The Ministry of Corporate Affairs (MCA) has set up a committee to look into the possibility of including what is called “pre-packs” under the current insolvency regime to offer faster insolvency resolution.

Practice question for mains:

Q.What are the key features of the Insolvency and Bankruptcy Code? Discuss how operationalization of IBC is hindered by the slower resolutions of insolvency cases. Suggest measures for faster resolution.

What is Pre-pack?

• A pre-pack is an agreement for the resolution of the debt of a distressed company through an agreement between secured creditors and investors instead of a public bidding process.
• This system of insolvency proceedings has become an increasingly popular mechanism for insolvency resolution in the UK and Europe over the past decade.

Why need Pre-packs?

• Slow progress in the resolution of distressed companies has been one of the key issues raised by creditors regarding the Corporate Insolvency Resolution Process (CIRP) under the IBC.
• Under the IBC, stakeholders are required to complete the CIRP within 330 days of the initiation of insolvency proceedings.

A case for India

• In India’s case, such a system would likely require that financial creditors agree on terms with potential investors and seek approval of the resolution plan from the National Company Law Tribunal (NCLT).
• This process would likely be completed much faster than the traditional CIRP which requires that the creditors of the distressed company allow for an open auction for qualified investors to bid for the distressed company.
• The process needs to be completed within 90 days so that all stakeholders retain faith in the system and cases that take more than this time should be taken through the normal CIRP.

What are the other key benefits of a pre-pack?

• Pre-packs would mostly be used for businesses that are running; the investors would likely need to maintain good relations with operational creditors.
• In the case of pre-packs, the incumbent management retains control of the company until a final agreement is reached.
• The transfer of control from the incumbent management to an insolvency professional as is the case in the CIRP leads to disruptions in the business and loss of some high-quality human resources and asset value.

Some limitations

• The key drawback of a pre-packaged insolvency resolution is the reduced transparency compared to the CIRP.
• Financial creditors would reach an agreement with a potential investor privately and not through an open bidding process.
• This could lead to stakeholders such as operational creditors raising issues of fair treatment when financial creditors reach agreements to reduce the liabilities of the distressed company.

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The idea of setting up a bad bank often comes up for debate, especially when stress in the banking sector is projected to rise in the near term.

Practice question for mains:

Q. What is a Bad Bank? Discuss how it can rescue the covid induced bad loans in India.

COVID induced NPAs

• Several economists and agencies project a recession in the Indian economy this year, due to the adverse effects of Covid-19 on economic activity.
• This will hit the banking and financial sector in particular, as a slump in earnings of companies and individuals could lead to a jump in NPAs, reversing the early trends.
• Various analysts suggest that in a couple of years, the proportion of stressed assets in the banking system could jump to as high as 18 per cent from around 11 per cent at present.
• To tackle this upcoming challenge, the banking industry has proposed the setting up of a government-backed bad bank.

What is the Bad Bank?

• A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution.
• The entity holding significant NPAs will sell these holdings to the bad bank at market price.
• By transferring such assets to the bad bank, the original institution may clear its balance sheet—although it will still be forced to take write-downs.
• A bad bank structure may also assume the risky assets of a group of financial institutions, instead of a single bank.

What is the recent proposal of a bad bank?

• The banking sector, led by the Indian Banks Association (IBA), had in May submitted a proposal for setting up a bad bank to the finance ministry and the RBI.
• The IBA proposed for having equity contribution from the government and the banks.
• This was based on an idea proposed by a panel on faster resolution of stressed assets in public sector banks headed by former PNB Chairman Sunil Mehta.
• This panel had proposed an asset management company (AMC), ‘Sashakt India Asset Management’, for resolving large bad loans two years ago.
• There were talks about creating a bad bank in 2018 too, but it never took shape.

What kind of NPA spike is expected during this outbreak?

• The impact of Covid-19 and the associated policy response is likely to result in an additional Rs 1,67,000 crore of debt from the top 500 debt-heavy private sector borrowers turning delinquent between FY21 and FY22.
• Given that 11.57 per cent of the outstanding debt is already stressed, the proportion of stressed debt is likely to increase to 18.21 per cent of the outstanding quantum.

What is the government’s view over Bad Banks?

• While the finance ministry has not formally submitted its view on the proposal, senior officials have indicated that it is not keen to infuse equity capital into a bad bank.
• The government’s view is that bad loan resolution should happen in a market-led way, as there are many asset reconstruction companies already operating in the private space.
• The government has significantly capitalized state-owned banks in recent years and pursued consolidation in the PSU banking space.
• In the last three financial years, the government has infused equity of Rs 2.65 lakh crore into state-owned banks.
• These steps, along with insolvency resolution under the IBC, are seen as adequate to tackle the challenge of bad loans.

What is the RBI view?

• The RBI has so far never come out favourably about the creation of a bad bank with other commercial banks as main promoters.
• Former RBI Governor Raghuram Rajan had opposed the idea of setting up a bad bank with a majority stake by banks, arguing it would solve nothing.
• Rajan argued that a government-funded bad bank would just shift loans “from one government pocket (the public sector banks) to another (the bad bank) and did not see how it would improve matters”.
• Indeed, if the bad bank were in the public sector, the reluctance to act would merely be shifted to the bad bank.
• Alternatively, if the bad bank were to be in the private sector, the reluctance of public sector banks to sell loans to the bad bank at a significant haircut would still prevail.

Alternatives to a bad bank

• Many experts argue that the enactment of IBC has reduced the need for having a bad bank, as a transparent and open process is available for all lenders to attempt insolvency resolution.
• The view is that an IBC-led resolution, or sale of bad loans to ARCs already existing, is a better approach to tackle the NPA problem rather than a government-funded bad bank.

Former RBI Deputy Governor Viral Acharya has proposed two models:

1) Private Asset Management Company

• The first model is a Private Asset Management Company (PAMC) which would be suitable for sectors where the stress is such that assets are likely to have economic value in the short run, with moderate levels of debt forgiveness.

2) Setting up National Asset Management Company (NAMC)

• The second model is a NAMC for sectors where the problem is not just of excess capacity, but possibly also of economically unviable assets in the short- to medium-term, such as in the power sector.
• The NAMC would raise debt for its financing needs, keep a minority equity stake for the government, and bring in asset managers such as ARCs and private equity to manage and turn around the assets.

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