A company that deals in risky and illiquid assets are known as a bad bank. These assets are owned by banks, financial institutions, or a group of banks. It was set up to assist banks to remove troublesome debts from their balance sheets. It enables them to focus on their main tasks, which include receiving deposits and extending credit. Depositors typically do not lose money from this arrangement, but stockholders and bondholders typically do. The process can result in the insolvency of banks, which can then be liquidated, nationalized, or recapitalized.
India’s bad bank would be known as National Asset Reconstruction Ltd. (NARCL). This NARC will function as a firm that reconstructs assets. It will purchase defaulted loans from banks, relieving them of their Non Performing assets (NPA) obligations. After that, NARC will try to sell the stressed loans to companies that buy distressed debt. India Debt Resolution Company Ltd. (IDRCL) will make an effort to advertise and sell them. After the stressed asset is sold, the involved bank will receive partial payment. The government guarantee will be used if the bad bank in India is unable to sell the stressed loan for a profit or at all. It’s significant to note that the government has made a guarantee available for this purpose in the amount of Rs 36,000 crores. If a bad bank is able to sell a loan for more than it paid for it when it bought it from a commercial bank, it will turn a profit from its activities. The main goal of a bad bank is typically not to make money; instead, it is to relieve banks of the burden of holding a significant amount of stressed assets and encourage them to lend more aggressively.
Justification for a Bad Bank:
- Lend incrementally: Banks profit from the fact that a sizable fraction of deposits stays idle in bank accounts. This deposit may be applied to borrowing. In a similar vein, not all advances made by banks are instantly deducted from the accounts. As a result, a portion of these loans might be utilized to expand credit. As a result, banks can give more loans to those in need the more money they have.
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Specialization: Since this would be its main responsibility, a bad bank would be very skilled at maximizing the recovery from a bad loan.
Banks, on the other hand, are not in the recovery business, therefore they have limited ability to settle the loans. - Releasing resources: Banks must reserve a portion of their operating income to pay for any potential dubious advances. The bank’s poor loans may be transferred to a bad bank, relieving it of the provisioning obligations. This implies that the same money can be used for lending because the banks are not compelled to set aside money for poor loans.
- Economic Sluggishness: There may be a rise in stressed assets as a result of India’s economic slump, according to reports. This could lead to a scenario where the NPAs reach an unmanageable limit when coupled with the COVID-induced lockout.
- Enhanced Sentiment: If India is serious about achieving its declared aim of a $5 trillion economy, industry needs to recover from the crisis it is currently suffering. This calls for an upbeat economic outlook. A bad bank might give the sector this boost by clearing the banks’ books.
- Less need for bank recapitalization: To meet the banks’ capital adequacy ratio, recapitalization is necessary. It is anticipated that this money can be used in other ways, such as for public welfare and infrastructure development, with the establishment of a bad bank.
Challenges Associated with Bad Banks:
- Changing the issue: A bad bank is anticipated to assume the obligations of the commercial banks that it is owed. It’s unclear, though, how much it will help to resolve the NPA crisis. This is due to the fact that the current commercial banks have tried practically all of the viable treatments. Therefore, it is only reasonable to anticipate that the bad bank will add to the issue rather than alleviate it.
- Losses incurred by banks: Similar to the previous argument, the banks’ haircuts would impact their profit and loss account and profitability. This could cast doubt on the bank’s management and the choices it made in the past and now about haircuts.
- Concern over unethical behavior: Employees at the bad bank might use unethical methods to increase the recovery on a bad loan because they would be under pressure to succeed. As there have been complaints of consumers of banks who were unable to pay their dues being harassed, this issue has persisted in the past.
- Not addressing the root problem: If governance reforms are not made, the public sector banks, which accounted for 86% of the total NPAs, may continue operating as they have in the past and wind up piling up bad debts once more. Additionally, the bad bank concept is equivalent to transferring debts from one government pocket (the public sector banks) to another (the bad bank).
Pros:
It can aid in the consolidation of all of the banks’ bad loans into a single, monopolistic organisation. In the past, nations including the United States, Germany, Japan, and others have experimented with the concept of a bad bank. In the wake of the 2008 financial crisis, the U.S. Treasury established the troubled asset rescue program, popularly known as TARP, which was based on the concept of a bad bank. A bad bank can assist in unlocking capital of more than Rs 5 lac crore that banks have locked in as provisions against these bad loans by removing bad loans from the accounts of problematic banks. As a result, banks will have the option to use the cash that has been released to offer more loans to their clients. By strengthening banks’ capital buffers rather than bank reserves, it can aid in enhancing bank lending. If a new bad bank established by the government can increase capital buffers for banks by freeing up capital, it might give banks greater confidence to resume lending.
Cons:
Government-backed bad banks will essentially transfer troubled assets from public sector banks, which are owned by the government, to bad banks, which are once more owned by the government. When the set of incentives these institutions face is essentially the same, there is no reason to think that a simple transfer of assets from one pocket of the government to another will result in a successful resolution of these bad debts. Public sector banks are run by bureaucrats who may not always be as committed to guaranteeing these lenders’ profitability as private sector banks, which are owned by people who have significant financial incentives to manage them well. In that sense, saving banks through a bad bank accomplishes little to solve the crisis caused by bad loans. Commercial banks that receive a bad bank’s bailout are unlikely to change their methods for the better. After all, the safety net a bad bank offers provides these lenders greater justification to make risky loans, which worsens the bad loan situation.
Note: NPA’s are financial institutions’ loans or advances on which the principle and interest have not been repaid for a predetermined amount of time. NPA’s are loans that have stopped bringing in money for the bank, to put it simply.
Recently in News:
The National Asset Reconstruction Company (NARCL) and the India Debt Resolution Company (IDRCL) will take over the first batch of defaulted loans from banks and attempt to settle them, according to a recent announcement from the Ministry of Finance. The condition of Indian banks’ balance sheets has dramatically improved over the past three years, as evidenced by the fact that their Gross Non-Performing Assets (GNPA) ratio fell from a peak of 11.2% in FY18 to 6.9% in Q2FY22. Banks have established NARCL to collect and consolidate stressed assets for later resolution. PSBs will continue to possess 51% of NARCL. IDRCL is a service organization/operational body that will manage the asset and work with market experts and turnaround specialists. A maximum of 49% of the stock will be held by public sector banks (PSBs) and public financial institutions, with the remaining private sector lenders. For Security Receipts (SRs) to be issued by NARCL, which will be purchasing Rs 2 lakh crore in non-performing loans from banks, the government has already pledged sovereign guarantees of Rs 30,600 crore.
Conclusion:
It will be beneficial from the standpoint of a commercial bank struggling with high NPA numbers. This is so that such a bank may quickly get rid of all of its toxic assets, which were eating away at its profits. The position of the bank will further improve if the recovery funds are returned. In the interim, it may resume lending. A bad bank is therefore a fine idea, but the real difficulty is in addressing the underlying structural issues in the financial system and proposing adjustments in line with them. The Government would need to take swift action in resolving the NPA issue, and introduce accountability with lenders. Also implement measures to prevent a repetition of the bad loan cycle in order to pivot towards sustainable lending moving forward.