Understanding Bad banks and NPA Crisis
With the banking sector crippling in the wake of COVID-19 induced depressionary forces, plans to place toxic assets in one or more bad banks have gained steam in recent weeks. Fundamentally, a Bad Bank purchases distressed assets from banks to eliminate toxic assets in their balance sheets and restore liquidity in the market. On account of the pandemic, India’s NPA crisis is all set to be exacerbated, where millions might not be able to uphold their end of the bargain.
Taking into consideration, the need to restructure the financial sector in India, Budget 2021-22 announced that the Centre will set up an ARC, commonly referred to as a bad bank, to resolve the issue.
Make no mistake, the Insolvency and Bankruptcy Code (IBC) and Asset Reconstruction Company (ARC) are two differentiable concepts. IBC aims toward the resolution and reorganization of insolvent companies, whereas ARCs are set up for clearing up NPAs. Thus, ARCs primarily deal with recovery, while the IBC seeks a resolution. Thus, ARC serves as a damage control policy rather than a damage prevention mechanism.
Given India’s deteriorating financial health, a preventive mechanism is the need of the hour. Given, Vijay Mallya’s felony to 17 banks, owing them 90 billion, which had sent shock waves throughout the market, Indian authorities should be cracking down on “bad boy billionaires” in order to restore financial discipline in the economy. Consequently, a preventive mechanism presents itself as an unadorned opportunity to usher India out of its bad bank crisis.
Shell companies, which are emphatically used by the corporate leaders to garb their revenues and clandestine corporate affairs, need to be rooted out from their core. The inefficiency to track such shell companies is what renders the government’s pursuit to counter defaulting banks, useless. It is to be noted that operating a shell company in India is not illegal.
With the shell company as a front, all transactions are shown on paper as legitimate business transactions, thereby turning black money into white. In this process, the business person also avoids paying tax on the laundered money.
It might come as a shock to many, but India does not have a concrete definition of shell companies. Shell companies are not defined in any law or act. This emphatically shows India’s reluctant attitude towards reviving its economy’s financial health.
Have all the countries not defined shell companies in any law or act? No, the US has defined shell companies under their Securities Act. The US Securities Act defines shell companies as – “Securities Act Rule 405 and Exchange Act Rule 12b-2 define a Shell Company as a company, other than an asset-backed issuer, with no or nominal operations; and either: >no or nominal assets>assets consisting of cash and cash equivalents; or >assets consisting of any amount of cash and cash equivalents and nominal other assets.”
How ARCs or Bad banks won’t solve India’s burgeoning NPA problem?
It is no news that one of the worst victims of the ongoing economic crisis in India is the country’s already wounded financial sector. As per various reports, with businesses struggling to survive, bad loans are expected to rise, denting Indian banks’ health. But as a law of nature, someone’s loss is another’s gain. Here the only organization smelling opportunity is ARCs.
As can be expected, given the current state of the Indian economy, ARCs demand in India going forward is all set to rise as the economic slump will eventually lead to a surge in non-performing assets (NPAs).
Even the global players are smelling an opportunity. Canada-based asset management firm Brookfield is reportedly going to set up an ARC in India. But does that imply that ARCs are devoid of problems? Certainly not. The economic crisis, which provides them with a huge opportunity, has also adversely impacted their business of raising capital to recover money.
As aforementioned, raising capital for acquiring more assets is one of the biggest challenges faced by ARCs. Initially, ARCs had a fee-based business model. Banks had to pay ARCs a fee to handle their bad loans, but with the introduction of the 5:95 rule by the Reserve Bank of India (RBI), the easy business became difficult.
Under the 5:95 rule, if ARC was buying a stressed asset, it had to invest a minimum of 5% of the acquisition price. Later, the woes of ARCs were exacerbated under Raghuram Rajan, when this ratio was increased to 15%. This certainly led to ARCs having more skin in the game.
Secondly, given the current economic slump, ARCs’ probability to recover bad loans has plummeted adversely as people are unable to pay back their liability. The ability to pay has also been adversely impacted by the operational difficulties that are being faced by the borrowers due to the lockdown.
Thus, more time is being asked to repay their dues. Additionally, some of the asset sales, which were in the process of getting completed, have been postponed due to the pandemic. Similarly, IBC cases have been delayed as the National Company Law Tribunals (NCLTs) are not fully functional. Thus, raising capital for acquiring more assets is one of the biggest drawbacks and challenges for bad loans.
As the financial crisis continues, the need to remove troubled assets from financial institutions’ balance sheets has become critical. Confidence in our banking and the financial system requires confidence in our financial institutions and the ongoing reporting of losses and write-downs continuously hampers progress.
Therefore, it is imperative to see the situation as-is wherein ARCs and Bad Banks may provide incremental improvements but is unlikely to dramatically restore balance sheets. Indian financial structure additionally needs the option of restructuring stressed assets and IBC and a preventive measure to treat the root cause of the problem, which is segregation of troubled assets and timely risk management.
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