Why the ‘bad bank’ will solve the problem of bankers but not that of banks

When there are new arrivals, the old better make room. Not just in fashion retail stores, but even when it comes to bad loans. That probably explains the finance minister Nirmala Sitharaman’s announcement in the Budget to creating an ARC-AMC structure to deal with the mountain of legacy bad loans lying with public sector banks.

From the looks of it, the so-called bad bank is likely to be an entity created by the banks, for the banks and of the banks – the government-owned ones. In a media interaction Debasish Panda, financial services secretary, was quoted as saying that the bank will house legacy NPAs of Rs.2.2 trillion, of which 70 are stressed assets with loan outstanding above Rs.5 billion. These include the defunct or incomplete power plants, EPC players, and several obsolete businesses.

Under the proposed ARC-AMC model, the ARC or the bad bank will aggregate all the stressed assets and transfer the assets to AMC, a skilled and professional asset management company for resolution. The transfer will be at the net book value (NBV). The banks will get 15% cash and 85% security receipts against the bad debt sold to the new ARC. Though there will not be equity infusion from the government, it may provide sovereign guarantee to meet regulatory requirements, Panda was quoted as saying.

What this means is that this super-duper ARC will be capitalised by the same banks that will be selling their bad loans to it. The actual form and substance are not yet clear in terms of who will run such an institution when it comes into being, and if there will be a fixed time by which resolutions must be effected and, more importantly, what kind of superhero the new entity will have to be able to achieve better and faster resolutions once the debt is aggregated. Will this be yet another bureaucratic creation that will try to solve a problem that cannot be solved, and therefore a pretense, while the real problem that needs solving remains untouched?

The government’s bad bank proposal comes on the back of the Sashakt Panel recommendations in July 2018 that as part of a five-pronged resolution for stressed assets included the creation of an AMC-AIF for bad loans of over Rs.5 billion (See: The anatomy of resolution). The idea was to create an AMC-AIF where the participating banks, and other domestic and foreign institutions would invest together to take over assets and achieve operational turnaround. The lead banker would be empowered to run the resolution process wherein the new AMC-AIF will partner with an ARC to jointly bid for an asset in a competitive bidding process and act as a market maker; once the bid is won, the ARC will restructure the asset and pay the banks in cash within 60 days.

To facilitate the process, 35 entities including banks, financial institutions, fund houses and insurance companies have already entered into an inter-creditor agreement (ICA). The Sashakt proposal also included creating a market for distress debt, which has not taken off in India. “All cogs of wheel have to move simultaneously for the whole thing to get moving,” says Sunil Mehta, chairman of the Sashakt Committee and former chairman of PNB. The structure proposed by the government appears to be somewhat similar, but the “devil lies in the details,” Mehta adds.

Debt aggregation has been a problem in selling bad loans since bankers differ on the price, based on the collateral they hold and their perception on recoveries, which governs the provisioning they make on the asset. “If ever this could be done, this is the best time,” says Rajnish Kumar, ex-chairman, SBI and currently advisor, Baring Private Equity Partners. That’s because the assets under consideration are legacy bad loans, where many banks have provided more than 85%. “A few years ago, different banks would have provided for those loans at different levels, which would have made it difficult to arrive at a common ground in terms of collating those assets,” says Kumar. This will fast track the process of asset sale as buyers do not have to haggle with multiple banks. But that is not to say that the realisation will be any better.

Either way, one key problem that could go away is the great reluctance bankers show in disposing off assets and bringing in cash onto the books.

BANKERS’ NIGHTMARE
Last year, an investment banker recalls a discussion with a PSU bank to buy an asset with an upfront 50% cash payment, but the banker refused to sell and asked for 95% upfront cash instead. “He categorically said, ‘Unless I get 95% cash, I’ll write-off this amount over a long period of time.’ The asset we wanted to takeover was already at the end of the term concession, so he could not have got a better deal than that, but no, he wouldn’t take it.”

This kind of refusal to sell bad loans has become systemic in the banking industry in the past few years for multiple reasons – the latitude bankers have when making provisions for bad loans, the once-bitten-twice-shy attitude that makes honest bankers cover their backside if decisions get questioned, and a mismatch in price expectation (See: The state of lending).

