Bad Bank and the role it will play for small financial banks

The creation of the National Asset Reconstruction Company (NARCL) is a welcome move for the banking sector, which has been reeling under the weight of bad debts. An overall assessment of the future of bad loans in India revealed that non-performing assets (NPA) are expected to increase in the near future and peak in 2022-23, estimated at 10-13% of the loan portfolio.

Although NPAs are considered bad credit decisions, they should be seen as a reflection of the ability to take risks. The NARCL will help recover bad debts and act as another solution to the problem of bad debts in India, not the only one.

Although the immediate beneficiaries of bad banking are likely to be traditional PSUs and private banks, especially large ones, NARCL is expected to be a support vehicle for the entire financial services industry. This is important, not least because the financial services regulator has highlighted heightened risks with respect to non-banking financial companies (NBFCs) and small financial banks (SFBs).

The Reserve Bank of India (RBI) has introduced a Rapid Corrective Action (PCA) framework for large NBFCs, introducing restrictions whenever key metrics drop below a set threshold. Among other things, the PCA framework set the first NPA threshold at 6%. This is where I think NBFC would be vulnerable, and it will require them to be conservative.

While the intent behind RBI’s introduction of APC is understandable, it is important to recognize that NBFCs play an important intermediation role and often fill funding gaps when banks falter. Thus, by their very structure, NBFCs should take more risks and have higher NPAs. Will the introduction of APC next year force NBFCs to change their business model? We will have to wait and watch.

This brings me to small corporate banks. Traditionally, SFBs have focused on lending to individuals and small businesses. However, the introduction of the PCA framework for NBFCs could create an opportunity for them to grow their business loan portfolio. With their cost of funding lower and NBFCs becoming more selective, SFBs can make inroads into non-blue chip businesses. While SFBs have stricter regulations than NBFCs, the recent surge in NPAs for smaller financial banks suggests that all is not well. In this context, do SFBs feel that NARCL would be an alternative should their books feel the pinch of NPA growth? It is too early to tell.

The pandemic, while having created opportunities for growth, has not been too kind to small and medium enterprises and has impacted SFB NPA levels. Before the pandemic, NPAs for small financial banks were around 2%; reasonably good given the profile of the borrowers. However, after the pandemic, the ratio increased to around 7%. With the anticipation of another wave of COVID, in March 2022, SFBs could look to double-digit NPAs. High capital buffers add an extra layer of cushion for SFBs, and most should be able to digest this loss. However, capital that was earmarked for growth and used for funding and amortization is not its best use. This will push SFBs into alternatives, including selling NPAs.

The immediate solution for small financial banks could be through asset reconstruction companies (ARCs). The role of CRAs has come under scrutiny in recent years. More than two decades have passed since the introduction of ARCs in India, but constant regulatory changes mean that their overall impact has been limited. Some consider the introduction of NARCL a partial failure of the ARC industry. However, I wouldn’t be too hard on them because the operating environment for CRAs to succeed has not been easy. The introduction of the Insolvency and Bankruptcy Code (IBC) some six years ago also significantly changed the way Indian creditors approached NPAs.

However, the pandemic has breathed new life into ARCs and they are crafting their new avatar. As banks look to transfer larger NPAs to NARCL, many CRAs are now changing direction and considering acquiring smaller loans. The disruption caused by the pandemic has caused many good small and medium-sized businesses to close and therefore default on loans. However, they are inherently good companies and CRAs believe that pooling assets can contribute to a stronger recovery.

Additionally, acquiring smaller-ticket NPAs (including retail) is difficult and highly dependent on technology support. SFBs, which are relatively smaller and nimble, have a strong technology implementation and are able to monitor the portfolio more closely than many large banks. This makes it a prime candidate for CRAs.

Considering the size and demographics of India, SFBs play an important role. A strong regulatory framework should only be an enabler and SFBs should be motivated to go where the big banks have failed. Dissemination of credit to low income groups and the weakest section is important to achieve sustainable high growth and income equality. Access to NARCL and ARCs will incentivize smaller financial banks to take on more risk without unreasonably caring about capital.

The author Tarun Bhatia is MD and director of Kroll South Asia. The opinions expressed are personal.

(Edited by : Kanishka Sarkar)

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