Bad Bank | 09 Jun 2022

Why in News?

Recently, the Ministry of Finance has announced that the National Asset Reconstruction Company (NARCL) along with the India Debt Resolution Company (IDRCL) will take over the first set of bad loans from banks and try to resolve them.

• The health of the balance sheets of Indian banks has improved significantly over the last few years with their Gross Non-Performing Assets (GNPA) ratio declining from a peak of 11.2% in FY18 to 6.9% in Q2FY22.
• NARCL has been set up by banks to aggregate and consolidate stressed assets for their subsequent resolution. PSBs will maintain 51% ownership in NARCL.
• IDRCL is a service company/operational entity which will manage the asset and engage market professionals and turnaround experts. Public Sector Banks (PSBs) and Public FIs will hold a maximum of 49% stake and the rest will be with private sector lenders.
• The government had already announced sovereign guarantees of Rs 30,600 crore for Security Receipts (SRs) to be issued by NARCL, which will be buying Rs 2 lakh crore non-performing loans from banks.

What is a Bad Bank?

• A bad bank is a financial entity set up to buy Non-Performing Assets (NPAs), or Bad Loans, from banks.
• The aim of setting up a bad bank is to help ease the burden on banks by taking bad loans off their balance sheets and get them to lend again to customers without constraints.
• After the purchase of a bad loan from a bank, the bad bank may later try to restructure and sell the NPA to investors who might be interested in purchasing it.
• A bad bank makes a profit in its operations if it manages to sell the loan at a price higher than what it paid to acquire the loan from a commercial bank.
• However, generating profits is usually not the primary purpose of a bad bank — the objective is to ease the burden on banks, of holding a large pile of stressed assets, and to get them to lend more actively.

What are the Pros and Cons of a Bad bank?

• Pros:
  • Single Exclusive Entity:
    • It can help consolidate all bad loans of banks under a single exclusive entity.
      • The idea of a bad bank has been tried out in countries such as the U.S., Germany, Japan and others in the past.
    • The troubled asset relief program, also known as TARP, implemented by the U.S. Treasury in the aftermath of the 2008 financial crisis, was modelled around the idea of a bad bank.
  • Freedom to Use Freed-up Capital:
    • By taking bad loans off the books of troubled banks, a bad bank can help free capital of over Rs 5 lakh crore that is locked in by banks as provisions against these bad loans.
    • This will give banks the freedom to use the freed-up capital to extend more loans to their customers.
  • Improving Capital Buffer:
    • It can help improve bank lending not by shoring up bank reserves but by improving banks’ capital buffers.
    • To the extent that a new bad bank set up by the government can improve banks’ capital buffers by freeing up capital, it could help banks feel more confident to start lending again.
• Cons:
  • Merely Shifts one Pocket of Government to another:
    • Bad bank backed by the government will merely shift bad assets from the hands of public sector banks, which are owned by the government, to the hands of a bad bank, which is again owned by the government.
    • There is little reason to believe that a mere transfer of assets from one pocket of the government to another will lead to a successful resolution of these bad debts when the set of incentives facing these entities is essentially the same.
  • Nature of Ownership:
    • Unlike private banks, which are owned by individuals who have strong financial incentives to manage them well, public sector banks are managed by bureaucrats who may often not have the same commitment to ensuring these lenders’ profitability.
    • To that extent, bailing out banks through a bad bank does not really address the root problem of the bad loan crisis.
  • Risk of Moral Hazard:
    • Commercial banks that are bailed out by a bad bank are likely to have little reason to mend their ways.
    • After all, the safety net provided by a bad bank gives these banks more reason to lend recklessly and thus further exacerbate the bad loan crisis.

What are the Associated Challenges?

• Mobilising Capital:
  • Finding buyers for bad assets in a pandemic hit economy will be a challenge, especially when governments are facing the issue of containing the fiscal deficit.
• Not Addressing the Underlying Issue:
  • Without governance reforms, the Public sector banks (accounted for 86%, of the total NPAs) may go on doing business the way they have been doing in the past and may end up piling-up of bad debts again.
  • Also, the bad bank idea is like shifting loans from one government pocket (the public sector banks) to another (the bad bank).
• Provisioning Issue Tackled Through Recapitalization:
  • Union Government, in the last few years, has infused nearly Rs 2.6 lakh crore in banks through recapitalisation.
  • Those who oppose the concept of bad banks hold that the government has on its part recapitalised the banks to compensate for the write-offs and hence, there is no need for a bad bank.
• Market-related Issues:
  • The price at which bad assets are transferred from commercial banks to the bad bank will not be market-determined and price discovery will not happen.

Way Forward

• So long as Public Sector Banks’ managements remain beholden to politicians and bureaucrats, their deficit in professionalism will remain and subsequently, prudential norms in lending will continue to suffer.
• Therefore, a bad bank is a good idea, but the main challenge lies with tackling the underlying structural problems in the banking system and announcing reforms accordingly.

Source: TH