Let’s take the last problem first because it deserves to be made the first priority although it is often not. Most deals do not happen because the bid-ask spread is too high to make the deal happen. Analysts say, one of the reasons why bankers often have a high expectation in terms of price is that asset values themselves are exaggerated in India. “What the bankers do not realise is that, when you go out to restructure or recover through asset sales, you do not get the price you expect,” says Vinayak Bahuguna, who quit as managing director of Arcil in September 2020, and now runs his own financial consulting firm. An additional factor is market conditions. While it may not appear to be a mistake to wait for market conditions to improve, often as time passes, the asset may end up losing more value.

“For the right price, you will get buyers in the market. Today for example, the only recovery you can make from some industrial assets may be the value in the plot, and the price of industrial plots will be significantly lower than a few years ago because of the state of real estate. But bankers have been stubborn on price, ignoring market conditions and decision making has been slow and poor,” says Bahuguna.

The other hurdle is with respect to how assets are valued in the books of the bank. Against the loans made, banks usually have a security by way of a charge on fixed assets or current assets. These fixed and current assets have a historic value. When you go to sell plant and machinery that is say over six years old, the value that you obtain is far lesser than even the depreciated value. But the books of the bank continue to show the historic value because that is the only value they have. Current assets are as per the last stock statement or the amount of bill receivables the bankers hold. And when bankers try and auction the asset, after a loan turns bad, the base reserve price is based on historic value. They do try and reduce prices to discover the value, but the reduction may not be enough. “If the reserve price is fixed at 80%, then they cannot bring it down to 20% even if the realisable value is only 20% without questioning the people who actually assessed the value at 80%. That creates a problem for everybody who has taken the asset value at 80% in the past,” says a banker from SBI.

The fear is not completely unfounded; if there is even a slight chance that the decisions are called into question, with no assurance of any benefit thereof, why even go there? The decision to sell an asset in good time may lead to faster resolution and better recoveries for the bank, but the decision not to sell won’t hurt the bankers, for none will question a deal not done.

An ex-managing director of a state-owned bank cites a real example of a land deal that was done by a DGM at the bank in Chennai. It is common knowledge that circle rate of land for stamp duty purpose is usually higher than the market price. When you try to sell at the circle rate, obviously there are no buyers. In a discovery auction process, while the banker attempted to sell at the circle rate, it did not find any takers. They were able to sell the third time after a 30% markdown to the original circle rate. The deal was executed through a transparent open auction process of bidding. Still, after the cash came in, the CBI prosecuted the concerned DGM, questioning the sale at below circle rate.

With that kind of Damocles sword hanging over bankers, they are afraid of taking decisions that will get them pulled up. They would much rather let the law take its course, where the bank can provide for it prudentially, and let the writeback happen whenever they recover through the legal process, says the earlier mentioned banker.

MATTER OF PROVISION
It is not only fear of prosecution that has prevented bankers from selling assets aggressively to asset reconstruction companies. “Bankers have often looked at ARCs not as partners in optimising their recoveries but as parking slots for bad loans to suit their own needs,” points out Rajendra Ganatra, MD, India SME Asset Reconstruction Company. “The problem is banks are mostly busy managing their financial position not their loans,” he adds.

ARCs, on the other hand, played along until 2015, when they could buy assets with a 5:95 structure, meaning an ARC could offer only 5% of the agreed price in cash and issue security receipts (SRs) for the rest of the amount. The capital requirement was thus small. It was party time because on just 5% cash commitment, they could earn a 2% management fee per annum, resulting in 40% internal rate of return on the investment for doing nothing.

So instead of focusing on recoveries, ARCs were busy offering backdoor entry to defaulting promoters and bingeing on management fee, while bankers, too, were happy to sell down assets because it offered a provisioning arbitrage – once the asset was off their book, they no longer had to provide for the asset (or SRs), which was a significant relief. “Bankers were happy to exploit the provisioning leverage available to them and ARCs had no real incentive to work hard on recoveries,” says Ganatra. “In fact, many a time the upfront 5% cash itself was funded by the promoters,” he adds. As a result, the recoveries from assets that were taken over before 2016 have been fairly poor.

