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Indian Growth and Development Review

ISSN : 1753-8254

Article publication date: 28 September 2023

Issue publication date: 24 November 2023

This study aims to provide a critique of the institutional framework of the National Asset Reconstruction Company Limited (NARCL), India’s “bad bank.”

Design/methodology/approach

The approach followed is the development of an economic model of the gains to trade of an Asset Reconstruction Company.

Using an economic model, the paper shows that the rules of the game create an uneven playing field and are likely to lead to a systematic overpricing of nonperforming loans (NPLs). While this might increase the upfront cash received by the bank, it will come at the cost of higher liabilities for the government on account of the sovereign guarantee that is part of the proposed structure. The overpricing is also likely to act as an obstacle to efforts aimed at the revival of the distressed company. The NARCL could become a warehouse for NPLs subverting the objective of reconstruction.

Practical implications

Solutions to create a vibrant market for NPLs are proposed.

Originality/value

The Indian case is unique in the sense that a bad bank backed by the government has been introduced after almost two decades of the existence of similar entities in the private sector. To the best of the author’s knowledge, this paper is the first that addresses the design of such a market using economic modeling.

• Level playing field
• NPL warehousing
• Sovereign guarantee

Acknowledgements

The author acknowledges the insights developed in the course of being a member of the Committee to Review the Working of Asset Reconstruction Companies set up by the Reserve Bank of India. All opinions and errors are mine alone.

Prasad, R. (2023), "A critique of the national asset reconstruction company, India’s bad bank", Indian Growth and Development Review , Vol. 16 No. 3, pp. 217-229. https://doi.org/10.1108/IGDR-03-2023-0028

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Can Asset Reconstruction Companies (ARCs) be Part Solution to the Indian Debt Problem?

Author(s): Jaimini Bhagwati, M. Shuheb Khan and Ramakrishna Reddy Bogathi

Working Paper 338

The Indian debt overhang issue is one of the major reasons that fresh investments are currently not being made in the scale required to promote higher growth and boost employment. Among banks the public sector banks (PSBs) are burdened with the bulk of net non-performing loans (NNPAs). These NNPAs are concentrated in long gestation projects, for example, in the steel, power and infrastructure sectors and most of the lending was to about 50 major borrowers. This paper details the approaches of other countries when their banking sectors were burdened with unsustainable levels of impaired assets. The paper examines the bad debt situation in India, the circumstances under which Asset Reconstruction Companies were registered and the changing regulatory requirements under which they have been operating in India. Till now, the extent to which ARCs have helped towards resolving the debt problem has been limited. Given that fixed costs in setting up ARCs have already been incurred this paper suggests how ARCs could play a catalytic and more significant role in addressing the debt overhang. The paper does not discuss the causal origins of Indian bad debt in any detail and is not intended to suggest comprehensive remedies to this debt problem.

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Asset reconstruction companies must be allowed to turn around distressed businesses

Former central bankers Viral Acharya and Raghuram Rajan recently released a paper titled “Indian Banks: A time to reform”. Among other things, they argue that when there are fewer bids in a bankruptcy auction, the value on loans is better realised if a bad bank (read an asset reconstruction company) takes over the borrower and places the firm under new management. The ARC could parachute a team of top managers to replace the promoter and her top aides. This situation is even more likely during an economic crisis when experienced industry players are unable to pay a reasonable price for the firm. This would effectively put an ARC in the role of a private equity manager.

These arguments have a bearing on the ongoing debate regarding an ARC’s role in insolvency resolution. Going by the stance taken by the RBI, an ARC can participate in resolutions under the Insolvency and Bankruptcy Code, 2016 (IBC) only if it partners with an equity investor, which is the resolution applicant. If the application succeeds, the equity investor would acquire the shares, while the ARC trust would acquire the debt. Some stakeholders, however, prefer a simpler arrangement — why not let ARCs directly invest in the equity of distressed companies through IBC resolution just like private equity funds?

