NARCL: Need and Challenges – Explained, pointwise

Introduction

Recently, the Cabinet has 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). 

What is National Asset Reconstruction Company Limited (NARCL)? 

NARCL is India’s first-ever “Bad Bank”. It has been incorporated as an Asset Reconstruction Company (ARC) under the Companies Act. 

Note: A bad bank is an asset reconstruction company (ARC), involved in the management and recovery of bad loans or NPAs of other banks.

It has been set up to acquire and consolidate stressed assets for their subsequent resolution. 

Public Sector Banks (PSBs) will maintain 51% ownership in the NARCL and private lenders will hold the rest. 

India Debt Resolution Company Ltd (IDRCL) is an operational entity of NARCL. It will manage the stressed assets acquired by NARCL and try to raise their value for final resolution.

How will the NARCL and IDRCL work? 

The NARCL will acquire nearly Rs 2 lakh crore of stressed assets from banks. These will be high value stressed loan assets of more than Rs 500 crore.  

Once acquired, it will pay banks 15%  cash upfront for these assets and issue “security receipts” for the remaining 85% of the asset value. 

The stressed assets acquired by NARCL will then be handled by IDRCL. IDRCL will focus on the resolution of the assets and employ turnaround professionals. When the assets are sold, the commercial banks will be paid back the rest.

And on completion of the resolution, the balance of 85% of value, being held as security receipts, would be given to the banks. 

If NARCL-IDRCL is unable to sell the stressed assets or has to sell it at a loss, then the government guarantee will be invoked. Under this, the difference between what the commercial bank was supposed to get and what they were able to raise will be paid from the Rs 30,600 crore that has been provided by the government. 

In a bid to disincentivise delay in resolution, the government has also proposed that the NARCL pay a guarantee fee to the Centre, which would increase with the passage of time.

How is NARCL different from other asset reconstruction companies? 

Like any other asset reconstruction company, the NARCL will buy bad assets from banks. What sets it apart is that it has a provision of a government guarantee worth Rs 30,600 crore.  

This guarantee, according to analysts puts the minimum recovery rate at 18% from the acquired loans. 

Different structure: While NARCL is the bad debt aggregator, IDRCL will take care of the resolution of bad assets. This structure is different from the existing asset reconstruction companies, which do both bad debt aggregation as well as resolution.

Why does India need a separate bad bank (NARCL)? 

Likely resurgence in NPAs: With Covid-related stress, Indian banks are expected to see a resurgence in their non-performing loans from Rs. 8.34-lakh crore in end-FY21 to ₹10-11 lakh crore by end of this fiscal. 

Declining performance of IBC: The IBC of late is following the law of diminishing returns—after the initial success of selling a few big steel mills and other good assets, where the lenders recovered well over 50% of their dues, things have gone downhill. In some high-profile cases, such as Videocon, Ruchi Soya and Jet Airways, the lenders have hardly recovered 5-6% of their dues.  

Pending cases: Also, too many cases and too few NCLT judges have meant pile-ups and most resolutions taking twice the time limit originally set under the IBC. 

Problem with existing ARCs: Also, the asset construction route has also run into issues. Here too the recoveries have slowed and the ARCs are also facing capital issues. Their security receipts are being downgraded by rating agencies as the recovery expectations move downwards. The ARCs are also reluctant to take up NPAs unless offered very steep discounts. 

Panel recommendation: K V Kamath Committee also suggested setting up Bad bank to revive sectors such as Trade, Textile, NBFCs, Steel and construction, etc. 

What are the issues and challenges involved? 

Owned largely by public sector banks: The biggest problem is that it will be owned largely by public sector banks and have its management drawn mostly from them. It is understandable that if the banks could not dispose of the bad debt easily under them, the NARCL will face similar results. Also, the PSBs will be both shareholders and customers—and it leads to the danger of the bad bank being nothing more than a means to shift some bad debt from one book to another. 

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. 

The guarantee comes with a price: The government guarantee mentioned earlier may ensure an 18% minimum recovery, but it is not free. Banks will have to pay a fee to the government for it. Adjusted for this, it remains to be seen how much recovery banks can make using NARCL. 

Uncertainty over the Response from the 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. 

Deterioration in asset value: Another issue is that physical assets tend to deteriorate soon. This has been a recurring problem in the IBC process, where pressing the bankruptcy solution too late has meant that there is little value left that will attract bidders. The NPAs that the NARCL will handle are all old, legacy assets and probably there is little residual value left in them.  

No sunset clause: It is not clear whether the bad bank has a finite end date—that is, it is a one-time solution—or whether it will continue to exist forever as another option for banks. In the US and other countries, the bad banks typically had a sunset clause and worked with a finite timeline in mind. In fact, the success of bad banks abroad too has depended on speedy disposal instead of trying to manage them until they got the best price. 

The bad bank 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. The underlying cause remains unaddressed by the latest reform. 

For these reasons, many economists including the former RBI Governor have opposed the establishment of Bad Bank in India. 

What are the implications of NARCL?

A major benefit of NARCL would be a faster debt consolidation, potentially leading to quicker decision-making and better recovery rates.

Reduction in NPAs: Through successful execution of phase-1, one can expect near term NPA reduction of >1% and NPA recoveries equivalent to 10bps of system credit. 

Increase productivity: It would result in freeing up the time and effort of banking staff for more meaningful pursuits such as getting more business. 

Repository for bad loans: The creation of a bad bank could help in the cleanup of bank balance sheets through in the absence of a successful resolution it may end up being a repository for bad loans. 

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

Suggestions/Measures to improve the performance of NARCL

Realistic valuations: Banks typically recover only 10-15 paise to a rupee against their fully provisioned bad loans, entailing substantial haircuts of 85-90 per cent. It is important that banks transfer bad loans to NARCL at realistic valuations that factor in such haircuts.  

Transparent process: There is a possibility of conflict of interest arising too. Banks will be part-owners of both NARCL (51 per cent stake) and the asset management company (49 per cent), and they will also be sellers to NARCL. It is important, therefore, that the processes are transparent and independent market professionals are employed to avoid conflicts.  

Right talent and incentives: The success of the bad loan experiment will require a talented management team of IDRCL and the incentive structure for its employees. If best talent is taken up from the market and is offered liberal incentives for recovery of loans above 18 per cent, it could generate more than what the industry is estimating now.

Conclusion

This is a positive move for the banking sector. The success of the bad bank however will depend on the implementation and management of the transferred NPAs. As we pass through the second wave of the Covid pandemic, consumer demand is picking up. There will be many takers for the brownfield projects. It is perfectly timed; there could not have been a better time for the sale of some of these projects.