The government has set up two new entities to acquire stressed assets from banks and then sell them in the market.
Following through with one of her key announcements in the Budget, Finance Minister Nirmala Sitharaman has announced the formation of India’s first-ever “Bad Bank”. National Asset Reconstruction Company Limited (NARCL) has already been incorporated under the Companies Act. It will acquire stressed assets worth about Rs 2 lakh crore from various commercial banks in different phases. About Rs 90,000 crore in bad loans will be transferred in the first phase.
Another entity — India Debt Resolution Company Ltd (IDRCL), which has also been set up — will then try to sell the stressed assets in the market.
The NARCL-IDRCL structure is the new bad bank. To make it work, the government has okayed the use of Rs 30,600 crore to be used as a guarantee. It will cover the entire pool of Rs 2 lakh crore.
As per the announcement made on Thursday, the bad bank or NARCL will pay up to 15 per cent of the agreed value for the loans in cash and the remaining 85 per cent would be government-guaranteed security receipts.
What are non-performing assets?
A non performing asset (NPA) is a loan or advance for which the principal or interest payment remained overdue for a period of 90 days. Banks and other financial institutions are required to classify the debts owned by them into the following four categories:
a) Standard: It is a kind of performing asset which creates continuous income and repayments as and when they become due.
b) Sub-standard: Loans and advances which are non-performing assets for a period of 12 months.
c) Doubtful: The assets considered as non-performing for a period of more than 12 months
d) Loss: All those assets which cannot be recovered by the lending institutions
Out of the above four, a non-performing asset would be either a sub-standard, doubtful or a loss asset.
What is Bad Bank?
A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution. The entity holding significant nonperforming assets will sell these holdings to the bad bank at market price. By transferring such assets to the bad bank, the original institution may clear its balance sheet
Technically, a bad bank is an Asset Reconstruction Company (ARC) or an Asset Management Company (AMC) that takes over the bad loans of commercial banks, manages them and finally recovers the money over a period of time.
The bad bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans.
US-based Mellon Bank created the first bad bank in 1988, after which the concept has been implemented in other countries including Sweden, Finland, France and Germany. Countries like Malaysia created a bad bank sponsored by the government, the US launched the Troubled Asset Relief Program (TARP) in 2008, Ireland, too, had set up a National Asset Management Agency (NAMA) in 2009. But conditions in these countries were far different from what is being tried in India.
Why do we need a bad bank?
In every country, commercial banks accept deposits and extend loans. The deposits are a bank’s “liability” because that is the money it has taken from a common man, and it will have to return that money when the depositor asks for it. Moreover, in the interim, it has to pay the depositor an interest rate on those deposits.
In contrast, the loans that banks give out are their “assets” because this is where the banks earn interest and this is money that the borrower has to return to the bank. The whole business model is premised on the idea that a bank will earn more money from extending loans to borrowers than what it would have to pay back to the depositors.
Imagine, then, a scenario where a bank finds a huge loan not being repaid because, say, the firm that took the loan has failed in its business and is not a position to pay back either the interest or the principal amount.
Every bank can take a few such knocks. But what if such “bad loans” (or the loans that will not be paid back) rise alarmingly? In such a case, the bank could sink.
Now imagine a scenario where several banks in an economy face high levels of bad loans and all at the same time. That will threaten the stability of the whole economy.
In normal functioning, as the proportion of bad loans — they are typically calculated as a percentage of the total advances (loans) — rise, two things happen. One, the concerned bank becomes less profitable because it has to use some of its profits from other loans to make up for the loss on the bad loans. Two, it becomes more risk-averse. In other words, its officials hesitate from extending loans to business ventures that may remotely appear risky for the fear of aggravating an already high level of non-performing assets (or NPAs).
If a bank has high non-performing assets (NPAs), a large part of its profits would be utilized to cut losses. As a result, any bank with high NPAs is likely to become more risk averse and would be less willing to lend money to borrowers. It would become more difficult for businesses and consumers to take loans from banks, thereby impacting the overall robustness of the economy.