That trick was called out by then-RBI governor Raghuram Rajan, who fixed it by bringing in a 15:85 structure, meaning the buyer would have to pay 15% of the agreed asset value in cash and issue SRs for the remaining amount, which would be redeemed at the end of the period. “Assets bought during this period did well,” says Siby Antony, CEO, Edelweiss ARC who quit recently. “At 5:95, one could play blind and make an IRR of 40%. With 15:85, you better have a solution before you buy,” Antony explains. As an example, he cites Bharati Shipyard’s resolution, which went wrong since it was bought under the 5:95 structure. On the contrary, Edelweiss ARC hit pay dirt with its investment in Vega Mall, owned by Hotel Horizon. Edelweiss bought 58% from two out of the three banks which held the asset; the other 42% was bought over by Phoenix ARC. “Together, we infused Rs.700 million to complete the project and then sold it to an international firm and got excellent recovery,” says Antony.

But then, other industry players suggest it is only a mixed bag and recoveries have not happened as one would have expected.

What spoilt the game for ARCs was a change in provisioning norms, once again (See: Who killed the ARCs?). Effective April 2017, the central bank mandated high provisioning for banks if their investments in SRs exceeded 50%. This was brought down to 10% in April 2018, increasing the need for cash to over 90% for acquisitions. According RBI prudential norms, in the first year when a default occurs, the bank has to make a provision of 15%, second year, if the situation continues, an addition provision of 10% should be made, and by the fourth year, the entire asset has to be written-off.

So, banks can still sell assets under 15:85 to ARCs, but they have to make provisions as if the asset were in their own books. “Then, bankers started to say why should we sell at all. We will keep it in the books, and keep providing for it,” says Antony.

On the one hand, the entire business model for ARCs has gone for a toss, as they now have to bring in a lot more capital – either their own funds or other investors – to make higher cash buyouts. Not only that, this situation has also made it imperative for ARCs to push for faster recovery to free up capital. Bankers, on the other hand, preferred the easier road to IBC.

The only problem, there was no hidden treasure in that promised land.

EVASIVE RECOVERIES
Only three years ago, IBC was seen as a huge positive. “Life before and after IBC is like winter and summer,” Bahuguna had commented at Outlook Business Leading Edge 2018. He had expected bankers to make a judicious choice in terms of assessing which cases should be dealt with and how to maximise recoveries. But it has largely been a one-way street. 1,942 cases are pending resolution under NCLT, and the post-pandemic delinquency wave has not even started.

As for the 70 assets that are proposed to be transferred to the bad bank, the common refrain is that looking at the vintage of some of the assets under consideration for resolution (defunct or incomplete power plants, EPC players, and several obsolete businesses), it may take several years to realise any value not only because of the quality of asset and market conditions but also because the debt resolution machinery in India is still wretched. “Debt is only a contractual obligation to pay. If the enforcement of the contracts is weak, what is the worth of these papers,” asks an investment banker underscoring the real problem.

In fact, it was only to fix this that the IBC took birth. But, rather than reinstating confidence among investors, it has created another weak link of the same kind – well, more or less. A dozen bankers, investment bankers, resolution professionals, chiefs of asset reconstruction companies Outlook Business spoke to reaffirm that starting with the rigmarole lenders have to go through to get cases admitted in the bankruptcy court, to finally realising the value of assets through a less than honest judicial system, and an evolving legal and resolution process, is not only painful and time consuming, but also unrewarding. Barring a few high-profile cases which have created an impression of exalted success at the IBC, the results are dismal in terms of both recoveries as well as time taken for resolution (See: All bark and no bite).

While having an asset manager with an expertise for business turnaround is more than welcome, to presume that the AMC-AIF will bring something remarkable to the table that will lead to exaggerated recovery is a fallacy. “In my 20 years of working with SBI, from chairman downwards, I have not got one improper suggestion. Other banks are a different story. If SBI and several well-managed ARCs are also failing, it is because the tools have been blunted,” says an investment banker.

