Bad bank will help clean up balance sheets, but credit culture must change for healthier financial system

Synopsis: Issues and challenges that may impact the performance of the National Asset Reconstruction Company Ltd.

Introduction

The balance sheets of banks show stressed loans worth Rs 2 lakh crore.

To address this problem the government had envisaged the formation of National Asset Reconstruction Company Ltd (NARCL) referred to as the bad bank within a period of five years.

Cabinet recently cleared a ₹30,600-crore guarantee programme for securities to be issued by the National Asset Reconstruction Company Limited (NARCL) for taking over and resolving non-performing assets (NPAs).

How the NARCL will function?

As the buyer of these bad loans, NARCL, through its operational entity, India Debt Resolution Company, will be tasked with the resolution of these assets.

The NARCL will acquire stressed assets of about Rs 2 trillion in phases, and these soured loans would be transferred by paying 15 per cent cash to lenders and the remaining 85 per cent would be paid through security receipts.

These security receipts issued by the NARCL would be backed by a government guarantee of up to Rs 30,600 crore.

How it will be beneficial?

Faster resolution of stressed assets: this may lead to better outcomes as consolidating loans from multiple banks into a single entity may lead to a more effective, and timely resolution process.

Provide Liquidity for banks: the upfront cash payment will aid cash flows of banks.

What are the issues and challenges involved?

Price discovery: the price at which NARCL buys the stressed loans from the banks might prove to be challenging, even though the transaction involves the public sector as both buyer and seller.

Uncertainty over the Response from secondary market: Banks though will have the freedom to sell the security receipts. But to what extent a secondary market for such securities evolves is debatable.

Uncertainty over the yield: Considering that these loans have been written down by banks, it is difficult to gauge what this will yield. For instance, Historically, banks see about 10 per cent recovery from written-off loans.

Lack of Buyers: The absence of buyers as reflected in the IBC process, the extent to which financial creditors have had to take haircuts on their admitted claims, all raise questions over the market appetite on both sides of the transaction.

NARCL may become another repository for bad loans: The creation of a bad bank could help clean up bank balance sheets though in the absence of a successful resolution it may end up being a repository for bad loans.

Net impact on NPA’s is negligible: While it will reduce gross non-performing asset (GNPA) ratios of public sector banks (PSBs), the reduction in net NPA (NNPA) will be limited to the extent of un-provided exposure.

Does not address the underlying cause of the bad loan problem in India: Only by reforming the banking system in India, especially the public sector banks, can the financial system be made more efficient.

Delays in resolution: Resolution of NPAs is a long-drawn process in India as it is difficult to find buyers and any delay will only lead to value destruction.

May incur losses for banks in the longer run: Upon extinguishment of government guarantee on Security receipts (after five years), banks will have to bear the loss on the un-redeemed Security receipts.

What is the way forward?

NARCL will have to be equipped with talented and passionate management and will require government and regulatory oversight to succeed.

Source: This post is based on the article “Bad bank will help clean up balance sheets, but credit culture must change for healthier financial system” published in Indian Express & “Focus now on faster NPA resolution to ensure NARCL’s success” published in Business Standard on 18^th Sep 2021.