A Good “Bad Bank”: Analysis of an Alternative tool for Resolution

[Winy Daigavane and Pavan Belmannu are 4th year B.A.LLB. (Hons.) students at the National University of Advanced Legal Studies, Kochi]

With the Insolvency & Bankruptcy Code (Amendment) Ordinance, 2020 coming into force, the operation of the Insolvency & Bankruptcy Code 2016 (IBC) has been suspended for a period of six months or a for a further period not exceeding one year. This necessitates the creditors to look at various alternatives for resolution. Filing civil suits for recovery or under Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (the SARFAESI Act) cannot be considered as effective alternative arrangements as they focus on the recovery of debts. While there is extensive literature on the schemes under the Micro, Small and Medium Enterprises Development Act, 2006, the Companies Act 2013, and the Reserve Bank of India’s (RBI’s) Prudential Framework, the authors seek to examine the possibility of a relatively lesser-known alternative proposed by the Indian Banks’ Association called the ‘Bad Banks’ as a solution to the prevailing problem of non-performing assets (NPAs), which is expected to increase further due to the pandemic.

The What and How of a Bad Bank?

A Bad Bank performs a dual function of an asset-reconstruction company (ARC) and an asset-management company (AMC) and is, in reality, not a bank. The assets owned by banks can be divided into two categories: first, the good assets; second, the NPAs and other illiquid and risky securities. Bad Banks are set up to buy the second category of assets from the banks, so that the assets held by the banks represent their core business. It helps the banks to reduce the risk and the burden of the liabilities from the balance sheet. The experts at the Bad Banks would take the onus off the bank to maximize the value of the assets so acquired and ‘quarantine the stressed assets’ away from the banking system. Instead of the banks or corporates individually seeking to realize the full value of assets, through the Bad Banks, an asset pool is created where the willing buyers can easily obtain assets.

The Bad Bank model is not novel and is usually set up in times of financial crises. It is not an unfamiliar idea even in the Indian context as the interim Finance Minister, in 2018, had set up a committee to examine the feasibility of setting up an ARC and/or AMC for quicker resolution of the stressed assets, in other words, a ‘bad bank.’ The committee submitted its report suggesting different models such as the ‘Bank-Led Resolution Approach’ for resolution of consortium loans between ₹50-500 crore and setting up a national AMC called Sashakt India Asset Management for resolution of bad loans over ₹500 crores. However, there was no proposal for setting up of a Bad Bank from the committee.

Viability of Bad Banks as an Alternative to the IBC

The preamble of the IBC shows that it was introduced to maximize the value of the assets of insolvent persons by providing for a time-bound resolution, while keeping in mind the interests of all the stakeholders. Dr. M. S. Sahoo, the chairperson of the Insolvency & Bankruptcy Board of India, has called “resolution as the soul of the code.” It has been oft-quoted that IBC is not for recovery but resolution. National Company Law Appellate Tribunal has also made it clear that the IBC was not enacted for individual creditors to recover their dues.  

From the process laid down in the IBC, one can appreciate that it seeks maximization of the value of assets by approving the most optimal resolution plan. Further, at the end of the successful corporate insolvency resolution process (CIRP), the corporate runs as a going concern with all the stakeholders receiving the maximum possible benefit. On the other hand, the recovery process is to maximize the benefit for the individual creditor. It results in an inequitable distribution of assets, as recovery serves the interests of the creditors on a first-come-first-serve basis.

Bad Banks work in a manner to facilitate resolution, perhaps even better than IBC, as the percentage of haircut that the creditors might endure would be lowered. This is because CIRP entails a collective decision making with the voting power being proportional to the percentage of the debt, and this can be avoided with Bad Banks, as the value at which the NPAs are sold are left to the judgement of the experts, which can further be monitored.

International Precedents on Bad Banks

The first Bad Bank of Grant Street National Bank was created in 1988 by US-based Mellon Bank. It merely served as a mechanism to resolve or liquidate bad debt to recover the maximum amount of money. Various countries like Malaysia, Ireland, Spain, and Germany have structured their own Bad Bank models based on their country-specific policies. All these countries were undergoing an alarming bad loan situation, similar to the present-day Indian situation of rising NPAs.