Moreover, in India, a large portion of NPAs is with the government-owned public sector banks. In the past, the government had to infuse fresh capital to improve the financial health of PSBs. The government infusing fresh capital in PSBs means less money for other schemes.
Background About Bad Bank
The idea gained currency during Rajan’s tenure as RBI Governor. The RBI had then initiated an asset quality review (AQR) of banks and found that several banks had suppressed or hidden bad loans to show a healthy balance sheet.
However, Former Reserve Bank of India (RBI) governor Raghuram Rajan opposed the idea of a government-led bad bank and instead suggested that private sector asset reconstruction companies be strengthened to have adequate capital to make all-cash purchases of bad loans from banks.
While there are 28 private ARCs, sales of bad loans have not picked up, as the banks and the reconstruction companies differ on the fair value of these assets, so the need was felt for government-backed security receipts.
Now, with the pandemic hitting the banking sector, the RBI fears a spike in bad loans as well as Finance Ministry is also Pushing the concept to clean the Balance Sheet of Public Sector Banks to make it more profitable to expand credit base.
Professionally-run bad banks, funded by the private lenders and supported by the government, can be an effective mechanism to deal with Non-Performing Assets (NPA).
Financial Stability Report (FSR): The RBI noted in its recent FSR that the gross NPAs of the banking sector are expected to shoot up to 9.8% of advances by March 2022, from 7.48% in March 2021. As of March 2021, the total bad loans in the banking system amounted to Rs 8.35 lakh crore.
K V Kamath Committee: Noted that corporate sector debt worth Rs 15.52 lakh crore has come under stress after Covid-19 hit India, while another Rs 22.20 lakh crore was already under stress before the pandemic.
That is why bad banks move by the government became the need of the hour.
How will the NARCL-IDRCL work?
The NARCL will first purchase bad loans from banks. It will pay 15% of the agreed price in cash and the remaining 85% will be in the form of “Security Receipts”. When the assets are sold , with the help of IDRCL, , the commercial banks will be paid back the rest.
If the bad bank is unable to sell the bad loan, or has to sell it at a loss, then the government guarantee will be invoked and the difference between what the commercial bank was supposed to get and what the bad bank was able to raise will be paid from the Rs 30,600 crore that has been provided by the government.
The government guarantee will be valid for a period of five years and the condition precedent for invocation of the guarantee will be resolution or liquidation. To disincentivise delay in resolution, NARCL has to pay a guarantee fee which increases with the passage of time.
National
Bank for Financing Infrastructure and Development (NaBFID)
In News: The Cabinet has cleared a Bill to set up a government-owned development finance institution (DFI) with initial paid-up capital of Rs 20,000 crore so that it can leverage around Rs 3 trillion from the markets in a few years to provide long-term funds to infrastructure projects as well as for development needs of the country. To put it in perspective, Rs 3 trillion constitutes slightly less than 3 per cent of the Rs 111 trillion to be spent on over 7,000 projects in the National Infrastructure Pipeline from 2019-20 to 2024-25. Besides, the government will give Rs 5,000 crore as grant to the institution
The National Bank for Financing Infrastructure and Development Bill, 2021 was introduced in Lok Sabha on March 22, 2021. The Bill established the National Bank for Financing Infrastructure and Development (NBFID) as the principal development financial institution (DFIs) for infrastructure financing.
- DFIs are set up for providing long-term finance for such segments of the economy where the risks involved are beyond the acceptable limits of commercial banks and other ordinary financial institutions.
- Unlike banks, DFIs do not accept deposits from people.
- They source funds from the market, government, as well as multi-lateral institutions, and are often supported through government guarantees.
NBFID has been set up as a corporate body with authorized share capital of one lakh crore rupees.
Shares of NBFID may be held by: (i) central government, (ii) multilateral institutions, (iii) sovereign wealth funds, (iv) pension funds, (v) insurers, (vi) financial institutions, (vii) banks, and (viii) any other institution prescribed by the central government.
- Initially, the central government will own 100% shares of the institution which may subsequently be reduced up to 26%.
Functions of NBFID: NBFID will have both financial as well as developmental objectives.
- Financial objectives will be to directly or indirectly lend, invest, or attract investments for infrastructure projects located entirely or partly in India.
