Bad Bank

In: Current Affairs, Economy By: Admin 0 Comments

The government of India is planning to set up a Bad Bank to rescue the banking system from the rising non-performing assets. The total stress in the Indian banking system is about Rs. 14 lakh crore, i.e., this is the amount for which loans have been given to industry and for which there is now no certainty of repayment. Public sector banks share a disproportionate burden of this stress.

What is Bad Bank?

A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution.
The entity holding significant nonperforming assets will sell these holdings to the bad bank at market price.
By transferring such assets to the bad bank, the original institution may clear its balance sheet—although it will still be forced to take write-downs.
A bad bank structure may also assume the risky assets of a group of financial institutions, instead of a single bank.
RBI, too, came up with a suggestion to form two entities to clean up the bad loan problems ailing PSBs -PAMC (Private Asset Management Company) and NAMC (National Assets Management Company).
PAMC would be formed by roping in banks and global funding companies.
This would invest in areas where there’s a short-term economic viability.
NAMC would be formed with government support, which would invest in bad assets with short-term stress but good chances of turnaround and economic benefit.

How Does a Bad Bank Work?

For example, let’s assume that Bank XYZ has made an extraordinary number of loans to borrowers who can’t pay them back.
As time goes by, it becomes increasingly clear that a majority of Bank XYZ’s loans will not be repaid in full.
The bad loans sitting on the bank’s balance sheet are jeopardizing Bank XYZ’s ability to stay in business.
Bank XYZ decides to create a wholly-owned subsidiary to buy the nonperforming loans from Bank XYZ.
This new “bad bank” will buy the nonperforming assets and get them off Bank XYZ’s balance sheet, thereby improving Bank XYZ’s ability to start lending again.
The bad bank can either hold the nonperforming loans and hope borrowers start paying on them, or it can sell the nonperforming loans to other investors.

Benefits:

The major benefit of forming a bad bank is asset monetization. It’s the process of turning a non-revenue-generating item into cash.
Bad assets would stay in the risky category, while the good one stays in the other category, saving them from mixing together.
Since 40% of the NPA is concentrated only in 60 firms, so better we create a centralized agency PARA, which will work as a Bad Bank and absorb the losses from the PSBs.
Since a bad bank specializes in loan recovery, it is expected to perform better than commercial banks, whose expertise lies in lending.
The recent IBC amendments make it complex for foreign players to take part in resolution.
Experts believe a vehicle like AMC or ARC that could address the stressed loan issue, till the bankruptcy code stabilizes, could be beneficial.
A single government entity will be more competent to take decisions rather than 28 individual PSBs.
Capacity building for a complex workout can be better handled by the government which has regulatory control and has management skill sets in public sector enterprises.
Foreign investors with both risk capital and risk appetite would be more in a government-led initiative, knowing that regulatory risks would stand considerably mitigated in various stages of resolution, including take-outs.

Challenges:

A banking institution has to keep in mind its choices of assets to be transferred into the risky category, business case, portfolio strategy, and the operating model.
Each of these choices must be made while considering the impact on funding, capital relief, cost, feasibility, profits, and timing.
The government support is also necessary to help banks understand regulatory and tax-related issues.
Once the NPA problem is settled, the Bankers may become complacent and again resume reckless lending.
A one-size-fits-all approach to designing a bad bank can be very expensive and less effective.
At least Rs. 25,000 to Rs. 30,000 crore of capital will be required to set up a bad bank in the initial stages.

Way Forward:

Bad Bank should be based on a set criterion as any such exercise creates a moral hazard that should be eschewed.
There have to be strict performance criteria for the banks selling such assets.
The criteria for buying assets should be transparent and a pecking order must be drawn up where probably the restructured assets get priority.
A competitive approach should prevail among the banks so that they work hard to qualify for the sale of bad assets to the bad bank. This, in fact, will ensure better governance standards too.
Set up a bad bank to deal with NPAs at some of the weaker PSBs, instead of one that picks up NPAs from all PSBs.
It would prove less controversial if the government had a majority stake in it..
The government must infuse more capital into the better-performing PSBs.
It must also create, through an act of Parliament, an apex Loan Resolution Authority for tackling bad loans at PSBs.
The resolution of bad loans and restoring the health of PSBs is among the biggest challenges the economy faces today. It’s a challenge that requires a response on multiple fronts. A bad bank cannot be the sole response. The most efficient approach would be to design solutions tailor-made for different parts of India’s bad loan problem and use Bad Bank only as a last resort once all other methods fail.

Important for Prelims:

What is a bad bank?

What is an Asset Reconstruction Company?

Who can set up a bad bank in India?

What are non-performing assets?

What are the stressed assets?

What is the difference between a bad bank and the ARC

Important for Mains:

Discuss the merits and demerits of setting up of bad banks.

What is a bad bank? Can it help create good banks in India? Critically analyse.

What is the benefit of establishing a ‘bad bank’?

Can a bad bank resolve Indian lenders’ NPA crisis?