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The Bad Bank Theory

The Bad Bank Theory

The government has given signal to banks to try out yet another resolution approach, including AMC-AIF, for dealing with growing stressed assets. Will it work?

The oft-repeated catchword 'desperate times call for desperate measures' has origins in an old saying: 'For extreme diseases, extreme methods of cure are most suitable.' Pinstriped bankers around the world couldn't agree more. The world has often resorted to extreme methods when faced with a mountain of bad debt. In the last decade, China created four asset management companies (AMCs) (or Bad Banks in banking slang) to house stressed loans. Even after a decade and a half, these four AMCs are happily writing more business. Almost four dozen region-specific AMCs have come up in the last five years, buying bad loans from local Chinese banks. In the late 90s, the Indonesian government was more clinical. It transferred all the bad loans at zero value to a restructuring agency. This was immediately followed by merging the four state owned weak banks into one big entity. The story in other countries is no different. India, too, has debated a plenitude of options including a bad bank, merger of weak banks, AMCs, etc. With the unveiling of the Insolvency and Bankruptcy Code (IBC) two years ago, the debate appeared to have been settled but clearly the last word has not been said on the issue.

In July, a committee led by Sunil Mehta, Chairman of Punjab National Bank, has come out with a new approach of slicing and dicing stressed loans based on size. This also includes an AMC and an AIF ( Alternate Investment Funds) to deal with large size loans. In other words. sn AMC or a Bad Bank would take over the stressed assets of banks first, with funding from the AIF. Interim finance minister Piyush Goyal, instantly gave a go ahead to this new approach (See New Three-point Approach). The backers of this new approach talk about the Indian banking system being in the middle of a major stressed assets cycle and the danger of leaving bad loan resolution to a court-driven IBC process. "You are getting peanuts in terms of valuation. There are also very high chances of liquidation," says the CEO of a state-owned bank on condition of anonymity. The Mehta committee has strongly advocated a flexible approach to deal with the bad loan problem given the scale of the NPA problem and lack of speed of the IBC-led resolution. "Multiple approaches need to work simultaneously for a quicker resolution," the committee noted in its 57-page report. " In general, it is not advisable to have multiple approaches. One or two approaches are generally adopted in other parts of the world. In India, the objective of multiple approaches is to increase the realisation from stressed assets," says Abhishek Pandey, MD at Duff & Phelps, a global corporate finance advisor

A Multiple Approach

Mehta, who drfted the report in just two weeks, has been trying hard to explain that the new approach is very much in sync with the Reserve Bank of India's time bound resolution directive. In February this year, the RBI had already asked all the banks to put in place a board approved policy to deal with loans where there is even a single day default. It also directed banks to act alone or jointly for initiating steps to resolve the stressed loans problem. The timelines for accounts with exposure more than Rs2,000 crore was fixed at 180 days. In addition, the RBI also said that it intends to announce a timeline of over two years for betwewwWen Rs50 crore to Rs2,000 crore. 'Project Sashakt' is only trying to create a pre-IBC kind of a framework for resolution of assets. Under the new framework , the banks will deal with resolution of stressed assets in a faster way. The key to the new approach is the inter-creditor agreement (ICA) where all the banks will be a signatory. The ICA actually authorises the lead bank to work out a resolution on behalf of all the lenders.

While the RBI is on a cleaning drive in the last two years, the bankers, faced with heavy losses under the IBC process, were also lobbying hard with the government for some relief. According to estimates, they were staring at provisioning losses of almost Rs 4 lakh crore given the Rs14 lakh crore stressed loan pile. There was also pressure on the government as the banking system needed some Rs2.70 lakh crore capital to absorb the losses. Under 'Project Sashakt' , the committee is talking of a much lesser capital of Rs1.30 lakh crore. The new approach is a win-win for both banks and the government. There was also a view that the new approach was needed to accommodate some battered sectors - like power, EPC, roads and textiles - that are easy candidates for liquidation under the IBC. The power sector has a huge 75,000 MW assets facing problems because of raw material linkages and absence of power purchase agreements. If demand comes back, these power projects would have substantial value in the future. "In the last two years, we have seen peak demand for power going up. We expect the demand to come back by 2020-21," says Venkataraman Renganathan, Senior Director at Alvarez & Marsal. A year ago, RBI Deputy Director Viral Acharaya had suggested creating two AMCs in the private and public sector for dealing with sectors like metals, engineering, telecom, textiles, etc.

Will It Work?