The vital part of a turnaround depends on the ability of the AMC-AIF to push through changes in the company, which is impossible without the cooperation of the promoters. “Many a time the promoters resist change. So much so that the company will not even issue equity (when debt is converted into equity during restructuring),” says Antony.

Under the circumstance, finding investors for the AMC-AIF will be a tough ask. Even today, there is nothing that stops foreign funds from coming and investing in Indian debt, but that has not happened. If it is a fund where government is a general partner, it will be even more complicated. “If we are expecting that a government-owned AIF will get money from foreign LPs and buy bad loans from government-owned banks, the question is how will the conflict of interest be ever addressed?” asks an investment banker.

India’s track record when it comes to governance in public institutions is dismal. The last version of the bad bank created in 2004 – Stressed Asset Stabilisation Fund (SASF), where the government coughed up Rs.90 billion to take over the bad loans of IDBI – did not even get the accounts audited for a good eight years until 2013, despite repeated concerns expressed by the CAG. Later, the public accounts committee also noted that the Ministry of Finance did not take action when inadmissible cases were exchanged between IDBI and the SASF, costing the exchequer. Till four years ago, the recoveries have not crossed even the halfway mark (See: When time isn’t money). That’s the reason it is imperative for the new entity to be completely out of the shadow of the government with an independent and credible board. “Unless we fix the core, we will only be going around in circles moving money from the left pocket to the right pocket,” says a seasoned banker.

STATEMENT OF PURPOSE
The absence of sharp tools for recovery and the lack of investor confidence in debt resolution circles back to the question of whether this is a problem worth solving.

Article 12 of the Constitution considers public sector undertakings including state-owned banks as a part of ‘the state’ so they can be subject to scrutiny of Parliament, Central Vigilance Commission, Central Bureau of Investigation and Enforcement Directorate. One can wonder how so many scams really broke out then, but that is not the point. The point is no banker would want investigating agencies spoiling their sunset years questioning any big write-offs. Instead, putting the onus on a bad bank is an easier option.

But then, the bad bank can warehouse the assets, and then what? “The bad bank will hardly be helpful in the current environment in which the delinquency levels are mostly coming from consumer and small ticket business loans, and banks have been taking higher provisions against such bad loans,” says broking firm Nomura in a research report.

Thus, creating another entity in the form of ARC-AMC won’t serve any immediate purpose for the banks that are starving for capital in the face of mounting bad loans. Unless banks get upfront cash over and above the NBV, resulting in significant writebacks as the capital need of public sector banks is far in excess of the Rs.200 billion allocated in the Budget.

Also, ARC-AMC which operate on 20% internal rate of return and/or 2% management fee may not find it lucrative enough to bid for the legacy assets in question. “All risks counted, you won’t find any investor willing to accept an IRR of less than 20%. Only government money can be cheaper than that,” says a banker.

Some bankers who feel the whole exercise may be futile think so only because the assets in question are businesses of which value has eroded and for which the banks have made significant provisions, so to try and expend time and energy on something that will bring no significant writeback unless the government itself knowingly – and willingly – buys them out at exaggerated prices. This is a quiet way of shoring up the capital of banks without writing a cheque to re-capitalise them, which would have made the fiscal deficit number look even worse. The Centre has already re-capitalised PSBs to the extent of Rs.2.65 trillion over FY18-20, and the current fiscal situation does not offer much room to plough more cash in.

The other unsaid motivation for the government may also be to urge banks to start making big-ticket loans to get the economy back on track. Buying assets at a notionally higher value, where the SRs are guaranteed by the government, may be another way to reinstate confidence of bankers in their own balance sheet, but that may still not be enough to encourage bankers to dole out loans as the risk perception continues to be high and confidence in growth wavering.

A straightforward way would be to simply direct the banks to put these assets on the block – the Sashakt committee states that an inter-creditor agreement has been forged already – and auction them within a fixed timeline with no additional administrative cost. Meanwhile, fix what really needs to be fixed.