Bad Bank – Remedy or Malady?
The finance minister (FM) has stated that an asset reconstruction company (ARC) and an asset management company (AMC) would be set up to consolidate and take over the existing stressed debt of the banks and then manage and dispose the assets to alternate investment funds (AIFs) and other potential investors for eventual value realisation. The ARC/AMC taking over the existing stressed debt of public sector banks (PSBs) has been described as Bad Bank (BB). The assumption is that with the BB cleansing the PSBs, the PSBs’ problems would be over. Let me explain that the BB in isolation will not prove to be a panacea for the PSBs.
High NPAs of PSBs: Chronic Malady
In India there is a significant impact of bank NPAs (non-performing assets) on the country’s GDP since the country’s financial system is predominantly bank-based. Hence, it is necessary that the banks must perform well and aid in the gross domestic product (GDP) growth. This means that the banks must have manageable NPA levels which, in the worst case, should be significantly less than 5% as is seen worldwide and even for well-run private sector banks in India. However, NPAs of Indian banks, particularly the PSBs remain unmanageably high (figure-1).
NPAs of PSBs, which had shown a sudden spurt of 93.9% in FY15-16, have stayed high since then. This spurt was due to the asset quality review (AQR) introduced by the Reserve Bank of India (RBI) governor in 2015. Even before FY14-15, PSBs had consistently churned out high levels of NPAs which were camouflaged with myriads of restructuring schemes of the RBI, mercifully withdrawn in February 2018.
So, how can the BB fix the chromic malady of PSBs? A peek into the past can give us ideas. Take the example of the Industrial Development Bank of India (IDBI Bank now). Similar to BB, a special bail-out package was given to IDBI in FY04-05, when it was cleansed with the transfer of a portfolio NPAs of Rs9,000 crore (gross NPAs – Rs12,945 crore) to stressed asset stabilisation fund (SASF), a trust. The transfer value of Rs9,000 crore constituted IDBI’s investment in 20-year zero-coupon government of India bonds to be redeemed out of recoveries from these NPAs. At the end of 20 years, the redemption period could be extended by 10 more years. During the past 15 years, despite passing through unprecedented pre-2008 boom period, recovery from SASF has been about Rs5,000 crore so far, and has almost completely tapered off. This is not a problem, however. Recoveries of banks (predominantly PSBs) is among the lowest in the world (figure-2). In comparison, SASF’s recovery of 38.62% is phenomenal, though far from desirable.
Cleansing of IDBI’s NPAs was not accompanied by management revamp. So, the bank continued with business as usual and continued to receive liberal recapitalisation by the government without a murmur. As a result, the government shareholding which was 51.2% in FY03-04 rose to 98.1% in FY19-20. Yet the bank has the dubious distinction of having the highest NPAs among all the banks as on 31 March 2020.
IDBI has shown us that BB in isolation will only give a short breather and the PSBs will regress IDBI Bank-style soon if not revamped. If the country does not learn from this blunder and rectify it, it is destined to repeat it with increased intensity.
There is a fairly high correlation coefficient of 0.77 between the government ownership of banks and NPA levels. The country, therefore, cannot turn a blind eye to the government’s ultimate responsibility of PSB mismanagement and huge NPAs. This was hinted at by Dr Raghuram Rajan with the following words in his book “I Do What I do”: We will have moved significantly towards limiting interference in public sector banks when the Department of Financial Services (which oversees public sector financial firms) is finally closed down, and its banking functions taken over by bank boards and the Bank Board Bureau.
PSB mismanagement was also highlighted in Dr PJ Nayak Committee Report in May 2014 which had lamented that the government as PSB shareholder had suffered deeply negative returns over decades (due to misgovernance and incompetent boards) and had, therefore, recommended government’s exit from the bank management. According to the Report, at the organisation level, there was need for wide-ranging human resource policy changes with requisite rewards with proper vesting schedules of benefits like stock options, etc, and punishments based on performance. Precious little has been done in this direction, and the PSBs have continued the business of churning out NPAs, as usual.
The government seems to have recognised the malaise and has announced privatisation of two PSBs now, apart from setting up the BB. This does not obviate the need to reform all the PSBs on the lines of Dr PJ Nayak Committee recommendations before setting up BB lest the PSBs suffer the IDBI syndrome. 
Determinants of Successful Bad Bank: International Experience
In the past, many countries have used BBs structured as AMCs to free the banks or other financial entities from non-performing loans (NPLs). The experience is mixed and has lessons for us. A study by Daniela Klingebiel for the World Bank in February 2000 showed that AMCs were set up to either expedite restructuring or rapid disposal of assets. Of the seven AMCs for which data were available, three were constituted as restructuring vehicles and four were set up for rapid disposal of assets. Tables 3 and 4 summarise the experiences.
