India’s biggest initiative to clean the balance sheets of public sector banks has fallen on rough weather due to last-minute objections by the Reserve Bank of India (RBI) on the business model of the proposed bad bank.

The commencement of the bad bank, which would have housed a whopping Rs 2,25,000 crore of stressed assets of public sector banks, is set for delay. The RBI informed lenders the previous fortnight that it would not permit a ‘dual structure’, with one entity acquiring non-performing loans and the other working on resolution of these soured assets. The constraint of RBI is that there is no provision under law which empowers the central bank to allow such an arrangement.

Simply put, the main objection of the RBI is on the bad bank’s operating edifice, as was being planned. As per this model, the parent company, National Asset Reconstruction Ltd (NARCL), would purchase the stressed assets, while arranging for their resolution through an associate entity named India Debt Resolution Company (IDRCL).

The RBI has advised that under the Securitisation and Resolution of Financial Assets and Enforcement of Securities Act (Sarfaesi), acquisition and resolution are conducted under the same structure. The central bank is bestowed its power to regulate and issue ARC (asset reconstruction companies) licences from the Sarfaesi Act.

The stage was set for the inauguration of the bad bank in the second week of January this year. Funding was in the pipeline, the companies were formed and the directors appointed. But after the RBI’s objections, an alternate model is being worked out. More time would be required to put the bad bank into an operational flow.

The NARCL (the state-run lenders) has now suggested a principal-agent relationship structure between IDRCL and itself. Under the new plan, NARCL will tie-up with IDRCL to outsource resolutions of non-performing assets (NPAs). However, the resolutions offered by IDRCL will not be obligatory for NARCL.

The participating banks wanted the RBI to regulate the dual structure. But NARCL has proposed a principal-agent relationship to enable the regulator to exercise indirect control over IDRCL. This proposal is not following the letter and spirit of the Sarfaesi Act. It would provide the recalcitrant corporates an opportunity to indulge in prolonged litigation in various courts, thus delaying resolution at fair market price. It would also discourage international investors who wish to acquire Indian assets at a comparatively comfortable price due to the fear of the ‘Bad Bank’ being constituted on a debatably flawed legal premise. 

The RBI should insist on a foolproof structure, especially when its recently released bi-annual Financial Stability Report stated the gross NPA ratio could rise to 9.5% under severe stress conditions by September 2022. The position may actually worsen due to the menace of the new Omicron variant of the coronavirus. The role of the ‘Bad Bank’ is crucial to harmonising the stressed assets scenario as the Indian economy aspires to touch the $5-trillion mark by 2027. 

Let us build a ‘Bad Bank’ configured on a sound legal footing as it has to walk a long distance in an ambience where non-performing loans seem to be piling up.