Content uploaded by Tamal Datta Chaudhuri
Author content
All content in this area was uploaded by Tamal Datta Chaudhuri on Oct 19, 2022
Content may be subject to copyright.
Resolution Strategies for Maximising Value of Non-Performing Assets (NPAs) *
By
Tamal Datta Chaudhuri #
October 20, 2005
The opinions expressed in the paper are those of the author’s and do not reflect
those of IIBI. Any errors are solely the author’s.
# Chief General Manager, Industrial Investment Bank of India (IIBI), 19, N S Road,
Kolkata- 700 001 and Visiting Faculty, IBS, Kolkata .
ABSTRACT
The paper examines the various reasons behind an asset turning into a Non-Performing
Asset (NPA) and the alternative resolution strategies that can be adopted for recovery
from such NPAs. It then devises a state resolution mapping whereby the reasons for an
asset turning NPA and the resolution strategy are linked together. It is shown that reasons
like management inefficiency, industry slowdown, technology, capital structure and
product failure will, to a large extent, determine the recovery strategy to be adopted by
the bank or financial institution.
2
1. Introduction
The issue of Non-Performing Assets (NPAs) in the financial sector has been an area of
concern for all economies and reduction in NPAs has become synonymous to functional
efficiency of financial intermediaries. From the early nineties till date, the regulators in
India, under the general recommendations of the Narasimhan Committee Reports (1 & 2),
Verma Committee Report, Basle 1 & 2 and insights and findings of scholars, have
continuously provided guidelines and directives addressed at reducing NPAs. A perusal
of the Reserve Bank of India (RBI) circulars in this regard will give the reader a
comprehensive idea about the extent of detail in which norms and guidelines have been
formulated to arrest the growth in NPAs. It started off with introduction of prudential
norms and has delved into adoption of a risk based management system. The Indian
financial sector has responded well and adopted the directives given, and the overall
health has shown considerable improvement.
Although NPAs are a balance sheet issue of individual banks and financial institutions, it
has wider macroeconomic implications and the literature, while discussing financial
sector reforms, has gone into a discussion on NPAs also. The reasons can be observed
from the following flow diagram.
3
Flow diagram
Presence of NPAs indicate asset quality of the balance sheet and hence future income
generating prospects. This also requires provisioning which has implications with respect
to capital adequacy. Declining capital adequacy adversely affects shareholder value and
restricts the ability of the bank/institution to access the capital market for additional
equity to enhance capital adequacy. If this happens for a large number of financial
intermediaries, then, given that there are large inter bank transactions, there could be a
domino kind of effect. Low capital adequacy will also severely affect the growth
prospects of banks and institutions.
With weak growth outlook and low functional efficiency, the sector as a whole will not
be able to perform its role and will adversely affect the savings investment process. Once
we realize this, it is evident that a micro problem of a bank translates into a macro
4
problem of the economy. Capital market development takes a back seat and GDP growth
rate weakens. The adverse effects of fiscal deficit loom large and a balance of payments
crisis also cannot be ruled out. Banking crisis and foreign exchange crisis get interlinked.
The problem at hand is quite serious and in a previous paper, Datta Chaudhuri (2003) had
provided a broad outline of various issues related to Non-Performing Assets (NPAs) and
a structure of pricing of NPAs. Batra (2003), Mor & Sharma (2003), Demirguc Kunt &
Detragiache (1997, 1998), Kearns (2003), Claessens (1990), Montreevat & Rajan (2003),
Ahn (2001), Ketkar & Ratha (2001), Hanson (2001), Mohieldin & Nasr (2003), Banerjee,
Cole & Duflo (2004), and Ranjan & Dhal (2003) have dealt with the various reasons
behind assets turning non-performing and have also analysed their macroeconomic
implications as demonstrated in the above flow diagram.
