Gains on sale of Zombie loans: RBI’s year-end bonus to banks
– Vinod Kothari & Dayita Kanodia (finserv@vinodkothari.com)
“There is no such thing as government money – only taxpayer money.”
— Margaret Thatcher
RBI has introduced a significant amendment to the prudential treatment of Security Receipts (SRs) guaranteed by the Government of India through its latest circular dated March 29, 2025. What this amendment briefly means is, that for sale of bad loans to NARCL, funded by issue of sovereign-backed SRs, the banks may book a gain equal to the sale consideration minus the provisioned value of the bad loans. Interestingly, this treatment will be applied not only to transactions done after the amendment, but to existing SRs held by banks too.
By way of a background, National Asset Reconstruction Company Limited (NARCL), along with its sister body India Debt Resolution Company Ltd. (IDRCL), was created to clean up the legacy stressed assets with an exposure of Rs 500 crore and above in the Indian Banking system. A 2021 cabinet note approved the grant of GOI guarantee for the SRs issued by NARCL for the bad loans it will buy from banks. When banks sell bad loans to NARCL (or, for that matter, to any other ARCs), they put in 15% of their own funds, and for the balance, they issue a paper called SRs. While presumably the bad loans are to be bought at their fair value, given that the chunk of the value is funded by the issue of this paper, one may understand that the fair valuation is quite often an abstraction.
As per para 77 of the TLE Directions, in respect of the stressed loans transferred to the ARC, the transferors are required to carry the investment in their books on an ongoing basis, until its transfer or realization, at lower of the redemption value of SRs arrived based on the NAV as above, and the NBV of the transferred stressed loan at the time of transfer. Hence, there is no gain on sale booked at the time of the sale, even if the sale is at higher than the net book value.
However, the RBI made a specific amendment, targeted at NARCL SRs (as those are the only ones guaranteed by GOI), having the effect of saying that, in view of the GOI guarantee, banks holding the SRs may value them at their face value. As a result, banks may book the entire difference between the sale consideration of the bad loans, and the net-of-provisions value of the loans, as a gain on sale or reversal of the provision. Either way, the credit goes to P&L account.
Key Highlights of the Circular
There are, of course, several caveats to booking this gain on sale. First of all, let everyone understand that the loans have been languising in the books of the banks for several years, and therefore, they would have mostly slipped in the category of “doubtful assets”, requiring steep and progressively scaling-up provisions. Therefore, it is quite likely that the fair value, which may, in turn, be influenced by the likely value in case of a resolution plan or liquidation, or the value of the underlying secured assets, may be substantially higher than the provisioned value.
The circular makes the following crucial changes to the treatment of SRs guaranteed by the sovereign:
- Reversal of Excess Provision: When a loan is transferred to an ARC for a value higher than its Net Book Value (NBV), the excess provision can be reversed to the P&L account. However, this is permitted only if the sale consideration consists solely of (i) cash and (ii) SRs guaranteed by the Government of India.
- Deduction from regulatory capital: Despite allowing provision reversals or gain on sale, the RBI mandates that the non-cash component (SRs) must be deducted from Common Equity Tier 1 (CET 1) capital/Tier 1 Capital. Additionally, no dividends can be paid out of the SRs component, ensuring that banks do not distribute unrealized profits to shareholders. This means that the provision reversal or gain on sale will stay in the bank’s balance sheet as a non-distributable surplus. How long will this credit remain non-distributable? Since the government guarantee is valid only for 5 years, it is incumbent that NARCL will do either a resolution or liquidation of the borrower sooner than this period. Eventually, the SRs may receive cash distribution, either by way of realisation from the bad loans, or by way of the devolvement of the GOI guarantee, or both. Will the non-distributable credit become part of usual distributable profits when the value of the SRs is realised? While the circular does not give clarity on the subsequent treatment of the credit, our understanding says, yes.
- Periodic Valuation Based on NAV: The SRs will be periodically valued based on the Net Asset Value (NAV) declared by the ARC, derived from the recovery ratings of such instruments. Here once again, it is not clear whether the recovery ratings will be disregarding the underlying GOI guarantee. Logically, since the SRs are fully guaranteed, there is no reason for the rating to drop. But if the recovery ratings are done disregarding the guarantee, then the valuation of the SRs is bound to drop in the near future, making the FY 24-25 profit short-lived.
- Final Valuation of SRs: If SRs remain outstanding after the final settlement of the government guarantee or upon the expiry of the guarantee period, they will be valued at a nominal price of ₹1.
- Conversion of SRs: If the SRs are converted into another form of instrument as part of the resolution process, their valuation and provisioning will follow the provisions outlined under the Prudential Framework for Resolution of Stressed Assets dated June 7, 2019.
The Implications of RBI’s Move
The amendment, issued just 2 days to the end of the fiscal year, means a lot to the profit and loss accounts of the banks holding the SRs.
However, on a policy front, it leaves several questions to be answered. The loans were evidently bad to their core. If the loans had any value in the hands of the banks, the banks would have used the several tools in their arsenal to recover them. Not that ARCs were unknown to the banks, or that IBC was far away from them. Therefore, if the banks were tempted to sell them to NARCL, the only reason would have been that the sale consideration, to the extent of 85% in form of paper-against-paper, was attractive. This paper, in the form of the SRs, suddenly means a lot of value in what was all this while not turning into value at all.
Central Government guarantee of Rs.30,600 crore to back Security Receipts issued by NARCL for acquiring stressed loan assets has been approved by the Union Cabinet. NARCL proposes to acquire stressed assets of about Rs. 2 Lakh crore in phases through 15% Cash and 85% in SRs. IDRCL will be engaged for management and value addition once NARCL acquires the assets.
It may be noted that according to the FAQs released by the Ministry of Finance on the subject, such sovereign guarantee will incentivize quicker action on resolving stressed assets thereby helping in better value realization. The FAQs state that this approach will also permit freeing up of personnel in banks to focus on increasing business and credit growth. Further, it will bring about improvement in the bank’s valuation and enhance their ability to raise market capital.
GOI guarantee is essentially tax payer’s money, eventually to fill the gap left in recovering a bad loan. Of course the bad loan is money lent by a bank to a bad borrower. Therefore, indirectly, the cost of this bad lending is transferred to the taxpayers.
It is quite okay for the GOI to recapitalise banks, but is it okay for the RBI or GOI to insert an item on the P/L accounts of banks by converting an imaginary profit into value?
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