash flows. The liquidation value will also be a benchmark for valuation,” he says.

Many say making a bad bank successful requires a lot of things. One, it has to be for a specific purpose, and have a sunset clause. In early 90s, Sweden AMC, backed by the government, recovered close to 90 per cent bad loans in six years. The government-backed Chinese AMC, however, failed to deliver.

Re-starting Private ARCs

Days after the NARCL announcement, there was hectic activity at RBI headquarters in Mumbai. In April, RBI’s Department of Supervision came out with an in-depth piece on ARCs. A week later, RBI set up a working group to re-look at regulations and suggest steps to give ARCs a bigger role in resolution of bad loans. The group is expected to submit its report in July. “The idea is to have a level-playing field for both sets (private and NARCL) of ARCs,” says a market player. “Given the new government-backed ARC, private ARCs want a level-playing field,” says Sundaresh Bhat, Partner, and Leader, Business Restructuring Services at BDO India.

Unlike some countries, India had bet on private sector-promoted ARCs in early years of the 2000 decade. The regulatory regime has remained static since then. “Somehow, the potential of ARCs was not realised,” says an expert. Out of 30-odd ARCs, top five control over 75 per cent assets under management. There has also been a drastic fall in loan buying by ARCs due to their low recovery rate. In FY20, the amount recovered was 45.5 per cent under IBC and 36.7 per cent under the ARC regime (See Why IBC is The Preferred Resolution Route). “The low capital requirement of Rs 100 crore attracted all and sundry players to the ARC business,” says a consultant.

The rewriting of ARC regulations will serve several objectives. “The government, faced with low growth and high unemployment, is perhaps more sympathetic to businesses at this stage. It wants to give them a better restructuring mechanism than IBC,” says a market player. The six-member RBI working group is also studying the role of ARCs vis a vis the new IBC code and also giving suggestions on improving liquidity in SRs.

However, experts say mandate of private ARCs is restrictive. For instance, they can take over management of companies in default only for recovering their dues. Similarly, the SARFAESI Act does not allow them to acquire fresh equity in such companies. It also prohibits them from carrying out any business other than asset recovery and restructuring.

The RBI committee is likely to correct some of these weaknesses. It is likely to recommend participation of ARCs as resolution applicants in the IBC process. The RBI had, a few years ago, turned down the application of an ARC for taking part in resolution of a failed telecom company as a resolution applicant.

ARCs, too, are trying new things such as tying up with outside players to bid for assets. “We have to think about bringing together large ARCs and AIFs for buying bad assets,” says a banker. The RBI committee will also look at allowing more freedom to AIFs in the bad loan market.

Many financial institutions are already setting up AIFs in Gujarat International Finance Tec-City (GIFT City) to pool global money for investing in India. “It is the best route for international investors. There is a five-year tax holiday with no withholding tax on pass-through. The entry and exit processes are also very simple for global investors,” says Jhaveri of Bhuta Shah & Co LLP. Greater participation of AIFs in the bad loan market will ease pressure on ARCs.

New-Look IBC

NARCL and the new regulatory regime for ARCs will reduce the workload of National Company Law Tribunal (NCLT) benches that is expected to increase considering that the bankruptcy code is back in force after being suspended post Covid-19 outbreak. The newest change under IBC is pre-packs for MSMEs, which will reduce the burden of NCLT benches and maximise value for creditors. But things may not go as smoothly as expected. “The promoter will opt for a pre-pack only if he gets an assurance from banks that they are not going to press for change of management,” says a market expert. “The key feature is the power to creditors to initiate insolvency by a two-third vote if they feel the pre-pack process is not going well,” says Ashwin Bishnoi of Khaitan. “The biggest issue with pre-packs is that you have to run an auction process if you are giving a haircut to trade creditors. This is going to be time-consuming,” he adds.

Some say the success of MSME pre-packs will prepare the ground for a similar framework for large companies. “The pre-pack regime is a welcome change. I think the government is trying to experiment with MSMEs. This could be expanded to large corporates,” says a corporate lawyer.

Some think otherwise. “I don’t think there is any political capital and will for implementing pre-packs for large companies,” says a corporate lawyer, adding, “If the two Covid waves don’t give you political motivation, nothing will.”

The IBC process has had its share of problems. It initially saw a lot of litigation. The defaulters often disputed the insolvency application itself. There was also lack of coordination among lenders and operational creditors. At times, there were multiple applications at the invocation stage with every lender wanting its own resolution professional to manage the company. The government is looking to remove such roadblocks. For instance, the rise in threshold of dues for starting IBC proceedings from Rs 1 lakh to Rs 1 crore will address the issue of operational creditors dragging companies to bankruptcy for small dues. Operational creditors have been the most ardent users of IBC. “Also, the new 330-day deadline for resolution is an acknowledgment of reality. No jurisdiction in the world delivers a restructuring of this scale in one year. The UK average is two years,” says Bishnoi of Khaitan and Co.

The Indian economy will see a continuous flow of distressed assets given its size and growth potential. Covid-19 alone will add stress to many companies once the one-time loan restructuring ends. The government and bankers have done their job by offering loan moratoriums, loan guarantees and one-time restructuring. Now, it is the turn of NARCL, private ARCs and IBC to protect the value of stressed assets through timely restructuring and resolution.