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Bad Bank And The Role It Will Play For Small Finance Banks

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The creation of the National Asset Reconstruction Company (NARCL) came as a welcome move for the banking sector, which was reeling under the weight of bad loans. An extensive assessment on the future of bad loans in India revealed that non-performing assets (NPAs) are expected to rise in the near future and reach their peak in 2022-2023 estimated at 10-13 per cent of the loan book.

While NPAs are seen as bad credit decisions, they should be considered as a reflection of risk capacity. NARCL will help in recovering bad loans and will act as another solution to bad loans problem in India, not the only one.
While the direct beneficiaries of a bad bank are likely to be traditional PSUs and private banks, particularly large banks, one would expect NARCL to be a vehicle to support the broader financial services industry. This is important, particularly because the financial services regulator has highlighted the increased risks in relation to non-bank finance companies (NBFCs) and microfinance banks (SFBs).

The Reserve Bank of India (RBI) introduced a rapid corrective action (PCA) framework for large non-profit financial institutions, introducing limits on each time key metrics fall below a specified threshold. Among other things, the PCA framework set the first threshold for NPAs at 6 percent. This is where I think the NBFCs are going to be at risk, and you’re going to force them to be conservative.

While the intent of the RBI’s introduction of a risk control terminal is understandable, it is important to realize that NBFCs play an important role in mediation and often fill funding gaps when banks are reluctant. Thus, by their very structure, NBFCs are expected to take higher risks and have higher NPAs. Will the introduction of an anti-corruption law next year force non-bank financial firms to change their business model? We’ll have to wait and watch.

This brings me to microfinance banks. Traditionally, SFBs have focused on retail and small business loans. However, the introduction of the PCA framework for NBFCs could create an opportunity for them to grow the company’s loan book. Its financing cost is lower, and with the increasing selectivity of non-bank financial firms, Islamic financial institutions can make their way to non-premium firms. While SFBs have stricter regulations in comparison to NBFCs, the recent rise in NPAs for microfinance banks suggests that all is not well. Against this background, do SFBs feel that NARCL would be an alternative if their books feel the tightness of growth in NPAs? It is too early to tell.

Although the pandemic has created opportunities for growth, it has not been very kind to SMEs and has affected NPA levels in SFBs. Before the pandemic, small financial banks’ NAPs were around 2 percent; Reasonably good considering the profile of the borrowers. However, after the pandemic, the percentage jumped to about 7 percent. With another COVID wave expected, coming March 2022, SFBs may be staring at double-digit NPAs. Higher capital buffers add an extra layer of cushion to SFBs, and most should be able to digest this loss. However, growth capital that is used for provisioning and write-offs is not its best use. This will push SFBs towards alternatives including selling NPAs.

The immediate solution for microfinance banks may be through asset rebuilding companies (ARCs). The role of agricultural research centers has come under intense scrutiny in the past few years. It has been more than two decades since the introduction of ARCs in India, but ongoing regulatory changes have meant that their overall impact has been limited. Some see the introduction of NARCL as a partial failure of the ARC industry. However, I wouldn’t be too harsh on them because the operating environment for the success of ARCs has not been easy. The introduction of the Insolvency and Bankruptcy Act (IBC) about six years ago has also dramatically changed the way Indian creditors deal with NPAs.

However, the pandemic has brought a new lease of life to ARCs as they work to develop their new avatar. As banks look to shift NPAs for larger tickets to NARCL, many ARCs are now turning their heads and looking to take out smaller ticket loans. The disruption caused by the pandemic has shut down many good small and medium businesses and subsequently defaulted on loans. However, these are inherently good business, and the ARCs believe that asset pooling can help a stronger recovery.

Furthermore, getting tickets for smaller NPAs (including retail) is challenging and relies heavily on technology support. SFB banks, which are relatively smaller and smarter, have strong technological application and are able to monitor the portfolio more closely than many large banks. This makes them a prime candidate for ARCs.

Considering India’s size and demographics, SFBs play an important role. A strong regulatory framework should only be a feasible factor, and small foreign banks should have the motivation to go where the big ones fail. The distribution of credit to the lower income groups and the most vulnerable section is important for achieving high sustainable growth and income equality. Access to NARCL and ARCs will incentivize microfinance banks to take on more risks without worrying unreasonably about capital.

The author Tarun Bhatia is MD and chair of the Kroll South Asia Division. The opinions expressed are subjective.

(Edited by: Kanishka Sarkar)

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