Bad Bank

IN NEWS:

• Recently, Finance Minister Nirmala Sitharaman 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.

MORE ON NEWS:

• As per the finance ministry, the NARCL, which will acquire the bad loans from banks, and the India Debt Resolution Company Ltd. - which will then manage these assets and seek to enhance their value - have secured necessary approvals and permissions.
• Also the ministry said that the boards of both entities, including the managing directors, are now in place.
• Finance Minister said that with the account-wise due diligence nearing completion, the first set of accounts is expected to be transferred during July 2022 and the remaining accounts are proposed to be taken over within the third quarter of the current financial year.

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.
  • About NPA :   https://ilearncana.com/details/NPA-Crisis-In-India/2232
• 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.

ARGUMENTS FAVOURING BAD BANKS:

• Improves banks’ capital buffers and lending capacity:
  • By taking bad loans off the books of troubled banks, a bad bank can help free capital that is locked in by banks as provisions against these bad loans.
  • Thus it will give banks the freedom to use the freed-up capital to extend more loans to their customers.
  • Also such a mechanism helps a bank segregate its good assets from bad ones, making it easier for it to raise capital by issuing equity or debt or both.
• Specialisation:
  • A bad bank can act as an aggregator of all stressed assets in the system and work towards the resolution of these assets whereas banks can focus on business.
  • By transferring NPAs to a bad bank, lenders can prioritize financing businesses, while letting a specialized institution focus on maximizing loan recovery.
• Reinvigorates investments:
  • The segregation of toxic assets helps generate confidence among potential investors who can then examine the financial health of the lender with greater clarity.
• The COVID-19 crisis:
  • With the pandemic hitting the banking sector, the RBI fears a spike in bad loans in the wake of a six-month moratorium it has announced to tackle the economic slowdown.
  • In this situation, a professionally-run bad bank, funded by the private lenders and supported the government, can be an effective mechanism to deal with the NPAs.
• Limited success of alternative measures:
  • Despite a series of measures by the RBI for better recognition and provisioning against NPAs and massive doses of capitalisation of public sector banks by the government, the problem continues in the banking sector.
• Global success stories:
  • The idea of a bad bank has been tried out in countries such as the U.S., Germany, Japan and others in the past.
  • For example, 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.
• Timely disposal:
  • Bad banks will ensure that the NPAs are cleaned up in a timely manner. Also, the presence of the government means that the process will be more accountable and judicious.
• Reduce unnecessary scrutiny:
  • Bad banks can eliminate the undue scrutiny by the 4Cs - Courts, CVC, CBI, CAG and thereby foster ease of doing business in the country.
• Minimum government, maximum governance:
  • As India seeks the interest of global investors to partner it in its economic growth, the country needs to demonstrate its non-interference-led-markets-philosophy

ARGUMENTS AGAINST BAD BANKS:

• Multiple mechanisms:
  • Presently, there exist several private asset reconstruction firms that buy bad loans at a discount. Also, the Bankruptcy Code, though not perfect, has helped in higher recoveries.
• Initial investments:
  • Large financial resources are essential for buying the NPAs from banks. But India’s corporate bond market is not developed enough to cater to such demands.
• Moral hazard:
  • A government-funded bad bank will allow the reckless lending by banks to continue. There is also the fear that it will end up as another case of throwing public money to fund corporate mismanagement.
• Mere shifting of loans:
  • It is poor governance to move a bad loan from one account to another entity, which is owned by the same bank or the original shareholders.
• Challenges associated with a government backed bad bank:
  • Transfer of assets from one pocket of the government to another:
    • Former RBI governor Raghuram Rajan has criticised the idea of government backed bad bank , arguing that such an entity 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.
  • Taxpayers money for bailing out troubled banks:
    • Unlike a bad bank set up by the private sector, a bad bank backed by the government is likely to pay too much for stressed assets.
    • While this may be good news for public sector banks, which have been reluctant to incur losses by selling off their bad loans at cheap prices, it is bad news for taxpayers who will once again have to foot the bill for bailing out troubled banks.

WAY FORWARD:

• Banks and other financial institutions are the key drivers of economic growth and their strength is vital for India to attain its ambition of $5 trillion economy. Hence, solving the NPA crisis is urgent.
• While shifting toxic assets to a bad bank will help banks lend more, it does not address the core issue of NPAs.
• The ultimate objective should be to stop the creation of bad debt. This requires strong banking regulators, transparent auditing and a stable resolution mechanism.

PRACTICE QUESTION:

Q. “Bad bank is a good idea in bad times – as a transitory solution with defined timelines – but it cannot be a permanent panacea to address the core issues behind the creation of non-performing assets”. Discuss.