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Event update: Financials - Funding is a key challenge for bad loan AMCs

The Finance Minister announced that there will be no state sponsored bad bank. However, banks through the Mehta Committee have planned a 5-pronged strategy to resolve bad loans. There are separate strategies for loans based on their sizes. The biggest proposal amongst the five is to set up one or more AMCs to resolve large bad loans of Rs5bn and above. Banks have already identified 200 loans of Rs3 trn in this segment including power loans. The plan is to fund the AMC with equity contribution from banks and private investors. Banks will get cash for the value of loans transferred. For banks the two key advantages are 1) They will be able to show a sharp reduction in NPLs 2) They will not need to make ageing provisions. We believe funding is a key challenge here. As such, as of now, we are not building in any upside from such schemes. If the government had supported or part-funded the scheme, it would have been more credible.

Explaining the structure of AMCs:  One or more AMCs with minimum capital of Rs200M will be formed. Then an AIF will be created to raise funds from institutional investors. Banks will also make equity contributions.  However, the key consideration here will be that the scheme will be capital neutral for banks i.e. they will contribute only as much capital as is released from the transfer of bad loans. The price discovery of these loans will be through open auction by the lead bank. Banks have already identified 200 assets of Rs3 trn to be transferred to this AMC. Most of these loans have a 50% cover and can be transferred at net book value without haircuts according to banks. Banks will receive security receipts in exchange but these will be redeemed in 60 days, so effectively banks will get cash for the bad loans sold. ARCs and other interested parties can bid to resolve these assets.

Why AMC not ARC? A senior banker told us that the reason why banks have proposed an AMC not an ARC structure is because ARCs have to resolve the assets while AMC can just be used to park these assets till a new buyer is found. Assets especially in the power sector may not have an immediate bidder. Rather than take large haircuts by trying to resolve these immediately, banks can use the AMC structure to wait for the right value to emerge. In the interim, to ensure proper functioning of the assets, experts can be roped in, such as giving NTPC a management contract to operate a few power assets till they are resolved.

Funding remains a challenge as private investors already have many other options: Funding will largely come from banks themselves and from private investors. As for banks, their contribution will be negligible as the basic principle of the scheme being capital neutral has to be followed. Assume that banks hold 50% provisions on Rs3trn of loans. So they will transfer Rs1.5trn to the ARC. The risk weight on these loans will be 50% because they will carry 50% provisioning. With Tier 1 of 9%, the total capital released will be Rs67.5bn (9% * 50%*Rs1.5trn). Any investment by a bank into an AIF will be risk weighted 250% which means that banks will be able to invest only 40% of the capital released to keep the transaction capital neutral. So banks will be able to contribute only Rs27bn as equity when they transfer Rs1.5trn of loans, which is a small contribution of 2%. The risk weights will be different based on the provisioning cover on loans. But even with different risk weights on loans transferred, the maximum contribution that banks can collectively make will be less than 5%. So the remaining 95-97% (over Rs1 trn) will have to come from private investments. The private funds were free to invest even before this scheme came up. They were already investing or joint-bidding for stress loans with existing, experienced ARCs. So these funds already have many existing, tested options.  Sorting out the funding will be a key challenge.

Power resolution remains a challenge: The separate power resolution schemes have now been clubbed with the AMC scheme. The key constraint for resolution of bad loans is that the power sector which is a big contributor to bad loans continues to remain challenged. Banks are finding it tough to resolve power loans within the 180 day deadline set by the Feb 12 circular. That deadline expires in end-August. RBI has refused to extend it. Till the financial health of SEBs stabilizes, resolving power will remain a challenge.

Other strategies: In addition to the AMC strategy there are 4 others – 1) SME strategy for loans upto Rs0.5bn where each bank has to form its own cell for managing SME stress and complete the resolution in 90 days 2) Bank led resolution approach for loans between Rs0.5bn to Rs5bn. Financial institutions will enter into an Inter-Creditor Agreement to authorize the lead bank to implement a resolution plan in 180 days. 3) Banks to continue with resolutions under the IBC 4) Banks to form an asset trading platform.