It is realized that if a resolution strategy for recovery of dues from NPAs is not put in
place quickly and efficiently, these assets would deteriorate in value over time and little
value would be realized at the end, except may be its scrap value. That is why, asset
securitisation has gained popularity among financial sector players. The literature,
however, has not specifically discussed about the various resolution strategies that could
be put in place for recovery from NPAs, and in particular, in which situation which
strategy should be adopted. The purpose of this paper is to indicate the various
considerations that one has to bear in mind before zeroing on a resolution strategy. The
details of the strategy would follow after that.
5
Accordingly, the plan of the paper is as follows. Section 2 deals with the various reasons
for an asset turning NPA. This analysis is important, as the required strategy would
crucially depend on the specific reasons. Section 3 describes in detail the various
recovery strategies. The main thrust of the paper is Section 4 and here a State-Resolution
Mapping (SRM) is done. This section will provide an indicator as to which recovery
strategies can be adopted when.. Once a specific strategy has been chosen, some broad
indications are given in Section 5 on the details pertaining to that strategy. Section 6
concludes the paper.
2. Reasons for an asset turning NPA
The various reasons, either singly or jointly, behind an asset turning NPA can be
classified as follows
Reasons from the economy side
Reasons from the industry side
Reasons from the borrower’s side
Reasons from the banking system side
Reasons from the loan structuring side
Reasons from the security side – collateral vs cash flow
Reasons from the regulatory side
6
From the above, it may be surprising to many that only the borrower is not always at
fault. At times, systemic faults can also adversely affect the profitability of financial
intermediaries. The following discussion will clarify our position.
Reasons from the economy side
a. Political – mindset regarding paradigm, proactive, fiscally responsible (national
income accounts)
b. Economic – growth, distribution, efficient allocation of resources
c. Social – acceptability, mobility, education
d. Technological – advances in use of IT
e. Legal – Enforceability of loan contracts
f. Environmental – liberalization & globalisation
If loan contracts are not easily enforceable, there will naturally be a tendency to default.
Opening up of the economy can render companies uncompetitive. Lack of adaptation of
IT will make data processing difficult and information dissemination will be impossible.
Objective analysis of risk would be difficult and appraisal would remain a subjective
matter. Similarly, directed programs of lending can be counterproductive.
Reasons from the industry side
a. Global competition
b. Cyclical downswing
c. Sunset industry
7
d. Frequent changes in regulatory norms
Reasons from the borrower’s side
a. Misconceived project
b. Poor governance
c. Product failure
d. Inefficient management
e. Diversion of funds
f. Dormant capital market
g. Regulatory changes
Reasons from the banking system side
a. Parameters set for their functioning were deficient: incorrect goal
perception and identification – lazy banking
b. Directed banking and lack of freedom to choose products and pricing
c. Being unexposed to international marketing methods and products, people
lacked training and knowledge resources
d. Ownership and management were not distinguished – composition of
Board of Directors
e. Lack of systems and procedures – audit and inspections
f. Banks lacked the ability to handle enormous growth in liabilities and
assets
g. Lack of a mechanism of credit information dissemination
8
h. Lack of an effective judicial system for recovery from defaulters
i. Collateral based lending leading to idle assets
j. Fixing of price and quantum of loans
k. Lack of an effective IT system and MIS
Reasons from the loan structuring side
a. High debt equity ratio
b. Timing of raising equity
c. Discrepancy between the rate of interest charged and the realistic rate of
return
d. Inconsistency between revenue generation and the loan repayment
schedule
e. Lack of binding penal clauses and performance guarantees
Reasons from the security side – collateral vs cash flow
There is a tendency among banks and institutions to depend excessively on collateral
for advancing of loans. While this is important, it presumes from the very beginning
that the borrower would default and the security would need to be encashed for
recovery of the loan. Clearly, this logic is unacceptable. Emphasis should then be on
cash generation and a charge on this should be built into the loan contract through
some escrow mechanism.
