The Stressed Asset Resolution announced in India’s 2021-22 Union Budget proposed the establishment of a novel twin structure to clean up bank balance sheets in India. In this dual structure, the primary company, the National Asset Reconstruction Company Limited (“NARCL”), is a public sector asset reconstruction company mandated to acquire and aggregate non-performing assets (“NPAs”) (i.e. the ‘bad bank’). The second company is a private sector asset management company established to focus on the management and resolution of the NPAs held by NARCL, the India Debt Resolution Company Limited (“IDRCL”). Two years on, it is fair to say that the aggregation and resolution of NPAs by the bad bank in the Indian banking sector have fallen short of initial expectations.

How to solve India’s NPA conundrum?

Why does the sale of NPAs make sense? Essentially, the benefit of offloading NPAs from a bank’s perspective is that, although sold at a steep discount to the book value of the NPA (thus forcing the selling bank to take a write-off), it allows the bank to crystalize its loss position, thereby removing the uncertainty and the inefficiency that takes hold in a traditional lending model. Among other things, this frees up resources for fresh origination and reduces the need to hold capital against risk weighted assets. From a governmental and regulatory perspective, a bad bank is a useful tool to clean up excessive NPA volumes, thereby reducing systemic risk in the economy and avoiding the need for the government to step in and potentially recapitalize banks, ultimately at the cost of the taxpayer.

A decade after the global financial crisis, gross NPA volume in India had increased at a compound annual growth rate of around 33%, far outstripping the growth of banking sector credit in the same period, indicating an accumulation of stress in the sector. However, over the past few years gross NPA volumes have steadily fallen, thus reversing the previous trend of steady growth. In December 2023, gross NPA volumes stood at a multi-year low of 3.2%. Standard & Poor have attributed this decline to “healthy corporate balance sheets, tighter underwriting standards, and improved risk-management practices”, as opposed to the effectiveness of the bad bank.

However, the Reserve Bank of India noted that there is significant risk of macro-economic exposure to asset quality, and with a general election coming up this year market participants will be aware of a risk of farm loan waivers to provide relief to the agricultural sector, which has been particularly affected by the lower-than-expected monsoon season last year. August 2023 was the driest month in over a century. Coupled with a rapid growth in unsecured personal loans, significant structural risks remain in the Indian banking sector.

NARCL’s last shot at success?

Since its establishment in October 2021, NARCL has fallen short of its self-imposed INR 50,000 crore origination target, having only acquired INR 21,350 crore of outstanding debt after two years of operation. It appears that one of the main reasons for a lack of use of the bad bank is that NARCL looks to acquire NPAs through a mix of consideration – 15% of the consideration being paid in cash up front and the remaining 85% being paid through the issuance of security receipts (“SRs“) backed by a government guarantee up to a cap. This has meant that of the INR 21,350 crore nominal value of the outstanding loans, NARCL only paid INR 4,215 crore. This represents a discount of 82% to the nominal value, of which only 2.58% was paid for in cash.

Given a reduction in overall gross NPA volumes, tighter underwriting standards and risk-management, the significant discount to book value currently being attained in the market and the long lead time to recover value under SRs (or the government guarantee following a sub-optimal resolution of the NPAs), banks have understandably not seen this as an attractive option. As NPAs are bought at a fair market value, the value proposition will change as the market shifts.

There have also been other issues such as the placement of legal liabilities associated with the sale of fraudulent accounts between NARCL and selling banks and a pronounced turnover in NARCL’s leadership. However, a hidden benefit has been that the operation of NARCL in the NPA market has increased the competitiveness of pricing offered by other private asset reconstruction companies in India.

Whilst NARCL’s first two years have been more tumultuous than one may expect, there is no reason the overall project of moving loans to a bad bank and then selling them on to other investors cannot be a success. There have been many countries around the world which have used this model, such as Malaysia (Danaharta/Danamodal), Ireland (the National Asset Management Agency) and Korea (the Korean Asset Management Company).

From an operations perspective, NARCL could potentially streamline its procedures, especially its protracted due diligence process in a way to take on more loans and enable transfers to happen more quickly. In this vein, a merger between NARCL and IDRCL has been suggested by some market commentators. The benefit here would be that IDRCL could work in tandem with NARCL to manage these distressed assets – consolidating and being in the driving seat from when those assets are taken over to their eventual sale to funds or other investors. In market terms, NARCL may also have to align its internal processes when it comes to offers for distressed assets, as these have often been seen as lower compared to the market as a whole.

That said, the long-term prospect of India building a vibrant secondary market in loan sales is certainly still possible.  India has vast potential and large volumes of bad debt. Government policy is clearly committed towards cleaning up these distressed assets. Whilst NARCL’s infancy has been perhaps more eventful than expected, it is not surprising that some variations are required over time in terms of leadership, procedures or pricing strategy. The global markets will look on at how any changes are implemented with great interest.