- Central government will prescribe the sectors to be covered under the infrastructure domain.
- Developmental objectives include facilitating the development of the market for bonds, loans, and derivatives for infrastructure financing.
Functions of NBFID include:
- extending loans and advances for infrastructure projects,
- taking over or refinancing such existing loans,
- attracting investment from private sector investors and institutional investors for infrastructure projects,
- organizing and facilitating foreign participation in infrastructure projects,
- facilitating negotiations with various government authorities for dispute resolution in the field of infrastructure financing, and
- providing consultancy services in infrastructure financing.
Source of funds:
- NBFID may raise money in the form of loans or otherwise both in Indian rupees and foreign currencies, or secure money by the issue and sale of various financial instruments including bonds and debentures.
- NBFID may borrow money from: (i) central government, (ii) Reserve Bank of India (RBI), (iii) scheduled commercial banks, (iii) mutual funds, and (iv) multilateral institutions such as World Bank and Asian Development Ban
Management of NBFID:
NBFID will be governed by a Board of Directors. The members of the Board include:
- the Chairperson appointed by the central government in consultation with RBI (Present Chairman - K V Kamath)
- a Managing Director,
- up to three Deputy Managing Directors,
- two directors nominated by the central government,
- up to three directors elected by shareholders, and
- a few independent directors (as specified).
A body constituted by the central government will recommend candidates for the post of the Managing Director and Deputy Managing Directors. The Board will appoint independent directors based on the recommendation of an internal committee.
Support from the central government:
- Central Govt sets Rs 1-trillion Infrastructure Lending Target for NaBFID for FY23.
- NaBFID will get a 10-year tax concession so that it can provide long-term funds at an affordable cost to the infrastructure sector.
- It will also get government guarantees at a concessional rate of up to 0.1% for borrowing from multilateral institutions, sovereign wealth funds, and other such foreign institutions
- The Central government has infused Rs 20,000 crore in NaBFID, and an additional Rs 5,000 crore has been given as grants.
Prior sanction for investigation and prosecution:
No investigation can be initiated against employees of NBFID without the prior sanction of:
- The central government in case of the chairperson or other directors, and
- The managing director in case of other employees.
Courts will also require prior sanction for taking cognizance of offences in matters involving employees of NBFID.
Other Development Financial Institutions:
- The Bill also provides for any person to set up a DFI by applying to RBI to involve private players and bring competition in Infrastructure financing.
- RBI may grant a license for DFI in consultation with the central government.
- RBI will also prescribe regulations for these DFIs.
NaBFID to be regulated as AIFI under RBI Act
- NaBFID shall be regulated and supervised as an All India Financial Institution (AIFI) by the Reserve Bank under Sections 45L and 45N of the Reserve Bank of India Act, 1934.
- It shall be the fifth AIFI after EXIM Bank, NABARD, NHB and SIDBI.
Significance of NaBFID:
Infrastructure usually generates predictable and stable returns in the long run. As a result, it primarily relies on low-cost debt financing. Debt financing has two main sources – banks and bond markets. Banks have access to cheaper short-term liabilities. They can therefore offer lower lending rates. But infrastructure assets are usually long-term. This creates a mismatch between the assets (long-term) and liabilities (short-term) on the banks’ books. Consequently, bank financing of infrastructure is inherently risky and may raise financial stability concerns.
In contrast, a deep and liquid bond market could attract a variety of investors. Investors (like pension funds and insurance companies) with long-dated liabilities are a natural fit for long-dated bonds. Strong demand from such investors could lower the yield on longer tenor infrastructure bonds, making infrastructure financing through bond markets cheaper and safer.
In India, infrastructure sector is heavily bank financed while the bond markets are not adequately deep and liquid. Against this backdrop, the government’s National Infrastructure Pipeline aims to invest Rs 100 trillion in the infrastructure sector by 2024-25. The challenge is to raise this capital at the least cost. There is broad consensus that this would require policy interventions. Two options have been widely debated: first, making Indian bond market deeper and more liquid; second, establishing a DFI for infrastructure financing to avoid excessive reliance on banks.