9
Reasons from the regulatory side
Frequent regulatory changes can turn assets non-performing. Accounting reason like
reduction in income recognition norms from 180 days to 90 days could be one such
reason. Pollution related issues could be the other reason. Distance between two sugar
mills could be a third.
3. Recovery Strategies
The various resolution strategies for recovery from NPAs include financial restructuring,
change in management, one time settlement, merger, sale to an asset reconstruction
company, securitisation of receivables and filing of legal suit. Under each option there
are options, which can be exercised either singly or jointly. The details under each
strategy are given in the following.
a. Financial restructuring
Reschedulement of the principal repayment
Reduction in the rate of interest
Funding of past due interest into loan or instruments (debt or equity or quasi
equity)
Funding of future interest
Waiver of past simple interest, compound interest or liquidated damages
Conversion of loan into equity or quasi-equity
Reduction in equity
Debt write-off
10
Funds infusion by way of equity or debt for project completion
Funds infusion for working capital purposes
Escrowing of receivables – Trust & Retention Account
Under this strategy, the company is in operation, but requires some relief. However,
along with reliefs, some additional fund infusion by the promoter should be a must.
b. Change in management
Change in the promoters
Induction of professionals
c. One time settlement (OTS)
Full principal with all past interest and future interest with prepayment
premium
Full principal with all past interest
Full principal with part interest
Full principal with full or part interest converted to equity or quasi
equity instrument
Part principal with the remaining part converted to some equity or
quasi equity instrument
Part principal and remaining part written off
11
d. Merger with another company
Nature of the industry – sunrise or sunset
Synergy issues
Valuation
Share swap ratio
Tax implications
e. Sale to an Asset Reconstruction Company (ARC)
Nature of the industry
Valuation – vintage of machinery, land
Provisioning made
Failed negotiations
Multiple bankers
The mechanism of sale of a loan to an ARC is given below.
12
In the Indian context, the time the ARC (ARCIL) has for executing a strategy is 5 years.
The ARC sells Security Receipts (SRs) to the bank, who invests in them. With these
proceeds, the ARC buys the loan from the bank. This asset is then restructured and sold
down the line to an investor and the SRs are redeemed. Thus a loan in the books of the
bank gets replaced by an instrument, which would be redeemed within five years. The
SRs would get valued on NPV basis.
e. Securitisation of receivables
This goes under the names of CLOs (collaterlised loan obligations), MBS (mortgage
based securitisation) and ABS (asset based securitisation). The basic concept is to convert
a loan into an instrument, which can be independently traded. This has gained popularity
13
for NPA resolution as it allows lumping of many NPAs or NPAs along with Standard
Assets into a single pool and tradeable securities are issued on their behalf. This ensures
liquidity and early exit option.
The originator (bank) floats a Special Purpose Vehicle (SPV) and transfers the asset to it.
The SPV then issues securitised notes to an investor whose proceeds go to the originator
as payment against the assets transferred to the SPV. The principal and interest payments
by the underlying asset get deposited with a Trust, which services principal & interest to
the investor.
14
Securitization allows issuers to lengthen the maturities of their debt, improve risk
management and balance sheet performance, and tap a broader class of investors—for
example, insurance companies facing limitations on buying sub-investment-grade debt. It
provides liquidity, improved asset liability management and better reinvestment options.
f. Filing of suit and recovery through liquidation proceedings
This is an option of last resort. It is time consuming and chances of asset value
deterioration is very high.
4. State-Resolution Mapping (SRM)
In Section 3, we have outlined the various reasons behind an asset turning NPA. In
Section 4 we have detailed the various resolution strategies. Given the above, we now
discuss the basic theme of the paper, i.e., as a lender, which strategy to apply and when.
Although we will be giving specific options, there may be a non-unique answer to the
state. But we will argue what is the best strategy available.