The RBI doesn’t appear to favour such an extended role for ARCs. This hesitation is not without basis. In the aftermath of the Asian financial crisis, countries like Indonesia, Korea and Malaysia established centralised, typically state-owned, asset management companies (AMCs) for resolution or restructuring of distressed financial institutions. At that time, India’s non-performing assets stood at a whopping 14.4 per cent. This meant enhanced provisioning requirement for banks which severely constrained their ability to extend credit. The absence of an effective bankruptcy system posed additional challenges. It was in this context that the Narasimham Committee (1998) recommended setting up an ARC specifically for purchasing NPAs from banks and financial institutions. Subsequently, the SARFAESI Act, 2002 created the legal framework for establishing multiple private ARCs.

With the advantage of hindsight, it is now evident that this policy achieved only modest success. The RBI’s Financial Stability Report (June 2019) indicates fairly low recovery for banks through the ARC model between 2004 and 2018. The maximum average recovery by ARCs as a percentage of total bank claims stood at 21.5 per cent in 2010. Since then, it has steadily declined and reached 2.3 per cent in 2018. Such low recovery is likely the outcome of a resolution model heavily dependent on collateral disposal rather than genuine business turnarounds.

In 2002, India lacked an effective bankruptcy system. There was no market for corporate control of distressed firms. ARCs were originally designed for this peculiar institutional ecosystem. They were required to hand over the distressed business back to the original promoter once they had generated enough value to repay the debt. Consequently, ARCs had little incentive to turn around distressed businesses. This situation completely changed in 2016. Now the IBC seeks to maximise the value of distressed businesses through a market for corporate control. ARCs should be able to fully participate in this market and attempt successful turnarounds by acquiring strategic control over distressed businesses.

A company that undergoes IBC resolution successfully, emerges solvent. In a solvent company, shareholders have stronger incentives than creditors to maximise enterprise value. This is because an increase in enterprise value automatically increases the value of its equity. In contrast, creditors do not benefit from increases in enterprise value beyond their individual claims.

If ARCs could hold more equity instead of debt in the resolved company, they would also have a stronger incentive to take strategic control to ensure successful turn around. The law should therefore enable ARCs to invest in a distressed company’s equity, whether by infusing fresh capital or by converting debt into equity. Effectively, an ARC should act more like a private equity fund, as Acharya and Rajan envision. This in turn would make the market for corporate control under IBC deeper and more liquid, improving ex-ante recovery rates for banks.

To appreciate how this market could work, consider the role played by hedge funds in the American distressed debt market. In the 1980s and early 1990s, market dynamics coupled with deregulation fuelled an active market for trading claims in companies undergoing resolution under Chapter 11 of the US Bankruptcy Code. This market provided better opportunities than equity markets for acquiring control of distressed businesses. Consequently, it attracted hedge funds. Hedge funds hired entrepreneurs with industry expertise who could play a more active role in turning around distressed companies. Over time, these hedge funds had a salutary impact on turnarounds under Chapter 11.

Distressed debt investors could similarly turnaround failing Indian businesses under the aegis of the IBC. Currently, investors could potentially use three kinds of domestic investment vehicles — Alternative Investment Funds, Non-Banking Finance Companies and ARCs — to invest in companies undergoing IBC resolution. While AIFs can invest in debt as well as equity subject to certain limitations, they don’t enjoy enforcement rights under SARFAESI Act, 2002. NBFCs enjoy the enforcement rights but are subject to provisioning norms for NPAs they purchase from banks. None of these limitations applies to ARCs. If only ARCs are allowed to directly participate in IBC resolutions by infusing equity, they could emerge as the most efficient vehicle for turning around distressed Indian businesses.

Contributed by: Pratik Datta, Senior Research Fellow

This is intended for general information purposes only. The views and opinions expressed in this article are those of the author/authors and does not necessarily reflect the views of the firm.

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