The study showed that major determinants of success of the AMCs for restructuring or speedy disposal of assets were efficient legal framework, effective management and governance structure and speedy processes. Determinants of bank success post-restructuring were efficient management and adequate capitalisation. 
Korean Experience
In March 1998, the total NPLs of all the Korean banks and financial institutions were 118 trillion won (27% of GDP). Of these, NPLs aggregating 100 trillion won were identified for rapid disposal, including the sticky assets of 68 trillion won. The rest were left for corporate restructuring processes. Half of the NPLs were to be disposed by the lenders themselves by selling off the securities and the remaining were to be sold to the non-performing asset management fund (NPA Fund) set up by the Korea Asset Management Corporation (KAMCO).
The rapid disposal of assets was successful with the bank NPLs declining from 17% in 1997 to 2.3% in 2002. During the same period i.e, 1997-2002, KAMCO’s NPA Fund acquired NPLs of face value of 110.2 trillion won for 39.7 trillion won (36%). The NPA Fund was adequately funded to be able to acquire the NPLs. 
While the secured NPLs were purchased at 52.9% of the debt outstanding by the NPA Fund, the unsecured loans were purchased for 18.8%. In 2013, when the Fund was wound up, it had recovered 48.1 trillion won and ended up with a profit of 8.9 trillion won. The Korean banks have stayed healthy after the bail out since their NPLs had emanated from extraordinary circumstances unlike in India.
The success of KAMCO’s NPA Fund resulted from effective legislation and legal system, effective management and organisation, and Korean ecosystem characterised by strong public interest in scrutinising the use of public funds. Yet it took 14 years for the NPA Fund to resolve NPL level of 17% caused due to the economic meltdown. 
Recipe for India’s BB
Based on international experience and our own experience so far, it is necessary that the creation of BB must be done along with PSB reforms sans bureaucratic / government interference as a part of a well-crafted execution plan. Further, the BB should be a special purpose vehicle to be wound up within a definite period so that a sense of urgency is induced in the BB. 
The AMC may segregate NPAs for speedy disposal and restructuring by invoking fast track corporate insolvency process under Chapter IV of the Insolvency and Bankruptcy Code, 2016 with special National Company Law Tribunal (NCLT) benches and members backed by highly competent back-office so that the disposals are indeed speedy. Development of a special NCLT cadre for this process could be replicated in the entire NCLT echo system later so that speedy resolutions and disposal become a norm rather than an exception as hitherto and induce sustained discipline among the Indian corporates. 
The disposal should be genuinely transparent and speedy on the lines of KAMCO’s NPA Fund. Incidentally, KAMCO's mandate was to resolve with maximisation of value. So it bought assets at a good value (it picked up only the assets, which the banks were not able to dispose rapidly).
This will entail recovery adjudication to be strengthened infinitely. Looking to the NPA levels (Rs8.99 lakh crore of gross NPAs on 31 March 2020) it is unlikely that the AIFs can acquire a significant part of the assets. This would mean delays, impairments, and eventual failure. Hence, it would be worthwhile to capitalise the AMC with adequate funds for takeover of the NPAs at book value over a period in terms of the execution plan. 
Now if you talk of selling to AIFs, the gap between the book value and the AIF price will be huge, going by the fact that our NPAs are known to have very low value. 
KAMCO's objective was maximisation of value, not the profit or return on the Fund. So, it picked up asset at fair value. With AIFs, such a thing is not possible.
So the KAMCO model suits India. We should not shoot from the hip and repent later!
Success of the BB will jumpstart the economy while failure will prove too costly. This presents a chance for creating an epoch-making paradigm after decades of spawning failed organisations. Can the government take the bull by horns and usher in a new era?
(Dr Rajendra M Ganatra is managing director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He has over 25 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in the above article are personal.)
3 years ago
Very well researched and informative article. NPAs are a part of the outcome of credit risk. If there is no NPA, the Bank has taken either zero risk or it has handled recoveries of NPAs highly efficiently. Will the Banks getting the NPA buffer either through their transfer to the BB or recapitalization be mandated not to create new ones? Is such a promise going to have credibility? No. What is required therefore, is a thorough clean-up of the systems, procedures, managerial practices from the grassroots to top management. Further, there should be a time and motion study in all the PSBs and NBFCs as to how much time they spend on core-banking like mobilizing resources through deposits, servicing customers efficiently and mobilizing credit and sale of third parties. GoI would do well to commission this study time-bound to realize what they need to do to clean up the system. The time that the present managers at the branch level devote to sale of 3rd party products and responding to failure of net transactions is stupendous. Branch Managers say that their performance reviews start with the review of sale of third party products and their promotions are linked to such performance!! Time we seek correction to this malaise. Second, all the Bank staff need to culture into doing due diligence of customer beyond their nose -KYC to assess the credit worthiness! KYC is at best a compliance tool for the knowledge of customer and not the entire knowledge of the customer to know his eligibility for extending credit service.