Any individual company can be described in terms of
a. Nature of the overall macroeconomy where it is located
b. Nature of the industry to which it belongs
c. Overall market growth
15
d. Competitive position in the market
e. Vintage of machinery used
f. Technology in use
g. Skill set required and gaps, if any
h. Management quality
i. Liability structure (Debt-Equity Ratio)
j. Outstanding liabilities
k. Asset quality and provisioning made in the books of the lender
We will take the above characteristics, two at a time, and design alternative scenarios.
We will then prescribe the required strategy.
Case 1
Market growth Competitive position
High Low
High Restructuring/Sale to an
ARC
Restructuring/management
change
Low OTS OTS, liquidation
For a company whose competitive position is good and also market prospects are bright,
clearly, the lender should stay with the company and provide necessary financial
16
restructuring. On the other hand, a company whose overall market growth prospects are
poor and its competitive position is also weak, the lender should do an OTS and exit. The
terms of OTS we will discuss in the next section. It is perfectly possible that the borrower
may not come forward for a negotiation, and in that case the only option would be to file
a suit. An OTS is a highly desirable strategy for a company whose current competitive
position is quite good, but where the future market growth prospects are dim. Further, for
a company, whose market growth is high, but competitive position is weak, there a
financial restructuring should be accompanied by a change in management.
Clearly we can see how the discussions in Sections 2 & 3 can combine to generate a
resolution strategy. In the remainder of the section, we will present various other cases in
tabular form. It is left to the reader to analyse the strategy recommended.
Case 2
Skill set Management Quality
High Low
High Restructuring Change in management
Low Merger OTS
17
Case 3
Management quality Outstanding liabilities
High Low
High Merger Restructuring/Merger
Low OTS Restructuring/ Change in
Management
Case 4
Debt-equity ratio Nature of the industry
Growing Declining
High Restructuring Liquidation
Low Merger/Sale to ARC OTS
Case 5
Growth prospects of the
industry
Overall macroeconomic
condition outward looking,
competitive
Growing Stagnating
High Restructuring OTS
Low OTS Liquidation
18
Case 6
Outstanding liabilities Asset quality &
provisioning
Substandard,
Low provisioning
Doubtful,
High Provisioning
High OTS Liquidation
Low Restructuring OTS
Given the cases above, the reader can construct alternative scenarios and derive optimal
recovery strategies.
5. Some details on specific strategies
Once we derive a strategy from the discussion in Section 4, we can then turn back to
Section 3 to get the details of that strategy. In this section we will discuss one strategy in
detail, i.e., one time settlement/sale to an ARC.
a. For substandard assets, the transfer price should be some average of the actual
market value of the asset as on that date minus the provision made, and the
outstanding principal plus the outstanding interest on it.
b. In case of D1 category assets, we recommend a pricing and profit sharing
procedure where the due interest amount will not be considered and pricing will
be an average of market value of assets and principal outstanding minus
19
provisions made. Apart from this base price, the sale proceeds by the ARC would
be shared on 20:80 basis where the ARC will enjoy the 80 % of profit from sales.
For many D1category assets, where long term viability can be established, the
approach in a) would apply.
c. For D2 and D3 category assets, the erosion in security needs to be considered.
The suggested pricing would be as under:
Suppose, the loan amount is L, of which the unsecured amount is z. So z has to be fully
provided for.
The secured portion of the asset is (L-z)
Say, x is the percentage provision required (20%, 30% or 50%).
So the fair value of the asset (FA) is {(L – z)(1- x/100)}
Apart from this base price, the sale proceeds by the ARC would be shared on 20:80 basis
where the ARC will enjoy the 80 % of profit from sales.
d. For loss assets it is recommended that assets be sold at the average of market value of
the assets and 20% of the loan outstanding. Apart from this base price, the sale proceeds
by the ARC would be shared on 20:80 basis where the ARC will enjoy the 80 % of profit
from sales.