The Malaysian model of setting up two AMCs, ‘Danaharta’ to take over bad loans and ‘Danamodal’ to infuse capital into weak banks, successfully fulfilled its objective. Danaharta, which was a completely government-backed AMC, provided for the issue of special government bonds in return for the purchase of distressed assets from Malaysian financial institutions after the Asian crisis. It also assisted in the determination of a market price for the asset beyond a threshold and provided for profit-sharing with the original financial institution after the restructuring of the distressed asset. Moreover, it was not a Bad Bank to perpetuity, and it wound up by 2005. Industry experts and professionals were involved in its operation, which in turn facilitated the quality recovery of the country’s financial market.

The Bad Bank of Ireland, National Asset Management Agency (NAMA) was legislatively established in 2009 as a consequence of the crisis in its real estate sector. The scheme provided for the transfer of bad assets to the NAMA at a discounted value and a payment in the form of government bonds for the same. After the transfer, a statutory liquidation was mandated within a period of seven to ten years, to obtain a maximum fiscal return. Similar to NAMA, in 2012, Spain established a Bad Bank called The Management Company for Assets Arising from the Restructuring of the Banking Sector (SAREB), which acquired real estate-related assets from various banks.

Challenges and Suggestions for the Indian Model

Drawing from the international models as well as testing the practicability of the proposed model against the objective sought to be achieved will be essential. To bring about a material change across the financial system, the size of the Bad Bank must be large enough to take away a meaningful chunk of bad loans from the banks. There is also a need to ensure that the issue of pricing mismatch between the buyer and seller is resolved. The Bad Bank can set a market price for an asset, similar to the Malaysian Model. While designing a Bad Bank model, the following concerns will have to be addressed.

First, the ownership structure. One of the very important factors is the funding of these entities, since adequate liquidity is a prerequisite for a Bad Bank to bring about a difference in the current scenario. Various options can be explored – entirely government-backed funding, private funding, or a public-private partnership (PPP).

Although the aforementioned international models follow entirely government-backed funding, it may not be feasible because of pricing issues. In furtherance of the objective of the creation of Bad Banks, a government-controlled Bad Bank will not bargain much and, in effect, may be forced to buy the assets at a bank desired price. This would be a failure of the rationale of the purchase of bad assets by a third party at a market-driven price based on the viability of the business. The NPAs would be merely transferred from one entity to another, but the root cause of the banking crisis would not be addressed. Moreover, to address the moral hazards, it is essential that the role of government is limited and that, for a time-bound resolution coupled with essential commercial freedom, a PPP model is applied. This way, the issue of funding can be resolved by resorting to initial government as well as private funding by utilization of alternate fund investments.

Second, the governance structure. It is essential that similar to international models, Bad Banks involve experts and professionals in its governance structure. Government bonds or recapitalization bonds can be issued against the purchase of distressed assets.

Third, asset resolution. The asset resolution stage is the eventual sale to a willing buyer based on a plan. If the recovery of these bad loans does not occur, there is a possibility that these Bad Banks end up becoming a warehouse for bad debts. The market-driven economy, with time, can address this issue as the demand for assets increases.

A major challenge is a legal tangle that will be created by the introduction of this system. Similar to the introduction of the IBC, it is essential that various sectors are on board with this change, so as to make systematic and consequent changes in other necessary legal frameworks, as required.

Conclusion

In order to tackle the rising problem of NPAs, the incorporation of a Bad Bank might be one possible solution. However, this solution cannot be taken at face value, and all the challenges along with it must be considered with effective solutions being provided. If not, the fears of failure of an institution would turn into reality and the government will lose both the money spent on acquiring the NPAs and the assets themselves. Hence, the need of the hour is not just a bad bank, but a good ‘bad bank.’

Winy Daigavane & Pavan Belmannu 

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