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Success of India's new bad bank hinges on resolution speed, expertise

India's new government-backed bad bank can help lenders recover capital from nonperforming assets if it can ensure a timely resolution and attract a pool of professionals who are allowed to work independently, analysts said.

India's move to establish a national debt resolution company that will buy about 2 trillion rupees of bad debt from lenders is aimed at addressing the bigger nonperforming loans that existing private sector asset reconstruction companies have stayed away from. The National Asset Reconstruction Co. Ltd., or NARCL, will pay 15% of an agreed price as upfront cash and the rest as security receipts, an instrument akin to bonds, that will be backed by a government guarantee of up to 306 billion rupees for up to five years, according to a federal cabinet decision on Sept. 15.

Bad debt will then be passed to a separate company, called India Debt Resolution Co. Ltd., which will try to resolve and recover value. The resolution company is expected to have a pool of turnaround professionals, not just bankers, with expertise in different sectors to maximize recoveries. It will curate assets, try to restructure and turn around or liquidate borrower companies.

Sandeep Upadhyay, chief executive at Centrum Infrastructure Advisory, said the new bad bank can very effectively address nonperforming loans as long as it has the requisite delegation power. "There has to be a change in the mindset with which we are approaching the resolution process. It has to be timebound and has to be handled with a lot of expertise," Upadhyay continued.

Bad debt

NARCL's portfolio will be bigger than any of the 28 asset reconstruction companies that already exist in India. They had purchased an estimated 4.5 trillion rupees of bad debt, mainly smaller-ticket loans, by March 31, according to CRISIL, an affiliate of S&P Global.

India has been seeking to address its high levels of bad debt, especially in state-owned banks. The Insolvency and Bankruptcy Code, a set of nation-wide rules, was announced in 2016 to ensure a timely resolution of corporate and individual bankruptcies. With the new bad bank, the government is hoping to consolidate bad debt under a single company and take it out of the banks' balance sheets. Previous efforts have shown that it is easier to resolve a company with a manufacturing plant, for example, a steel mill. However, for sectors such as service companies and engineering procurement and construction contractors, the lack of understanding of the business at banks proved to be a stumbling block.

NARCL can help speed up the resolution process and help the economy by creating a recovery process that can be institutionalized, said Deepak Shenoy, CEO and founder at Capitalmind, an Indian wealth manager.

However, Shenoy believes the plan also comes with a moral hazard. "Some banks may try to overprice their [bad] loans and game the system," the CEO said.

The central bank's stress tests indicated that the bad loans of all banks may rise to 9.80% by March 2022 from 7.50% in the same month of this year under a baseline scenario. However, the bad loans ratio could rise to as high as 11.22% by March 2022 under a "severe stress" scenario for key macroeconomic indicators, the central bank said in its biannual Financial Stability Report released July 1.

The government's offer of a sovereign guarantee "is a significant step towards the operationalization of the national asset reconstruction company and the resolution of nonperforming assets in India's banking sector," Krishnan Sitaraman, senior director for the financial sector and structured finance ratings at CRISIL, told Market Intelligence in an email. The sale of bad loans to NARCL should lower the NPA levels of banks by 20-25% over time, Sitaraman said.

Provision write-backs

Banks, especially state-run lenders, will gain by being able to write back provisions they have already made, and the cash receipts can be used for lending, ICICI Securities said in a Sept. 17 note. The sovereign-guaranteed security receipts will attract zero risk weights for five years, freeing capital on bad assets that have not yet been fully provided for, it said.

However, the firm believes resolution will be key. "If initial cash receipts are more or less equivalent to the amount invested by banks, would it then merely amount to shifting the problem from one place to another without fundamentally solving it?" it questioned.

Most of the 900 billion rupees of bad debts that will be transferred to NARCL in the first round will be from lists that the Reserve Bank of India had asked banks to move to the insolvency process a few years ago. "Chances of material recovery from these assets look bleak," Nomura analysts said in a Sept. 17 report.

The "quality of assets matters the most," Jefferies said. Historically, banks see about a 10% recovery from written-off loans, and Jefferies believes that recoveries here may broadly be in line, advising the central bank and the lenders to take a conservative stance.

As of Sept. 24, US$1 was equivalent to 73.81 Indian rupees.