It should be borne in mind that any settlement is a result of negotiation. The above only
provides the frame of analysis. In many cases, promoters come in for settlement when
20
their personal guarantees are invoked as they want to keep their names and dignity
untouched. Again in cases of even loss assets, the land value when sold, has compensated
for not only the principal, but also part of the interest.
6. Concluding remarks
In conclusion, as discussed in Datta Chaudhuri (2003), it is again emphasized that a
conceptual distinction has to be made between past NPAs and future NPAs. Past NPAs
are stock. The value is known and recovery has to be maximized. For these assets the
recovery strategies are detailed in Sections 3 & 4. However, it is obvious that any asset,
when acquired, can turn non-performing. It is this risk for which financial intermediaries
are compensated. In order to minimize future risk, the strategies should include
1. Introduction of a risk based management system
2. Adoption of Corporate governance practises
3. Human Resources Management
4. An efficient Management Information System
5. Proper IT environment
6. Adoption of credit rating modules and risk based loan pricing
7. Securitisation
8. Market research
*******
21
References
1. Ahn, Choong Yong, (2001), “Financial System Reform and NPLs in South Korea”,
Paper presented at the Shizuoka Asia Pacific Forum, Japan, 1-33.
2. Banerjee, Abhijit, Shawn Cole and Esther Duflo, (2004), “Banking Reform in India”,
BREAD Policy Paper No.006, 2-58.
3. Batra, Sumant, (2003), “Developing the Asian Markets for Non-Performing Assets:
Developments in India”, 3rd. Forum on Asian Insolvency Reform, Seoul, Korea, 2-52.
4. Claessens, Stijn, (1990), “Experiences of Resolution of Banking Crises”, Paper
presented at the PBOC/BIS Seminar on Strengthening the Banking System in China,
Beijing, 1-17.
5. Datta Chaudhuri, T, (2005) “Strategies for Recovery from Non-Performing Assets
(NPAs), Issues in Financial Economics, edited by Basabi Bhattacharya and Malabika
Roy, 208-228.
6. Demirguc-Kunt, Asli & Enrica Detragiache, (1997), “The Determinants of Banking
Crises: Evidence from Developed and Developing Countries”, Working Paper, The
World Bank.
22
7. Demirguc-Kunt, Asli & Enrica Detragiache, (1998), “Financial Liberlisation and
Financial Fragility, Paper presented at the World Bank Annual Conference on
Development Economics, 1-53.
8. Hanson, James A, (2001), “Indian Banking: Market Liberalisation and the Pressure for
Institutional and Market Framework Reform”, Working Paper No.104, Centre for
Research on Economic Development and Policy Reform.
9. Kearns, Allan, (2003), “Corporate Indebtedness and Liquidation in Ireland”, Quarterly
Bulletin, 1-15.
10. Ketkar, Suhas and Dilip Ratha, (2001), “Securitisation of Future Flow receivables: A
Useful Tool for Developing Countries”, Finance Development, 1-10.
11. Mohieldin, Mahmoud and Sahar Nasr, (2003), “Vulnerability of Banking Systems to
Crises in Emerging Markets: The Case of Egypt, Morocco and Tunisia”, Paper presented
in the ERF 10th Annual Conference.
12. Montreevat, Sakulrat and Ramkishen S Rajan, (2003), “Financial Crisis, Bank
Restructuring, and Foreign Bank Entry: An Analytical Case Study of Thailand”, Asia
Pacific Journal of Economics & Business, 53-77.
23
13. Mor, Nachiket & Bhavna Sharma, (2003), “Rooting out Non-Performing Assets”,
Paper presented in the 5th Annual Conference on Money and Finance in the Indian
Economy, Indira Gandhi Institute of Development Research, Goregaon, Mumbai, 1-22.
14. Ranjan, Rajiv and Sarat Chandra Dhal, (2003), “Non-Performing Loans and Terms of
Credit of Public Sector Banks in India: An Empirical Assessment”, Reserve Bank of
India Occassional Papers, Vol 24, No. 3, Winter 2003.
24
