The setting up of the National Asset Reconstruction Company (NARCL) has come as a welcome move for the banking sector, which has been reeling under the weight of bad loans. A broad assessment on the future of bad loans in India revealed that Non-Performing Assets (NPAs) are expected to rise in the near future and peak in 2022-23 estimated at 10-13 percent of the loan book.

While NPAs are viewed as bad credit decisions, they should be considered as a reflection of risk-taking ability. The NARCL will help recover bad loans and act as another solution to the bad loans problem in India, not the only one.

While the immediate beneficiaries of the bad bank are likely to be the traditional PSU and private banks, especially large ones, one expects NARCL to be a vehicle of support for the broader financial services industry. This is important, especially because the financial services regulator has highlighted increased risks with respect to Non-Banking Finance Companies (NBFCs) and Small Finance Banks (SFBs).

The Reserve Bank of India (RBI) has introduced a prompt corrective action (PCA) framework for large NBFCs, introducing restrictions for whenever key metrics dip below a defined threshold. Among other things, the PCA framework has set the first threshold of NPAs at 6 percent. This is where I believe NBFCs would be vulnerable, and it will force them to be conservative.

While the intent behind RBI’s introduction of PCA is understandable, it is important to recognise that NBFCs play an important intermediation role and often bridge funding gaps when banks are hesitant. Thus, by their very structure, NBFCs are expected to take more risk and have higher NPAs. Will the introduction of PCA next year force NBFCs to alter their business model? We will have to wait and watch.

This brings me to small finance banks. Traditionally, SFBs have been focused on retail and small business loans. However, the introduction of PCA framework for NBFCs could create an opportunity for them to grow their corporate loan book. Their cost of funds is lower and with NBFCs becoming more selective, SFBs can make inroads into the non-blue chip corporates. While SFBs have tighter regulations as compared to NBFCs, the recent spike in NPAs for the small finance banks suggests that all is not well. Against this backdrop, do SFBs feel that NARCL would be an alternative should their books feel the pinch of growing NPAs? It is too soon to tell.

Pandemic, while having created growth opportunities, hasn’t been too kind to small and medium enterprises and has impacted the NPA levels of SFBs. Pre pandemic, NPAs for small finance banks were about 2 percent; reasonably good keeping in mind the profile of the borrowers. However, post pandemic, the ratio has jumped to around 7 percent. With the anticipation of another COVID wave, come March 2022, SFBs could be staring at double-digit NPAs. High capital buffers do add an extra layer of cushion for SFBs, and most should be able to digest this loss. However, capital that was earmarked for growth being used up for provisioning and write-off isn’t its best use. This will push SFBs towards alternatives including the sale of NPAs.

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The immediate solution for small finance banks might be through Asset Reconstruction Companies (ARCs). The role of ARCs has been under immense scrutiny in the last few years. It has been over two decades since the introduction of ARCs in India, but constant regulatory changes meant that their overall impact has been limited. Some view 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 ARCs to succeed hasn’t been easy. The introduction of the Insolvency and Bankruptcy Code (IBC) about six years back also significantly changed the way Indian creditors approached NPAs.

However, pandemic has offered a new lease of life to ARCs and they are working out their new avatar. With banks looking at transferring bigger ticket NPAs to NARCL, many ARCs are now shifting direction and looking at acquiring small ticket loans. The disruption caused by the pandemic resulted in many good small and medium businesses being shut down and hence defaulting on loans. However, these are inherently good businesses and ARCs believe that pooling of assets can help in stronger recovery.

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Further, acquisition of smaller ticket NPAs (including retail) is challenging and relies heavily on technology support. SFBs, who are relative smaller and nimble, have strong technology implementation and are able to monitor the portfolio more closely than many large banks. This makes them a prime candidate for ARCs.

Given India’s size and demographics, SFBs play an important role. A strong regulatory framework should only be an enabler and SFBs should be motivated to go where larger banks failed. Credit dissemination to low-income groups and the weaker section is important to achieve high sustainable growth and income equality. Access to NARCL and ARCs will motivate small finance banks to take more risks without unreasonably worrying about capital.

The author Tarun Bhatia is MD and Head of Kroll South Asia. Views expressed are personal.

(Edited by : Kanishka Sarkar)