Non-performing Loan Auctions

A Reserve Bank of India (RBI) bulletin released in 2021 (RBI 2021) on Asset Reconstruction Companies (ARCs) finally sta­ted what was obvious to many, for years. The acquisition of assets at an inflated cost predominantly using “seller financing” was a recipe for disaster. Moreover, the management fee structures that all­owed ARCs to recoup the de minimis ­upfront cash payment, even assuming zero recoveries from non-performing loans (NPLs), further exacerbated the problem. But the seminal problem in the entire transaction was the choice of auction mechanism used by the banks. They sold NPLs to ARCs using a contingent payment auction mechanism (CPAM) and the ultimate proceeds to the bank were conditional upon the realisation of the auctioned NPL.

CPAM is not a new development—it has been used in the past for awarding contracts for drilling oil reserves and for awarding spectrum (Riley 1988; Sheng 2001). However, it is extremely important that features associated with the CPAM are carefully defined so as to avoid inflated bidding, moral hazard, and coll­usive behaviour (Hansen 1985; Samuelson 1987; Crémer 1987). The Federal Commu­nications Commission (FCC) auc­tion in the United States using CPAM was marred by controversies and ultimate failure (Cra­mton 1997; Sheng 2001). In this short article, I address the features of the auction mec­hanism used by Indian banks and provide my views on their appropriateness.