Public sector banks' tale of debt overhang and ARCs

Unwillingness to mark down value of assets to values acceptable to ARCs is stalling NPA resolution

Public sector banks (PSBs) provide the bulk of long-term funding in India. Over the past 10 years, lending by PSBs for steel production, power generation and infrastructure projects was not adequately prudent. At the end March 2016, the net non-performing assets (NNPAs) of PSBs amounted to Rs 2.5 lakh crore. The same number as a percentage of gross domestic product was 1.9 per cent and for all scheduled commercial banks (SCBs) it was 2.6 per cent. By September 2016, the ratio of NNPAs to total net advances for PSBs had risen to 7.4 per cent. Total government provisioning for recapitalisation of PSBs is comparatively inadequately lower at Rs 80,000 crore.
 
The mounting bad debt of PSBs is constraining fresh long-term lending which in turn is inhibiting generation of employment. It follows that PSBs need assistance to get impaired assets off their books. This article reviews how best to enhance the limited role asset reconstruction companies (ARCs) have played till now given that the fixed costs in setting them up have already been incurred (ICRIER Working Paper: Can ARCs be Part Solution to the Indian Debt Problem? by Jaimini Bhagwati, M Shuheb Khan and Ramakrishna Reddy Bogathi at http://icrier.org/pdf/Working_Paper_338.pdf).
 
The latest Economic Survey mentions that large amounts are due from just a few borrowers. For instance, “on average, 50 companies owe Rs 20,000 crore in debt, with 10 companies owing more than Rs 40,000 crore apiece”. The Survey suggests that debt forgiveness for defaulting corporates should not be denied based on a “morality play”and that government and the Reserve Bank of India (RBI) should provide the required capital. Using morality for guidance may indeed be counterproductive. However, promoting “moral hazard”, namely that the government will always bail out private firms at taxpayer cost cannot be sustainable policy either.
 
After 2008, the US government did provide $275 billion to banks under its Troubled Asset Relief Programme (TARP) which has since been returned. However, the fuller story of support to banks includes the buying up of worthless mortgage-backed securities by the US Federal Reserve the stock of which stood at $1.78 trillion even in January 2017. The Federal Reserve has pushed real dollar interest rates down to unprecedented lows and even negative real levels. Over the last eight years, this has transferred enormous amounts of wealth from the salaried and pensioners, those who depend primarily on interest income, to banks.
 

The authorisation for banks to sell non-performing loans (NPLs) to ARCs comes from the Sarfaesi  (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest) Act, 2002. From 2002 till August 2014, ARCs paid just 5 per cent of the marked down value of the acquired asset. The balance 95 per cent was accounted for through the issuance of security receipts (SRs). SRs do not carry any interest and are almost entirely purchased by the bank selling the NPA to an ARC. If there are any recoveries, the legal and resolution expenses are met first.

Thereafter, ARC management fees, around 1.5 per cent annually of outstanding SRs, are deducted from proceeds before balance recoveries are distributed by ARCs to SR holders.
 
In August 2014, RBI raised the initial payment by ARCs from 5 to 15 per cent of the acquisition value of NPAs. Further, after 2013, the acquisition values increased from around 20 per cent of book value to above 40 per cent causing a sharp reduction in NPA purchases by ARCs. To-date, RBI has not allowed ARCs to access Indian capital markets for equity or debt capital. As ARCs do not have adequate risk capital they have been more in liquidation rather than turning around or restructuring of entities. RBI should allow ARCs to raise funds from all private capital market sources.
 
The Insolvency and Bankruptcy Code of 2016 may reduce the time taken to resolve insolvencies. However, at this nascent stage of the setting up of the National Company Law Tribunal and the Insolvency and Bankruptcy Board of India, it is unclear whether Indian courts would expedite relief to creditors.  The recent ordinance amending the Banking Regulation Act empowers RBI to direct PSBs to get on with the resolution of NPAs. It is only over time that we will know how much of a game changer this ordinance will be in practice.   
 
An overriding factor which obstructs resolution of NPAs is the unwillingness of banks to mark down the value of their impaired assets to values which would be acceptable to ARCs and others. The concern about ex-post facto vigilance scrutiny of asset sales is compounded by the fact that NPAs are largely on the books of PSBs and ARCs are mostly owned by private sector entities. The possibility of collusion can be reduced by auctioning assets through open bidding processes. Successful purchases of NPAs require experienced insolvency and mergers and acquisitions professionals, flexible labour laws and credit lines. The Parliamentary Consultative Committee of the Ministry of Finance has considered the possibility of public auctioning of NPAs. According to media reports, the government may encourage public sector undertakings (PSUs) in the steel and power sectors to participate in such auctions. Cash-rich PSUs should not be arm-twisted by the government to make unrealistically high bids for impaired assets. It is important, for the integrity of the price discovery of distressed assets, to include private sector parties with domain knowledge in transparent bidding processes open to ARCs, non-banking financial companies, banks and PSUs. In these continuing times of extremely low interest rates in Japan, Eurozone and the US, it is conceivable that foreign capital may be attracted, equivalent to foreign direct investment in India, through ARCs.
 
The Indian reality is that any approach to resolving this problem of growing volumes of NPLs will be mired in political economy and legal tangles. To sum up, the extent to which defaulting firms can be compelled by courts to comply with contractual obligations and private investors are willing to fund the resolution of impaired assets through transparent auctions, taxpayers would have to provide lower amounts of funding support to PSBs.

j.bhagwati@gmail.com
The writers are RBI chair professor and research associate, respectively, at ICRIER