Bad bank

A bad bank is a corporate structure that isolates illiquid and high-risk assets or non-performing
loans held by a bank or a financial Organization. It is also referred to as Asset Management
Company (AMC).

The concept of a bad bank originated at the Pittsburgh headquartered Mellon Bank in 1988.
The idea and discussions over bad bank have been in place since 2015 when former RBI
Governor Raghuram Rajan started a debate on bad bank as a possible solution to the problem
of NPAs.

Afterwards, former Interim Finance Minister Piyush Goyal put forth the idea of National ARC on
a recommendation of the Committee headed by Sunil Mehta. The Economic Survey 2017 also
propounded to create a Public Sector Asset Rehabilitation Agency (PARA).

Company National Asset Reconstruction Ltd

National Asset Reconstruction Company Ltd.(NARCL), India’s first-ever Bad Bank, was set up in
2021, and RBI has recently granted the same under the SARFAESI Act 2002.

If the bad bank is unable to sell the bad loan or has to sell it at a loss, then the government
guarantee will be invoked.

To manage assets with the help of market professionals and turnaround experts, the
Government will also set up India Debt Resolution Company Ltd. (IDRCL) along with NARCL. The
IDRCL is a service company or an operational entity wherein public sector banks (PSBs) and PFIs
will hold a maximum of 49% stake and the rest will be with private-sector lenders. When the
assets are sold, with the help of IDRCL, the commercial banks will be paid back the rest.
Bad Bank is aimed at easing the burden of banks holding a pile of stressed assets and allowing
them to lend more actively. It generally does not have a primary purpose of generating profits.
It will mainly focus on resolving and restructuring accounts.

It works by demarcating assets into good assets (that are repaid within time) and toxic or bad
assets (defaulted loans).

Such toxic assets are meant to be transferred from the books of banks to bad bank at a price
below their book value, for the sole purpose of recovery of risky assets.

Need in India:
Economic Recovery:

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.

Government Support:

Professionally-run bad banks, funded by the private lenders and supported by the government,
can be an effective mechanism to deal with Non-Performing Assets (NPA).

The presence of the government is seen as a means to speed up the clean-up process.

Rising NPAs:

Financial Stability Report (FSR):

The RBI noted in its recent FSR that the gross NPAs of the banking sector are expected to shoot
up to 13.5% of advances by September 2021, from 7.5% in September 2020.

K V Kamath Committee:

Noted that corporate sector debt worth Rs 15.52 lakh crore has come under stress after
Covid-19 hit India, while another Rs 22.20 lakh crore was already under stress before the
pandemic

International Precedents:

Many other countries had set up institutional mechanisms to deal with a problem of stress in
the financial system.
 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.

• Bad Banks

• Bad Banks are good for the economy.

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.
The pandemic has resulted in several big-ticket reforms in India, most of them geared towards
improving productivity levels.

India’s total factor productivity growth in 2019 was 0.43 per cent while that of China was 2.8
per cent. If we look at labour productivity measured as output per hour per labour employed in
the economy, China has roughly 1.5 times our productivity levels.

The proposed Bad Bank is important for various reasons. First, it addresses a major bottleneck
to India’s growth over the last few years due to heightened risk aversion in the banking sector.
This risk aversion was largely an outcome of piling up of non-performing assets in the system
due to excessive lending between 2008 to 2012

The government of India has established two new firms to acquire stressed assets from banks
and then sell them in the market in order to resolve large NPAs (Non-Performing Assets) in the
Indian banking sector.

NARCL: National Asset Reconstruction Company Limited (NARCL) was established under the
Companies Act and has applied for an Asset Reconstruction Company license from the Reserve
Bank of India (ARC).

In phases, NARCL will buy stressed assets totaling roughly Rs 2 lakh crore from various
commercial banks.

NARCL will be owned by public sector banks (PSBs) to the tune of 51 percent.

The NARCL will buy bad loans from banks first.