"Every approach in the last two decades has been new in some sense," points out a private banker. The history of bad loan resolution tools actually doesn't inspire any confidence. In the last decade, SARFAESI (Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002) was called path-breaking as it gave the power to banks to acquire assets of defaulters. The Supreme Court had to stay the process for three years after Gujarat-based Mardia Chemicals disputed its legality.

The new asset reconstruction companies (ARCs) were armed with SARFAESI to deal with bad loans. But the Act was marred in litigations and delays. In addition, the RBI also allowed a corporate debt restructuring (CDR) mechanism around the same time, but failed to address bad loan issues. Three years ago, the RBI launched three new restructuring schemes - strategic debt restructuring ( taking management control), S4A ( converting the unsustainable debt portion into equity) and 5/25 ( allowing refinancing of loan after every five years). But very little time was given to stabilise these schemes, later branded as unworkable. Two years ago, the IBC was seen as a permanent court based solution for bad loans. But successes are few and far between. Now, there is a new set of schemes including an AMC structure to deal with stressed loans.

Under the AMC-AIF structure, the big challenge is to get the capital from institutional investors, both domestic and foreign. The global distressed funds are anyway very cautious in plunging into the Indian distressed market because of frequent amendments and litigations under the IBC process. Some fear that the banks will route their money to float AMCs and later subscribe to AIFs for buying their own assets. Pricing is another issue that will become a bone of contention among banks for transferring the assets from their book to an AMC-AIF structure. Will they be comfortable taking haircuts outside the IBC? Most of the earlier restructuring schemes were unworkable because of the fear of government agencies questioning sale at a discount.

The committee also talks of an AMC-ARC structure where the duo would jointly bid for the assets. The first leg of the transaction will be between a bank and the ARC - the ARC will pay upfront 15 per cent cash and 85 per cent in security receipts (SRs) redeemable within 60 days. The ARC will then do the debt restructuring, convert debt into equity and acquire majority control, etc. The restructured company will then issue Non Convertible Debentures to AIFs and the money so raised will be paid to the ARC to redeem the SRs issued to banks. The entire exposure of the ARC will be transferred to AIFs where AMC-AIF will own majority stake in the asset. The actual turnaround will be done by the AMC. Theoretically, it sounds good. But there is a huge responsibility on the AMC to turnaround the company. Currently, there is no AMC or turnaround team in place. Not all banks have signed the inter-creditor agreement. In the past, PSBs have engaged turnaround specialists but with limited success. "The biggest hurdle specialists face is on interim finances. The banks stay away from funding the already funded company anymore," says a consultant. There is also a risk of a dissenting creditor or an ARC, NBFC or a foreign lender invoking IBC while the AMC-ARC process is on. "One bank sitting out of the inter-bank agreement can bring the house down," says a foreign banker. In fact, foreign bankers are reluctant to sign the inter-bank agreement that authorises the lead bank to work out a resolution plan on behalf of others. While the committee encourages multiple AMCs, there is need for one proof of concept. Abizer Diwanji, Financial Services Head at EY India suggests the AMC should pick up four-five companies and make the deal happen in the next six months.

Yet another issue is of demand and policy actions. For many large cases, which are from power sector, there is need of policy support. AMC set-up or any other resolution tool won't solve the policy issues that are crippling these companies. Venkataraman of Alvarez & Marsal talks about finding alternatives to the existing distribution model for the power sector. "One way could be to create alternate distribution companies in the states," he says.

Nothing New

The bankers are giving power to the lead bank to decide the resolution plan for stressed assets between Rs50 crore to Rs500 crore. This is almost like a pre-IBC process where the lead bank will work out a resolution plan like debt restructuring, one time settlement, appointing turnaround agents, selling assets to ARCs or strategic players. The banks were actually doing that under the previous schemes. Experts say that the lead bank will enjoy a lot of power as with their size they dominate lending. The smaller banks will have little say. There are going to be disputes among bankers. Also, not all banks have the same collateral or loan facility. Those with good collateral will veto many of the resolution plans.

Critics suggest that the new schemes are just a glorified CDR and nothing new. Project Sashakt will end up giving a lifeline to an asset through the AMC structure but experts doubt whether turnaround will actually happen. They will need turnaround expertise , additional funding / interim finances. Systems are not in place yet, so it is more like housing stressed assets of banks in a different vehicle . Some experts believe these schemes are actually paving the way for promoters to get haircuts from banks.The more structural solution is something the Indonesian government did - merge weak banks to create few large entities in the PSB space and improve governance.

Some suggest that the new schemes should be seen as a part of the larger resolution ecosystem that India needs because of its PSB legacy systems, promoter-driven companies and capital constraints. IBC, ARC and AMC, then, will be the framework for resolving the bad loan backlog.