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Bad bank - A good solution to NPAs?

Any emerging and fast growing economy in the world is supported by a huge number of financial institutions and banks. These financial institutions provide much needed credit to the already growing industries and the new startups which need a strong support system in order to grow in the competitive market. Good health of these institutions is extremely essential to keep the economy going positively on a high growth trajectory. However, for the last 2 decades Indian banking system is experiencing a crisis of Non Performing Assets (NPAs) which has been decreasing their capacity to lead and keep the economy on a needed growth trajectory.

Since, over the years, Indian banking sector is suffering from the issue of Non-Performing Assets (NPAs), it has become a subject of discussion and scrutiny over time. Non-Performing Assets are the loans and advances provided by banks on which the borrower has stopped making interest or principal repayments for more than 90 days. The lender and the borrower should be aware about performing and non-performing assets, as for the borrower, if the asset is non-performing, it will negatively impact his credit and growth, hampering future borrowings. For the bank, the interest earned on loans is the main source of income, and if the loans provided to the customers turn out to be non-performing, it negatively affects the liquidity position of banks and their overall profitability.

Origination of NPAs in India

The origination of NPAs in India lies back in mid 2000s when the economy was booming and business outlook was very positive. Banks granted loans to large corporations based on extrapolation of their recent growth and performance. Since the loans were available so easily than before, corporations started financing more via external borrowings rather than internal promoter equity. However, in the year 2008, stagnation in the Indian Economy due to the Global Financial Crisis arose and the repayment capability of these corporations decreased, which contributed to India’s Twin Balance Sheet problem, where both the corporate sector and the banking sector came under financial stress. The projects for which the loans were granted started underperforming and borrowers/corporations lost their capability to pay back to the banks, leading to the generation of NPAs in India.

Gross NPAs of banks (as percentage to total loans) have increased in the past years from 2.3% of total loans in 2008 to 9.3% in 2017. They are further expected to in fiscal 2022 according to several Global Rating Agencies. This increase in the amount of NPAs has ceased a proportion of banks assets making it difficult to generate income for the bank, lowering bank profitability and its ability to provide further credit. The profitability of banks is measured by Return on Assets (ROA), and the decline in returns due to NPAs has hindered the profitability of banks, making them vulnerable to economic shocks and this puts consumer’s deposits at risk.

Impact of COVID on NPAs in India

Recently, the banks and financial institutions globally are facing the impact of the coronavirus pandemic, as it has led to rise in default and bad loans. For the Indian banks it has been challenging times as they were already struggling to cope up with the rising bad loans. COVID-19 induced lockdowns had a devastating impact on many small and medium scale companies as they are now struggling to repay dues owed to banks. Along with them, a large number of individuals are also struggling to repay their loans after losing income and employment due to the pandemic.

Restrictions in movements due to COVID induced lookdowns impacted the collections of Non Banking Financial Companies (NBFCs) and Housing Finance Companies (HFCs), which are expected to see a rise in NPAs by 4.5-5% by March 2022. NBFCs having exposure to rural and semi urban borrowers, microfinance, vehicles loans and unsecured loans are expected to get more affected as they have a relatively larger share of filed collections. NBFCs have about 35-40% share in field collections while HFCs have 5-10%, which signifies that NBFCs are going to get affected more than HFCs.

Resolving the NPAs in India

In order to deal with the problems of NPAs in India, two kinds measures were taken by the authorities – first, regulatory measure, resolving NPAs through various laws (such as Insolvency and Bankruptcy Code), and second, remedial measures taken by the Reserve Bank of India (RBI) for internal restructuring of stressed assets. Even after such measures to resolve and prevent NPAs, they have been on a rise.

To improve the situation of NPAs in India, in the budget of 2021, the government announced the formation of bad banks in order to take over NPAs from banks. An ARC, namely National Asset Reconstruction Company Limited (NARCL) is going to be set up to take over the NPAs.

An Asset Reconstruction Company (ARC) is a specialized financial institution which buys NPAs from banks and financial institutions at a mutually agreed price, this helps the banks to clean their balance sheets and start delivering normal banking services to the customers. To meet the funding requirements, ARCs issue bonds, debentures and security receipts. After acquiring the bad loans from banks, ARC can restructure or reschedule the loans, sell borrowers business, or get into settlements according to the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act of 2002. SARFAESI Act allows the banks and financial institutions to auction residential and commercial properties in order to recover unpaid loans. In case ARC is not able to recover the bad loan, they have the option to file a civil suit against the creditor.

The Bad banks will have a positive impact on the economy in the short and medium term, while the long term needs to be dealt with timely reforms. Other structural reforms are also needed, such as greater governance and supervision during the lending process, stringent monitoring of loans for early detection of signs of distress to support dealing with NPAs in India.

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