It will pay 15% of the agreed price in cash and the rest 85% in "Security Receipts."

o The commercial banks will be paid back the remainder when the assets are sold with the
help of IDRCL.

o The government guarantee will be activated if the bad bank is unable to sell the bad
loan or must sell it at a loss.

o This guarantee is extended for a five-year period.

• IDRCL: The stressed assets will subsequently be sold in the market by another firm, India
Debt Resolution Company Ltd (IDRCL).

o IDRCL will be owned to a maximum of 49 percent by PSBs and Public Financial Institutes
(FIs).

o Private-sector lenders will own the remaining 51 percent of the company.

Bad bank models

1. In a 2009 report, McKinsey & Company identified four basic models for bad banks.[1]

losses. While simple to implement, this situation is difficult for investors to assess.

2. In an internal restructuring, the bank creates a separate unit to hold the bad assets. This
solution is more transparent, but does not isolate the bank from risk.

3. In a Special purpose entity (SPE), the bank transfers its bad assets to another organization,
typically government backed. This solution requires significant government participation.

4. Finally, in a bad bank spinoff, the bank creates a new, independent bank to hold the bad
assets. This completely isolates the original bank from the risky assets.

What are the Pros and Cons of a Bad bank?

Pros

• Improves the health of the banking system: By removing NPAs from the balance sheets
of banks, a bad bank can help to improve the overall health of the banking system. This can lead
to increased lending and economic growth.

• Frees up capital for lending: When banks transfer NPAs to a bad bank, they free up
capital that can be used to lend to new customers. This can help to stimulate the economy and
create jobs.

• Reduces the risk of systemic risk: A bad bank can help to reduce the risk of systemic risk,
which is the risk that a financial crisis could spread from one bank to another. This is because a
bad bank can isolate NPAs from the rest of the banking system.

Cons

• Costly: Setting up and running a bad bank can be costly. This is because the bad bank
will need to hire staff with expertise in managing NPAs.

• Ineffective: There is a risk that a bad bank may not be effective in recovering the value
of the NPAs that it acquires. This is because some NPAs may be irrecoverable.

• Moral hazard: There is a risk that a bad bank could create moral hazard. This is because
banks may be less likely to carefully assess the risk of loans if they know that they can always
sell them to a bad bank if they go bad.
How do bad banks recover money?
Banks may recover bad debts by selling collateral, or may even take legal action. To resolve the
problem of bad debt with public sector banks, the Government passed Insolvency and
Bankruptcy Code (IBC) Bill.

Why Do We Need Bad Banks in India?

The establishment of a bad bank in India, like in other countries, serves several purposes:

1. Asset Quality Improvement: This enables banks to focus on their core lending activities and
reduces the burden of managing and provisioning for non-performing loans.
2. Efficient Resolution of Distressed Assets: By centralizing the resolution process, bad banks
can streamline and expedite the recovery process.
3. Financial Stability: By isolating distressed assets in a bad bank, the overall health of the
banking sector can be improved. It helps prevent the contagion effect, where the problems
of one bank spread to other banks and the economy.
4. Enhanced Asset Recovery: By maximizing recovery, bad banks can reduce losses for the
banking sector and potentially recover taxpayer funds used for bank recapitalization.

What Is the Role of Government in Bad Bank?

The government can play several roles in the establishment and functioning of a bad bank. Here are
some key roles that the government typically takes on:

Creation and Capitalization: The government may initiate the establishment of a bad bank and provide
the necessary capital to set it up. This capital infusion helps the bad bank acquire the distressed assets
from the participating banks at a fair value. The government may also provide guarantees or financial
support to ensure the viability of the bad bank.

Legal and Regulatory Framework: The government is responsible for creating the legal and regulatory
framework within which the bad bank operates. This includes defining the powers, governance
structure, and operational guidelines of the bad bank.

Asset Transfer Mechanism: The government plays a crucial role in facilitating the transfer of non-
performing assets from the participating banks to the bad bank.
Recapitalization and Support: In some cases, the government may provide additional capital or financial
support to the participating banks to strengthen their balance sheets after transferring their distressed
assets to the bad bank.

Resolution and Recovery: The government's involvement can help maximize recovery and minimize
losses for the banking sector.