Replied to yerramr comment 3 years ago
Agree with your scholastic comments. Know you as an author. PSBs suffer huge employee moral hazard. Unless this is rectified, huge NPAs will continue.
3 years ago
Excellent article. It has very useful information. The details about NPA cleanup in other countries is very informative. Let us see how the NPA crisis is resolved. Thanks to Dr Ganatra and ML team for this.
3 years ago
Remedy or Malady they are made for each other. Right remedy can only cure Malady. How:
1) Ownership concept must be put in place among operating platforms to deliver results with utmost dedication by all, regardless of position.
2) Self-satisfaction with syndrome of Underperformance stands as curse to erode quality of jobs that involve in negative outcomes.
3) Good Bank can turn out as Bad Bank in the event of syndrome stated above.
4) RBI as Regulatory Authority may examine Quarterly/Half Yearly reviews of Good Banks in respect of both Assets & Liabilities products to leverage steps towards any functional imbalances.
5) There already exists in Bank a robust Credit Management mechanism under present digital platform to support Supervision, Monitoring & Control of Loans & Advaces.
6) If the appropriate functionaries mind their intensive look to its careful maintenance, there leaves little scope to loan to become Bad. Early warning system helps Bank rescue loan becoming potentially sick by following Delinquency Norms.
7) RBI at the instance of Government must monitor Bank directly to keep at safe distance of any political predators or corrupt Businessman to influence upon Government & Bank.
8) Law of Limitations Act prejudicing loan documents getting Time Barred is common tricks to squeeze the Good Banks, being engineered by legal intermediaries. The Rules should be meant not for Bank to stop such malicious activities because Public Money lent out is different from Private Lenders.
8) Quick disposal of pending suits filed to IBC & NCLT must be ensured to make corrupt borrowers responsible & liable for faster recovery of Bad Debts.
9) Chartered Accounting Firms must exercise due diligence while preparing Balance Sheets of any Company to represent the correct views of financial positions. There are lot many cases where low income shown as high and high expense shown as low. Of course, restructuring of BS by Bank can easily check such manipulations.

3 years ago
ARC, AMC, BAD BANK ETC are a simple eye wash. The wine is same. You are putting in a new bottle.
Finally who pays? The Government!
If these NPAs are written off, it catches the attention of the public and there will be adverse criticism.. Hence these types of methods are followed.
The correct solution is RECOVER.
This is not possile in our country, as all these cases are frauds. I am afraid nearly half of these cases are frauds and they cannot find the addresses of these companies and owners.
In the recent budget, Government alloted 20000 crores to strengthen the capital of the public sector banks. That means soon another 20000 crores are going to bad bank!
Replied to rajoluramam comment 3 years ago
Best is recovery. There are two issues here. Recovery from India's NPAs is very low as you would have seen in the article. That is due to huge padding / fund diversion. Yet recovery is the best approach but we specialise in failing incessantly. For recovery RDDBFI Act iss bad legislation and has failed. SARFAESI Act is effective legislation but that has also failed. IBC is a robust legislation but that is also on the verge of failing due to clogging.
Replied to rmganatra comment 3 years ago
I totally agree about the failure of the Acts, but again unless and until the top officials of the Bank are held responsible for the bad loans, we cannot expect to get the effective results. At the same time non-interference by the political bosses in the matter will go a long way to improve the situation.
Meenal Mamdani
Replied to vaswani.rk comment 3 years ago
Agree. But as long as the so far unnamed bureaucrats in the "Department of Financial Services" in the Finance Ministry are not investigated and held responsible for the mismanagement, nothing will change.
These bureaucrats have a very cozy relationship with the top management of PSBs and a previous article in MLF nesletter has said as much.
When this has been pointed out repeatedly then why does the situation not change?
Finance can be a very complex subject for the ordinary politician and she/he needs the expertise of these bureaucrats to devise policy, answer questions put to them by the Indian as well as by foreign entities. Therefore the politicians are held hostage by these suave bandits.
Remember politicians may come and go but bureaucrats continue forever.
Let us see which politician/political party has the gumption to bell the cat and disband this dept as suggested by several eminent administrators.
Replied to Meenal Mamdani comment 3 years ago
Agree. DFS must have nothing to do with overseeing.
Replied to vaswani.rk comment 3 years ago
Agree. PSBs unfortunately are like unguarded treasures which are nibbled inside out. The bankers need to be made accountable.
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