As a result of the Covid-19 pandemic induced economic slowdown, the commercial banks are about to witness the spike in NPAs, or bad loans. To deal with it, Reserve Bank of India (RBI) Governor is considering the proposal for the creation of a bad bank.
What is a Bad Bank?
A bad bank is an asset reconstruction company (ARC), involved in management and recovery of bad loans or NPAs of other banks.
Generally, these Banks are initially funded by the government and gradually, banks and other investors start to co-invest in them.
What are the functions of Bad banks?
Commercial and Public Sector Banks (PSBs) sell their NPAs to the bad bank. The bad bank manages the NPAs/bad loans and finally recovers the money over time. The takeover of bad loans is normally below the book value of them. These banks are not involved in activities like lending and taking deposits.
For example, consider a steel plant’s loan with SBI, turned into an NPA. Bad bank purchases this NPA from the SBI. After that, the bad bank appoints domain experts to manage the assets of the plant with an aim to maximize revenues and cut losses. This is called reconstruction and increases the economic value of the plant. When the bad bank sells this plant, it will recover more money.
The first bad bank was created in 1988 by the US-based Mellon Bank. After that, a similar concept has been implemented in other countries including Finland, Sweden, France and Germany.
Concept of Bad bank in India:
- The idea gained momentum when the RBI held asset quality review (AQR) found several banks showing a healthy balance sheet but have suppressed or hidden bad loans.
- Sunil Mehta panel on NPA’s (Non-Performing Assets) proposed Sashakt India Asset Management company, for resolving large bad loans in 2018.
- The Bad bank proposal was also discussed during the Financial Stability and Development Council (FSDC) meeting, but the government preferred a market-led resolution process instead of a bad bank.
Difference between Bad Bank and ARC (Asset Reconstruction Company):
|Bad Bank||Asset Reconstruction Company|
|A bad bank is simply a corporate structure that isolates liquidity and high-risk assets held by a bank or a financial organisation, or perhaps a group of such lenders.||ARCs are registered with RBI under Section-3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.|
|Bad Banks if established can take over all types of stressed assets||ARCs will only buy those pools of stressed assets if they see business-viability of those pools.|
|Currently the Bad banks are at conceptual stage and yet to be materialized||Currently, there are many licensed ARCs in India|
Why a bad bank is required?
First, Banks have difficulty in solving these cases due to lack of expertise, coordination, capital etc. Even the private ARCs have also failed to recover the loans.
Second, The RBI fears a spike in bad loans after the Covid-19 pandemic and the six-month moratorium announced to tackle the economic slowdown. This creates a necessity of Bad banks.
Third, the panel led by KV Kamath, has said companies in sectors such as wholesale trade, retail trade, textiles and roads are facing stress. So, setting up a bad bank is crucial to revive these sectors.
Fourth, Bad banks are targeted banking system with domain experts to focus particularly on NPAs Bad banks can be more effective, quicker in restructuring of the loans.
The Financial Stability Report points 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, under the baseline scenario. So, the Bad banks are essential considering the Indian conditions.
Advantages of having Bad bank:
First, Bad banks will improve credit mobilization culture in the economy: By holding the defaulters accountable the Bad Banks will ensure the accountability of borrower to pay the loan at any cost.
Second, Bad Banks will improve monetary Policy Transmission. NPAs were one of the major reasons for the lack of monetary policy transmission (MPT) in India. Even though RBI has reduced policy rates, Banks don’t reduce lending rates, to recover the cost of NPAs with them. If bad banks can manage their NPAs, their financial health will improve and facilitate MPT in the economy.
Third, Bad Banks can take bold decisions compare to commercial Banks. In General, the price at which NPAs are sold comes under the preview of CVC, CBI and CAG. Banks were hesitant to reveal and disposal of stressed assets fearing adverse reports by these institutions. A bad bank that can maximize recovery due to professionalism and hence will be less hesitant.
Fourth, Higher prices for stressed assets can be realized by bad banks.
Challenges associated with bad banks:
First, the major challenge associated with the Bad bank’s establishment is regarding what kind of loans will be taken over by bad banks, and at what cost? This is aggravated when the commercial banks were reluctant in the past for haircuts. If a PSB accept the NPA sale at lower price to Bad Bank then that loss is incurred by that PSB (I.e., the government)
Second, the stake of government in Bad bank is criticised for political influence in decision making. Especially when the majority of the NPAs are associated with the Public Sector Unit.
Third, the establishment of bad banks may not incentivise banks to focus on the quality of credit provided, monitor loans, and protect against ever-greening of loans. Banks might perform lending activities in the mindset that there is a system in place for recovering the loans.
Fourth, larger systemic issues will not be addressed. A bad bank does not address the structural weaknesses in public sector banks such as management etc.
For these reasons, many economists including the former RBI Governor opposed the establishment of Bad Bank in India.
First, laying out a clear road map for Bad Bank is crucial. Government can address the issue in the upcoming budget session.
Second, Exploring the models suggested by former RBI Deputy Governor, Viral Acharya. He suggested two types of Bad banks. The possibility of these two models can be explored before setting up of Bad Bank. The models were:
- Private Asset Management Company (PAMC)– This model is suitable for stressed sectors where the assets are likely to have an economic value in the short run, with moderate levels of debt forgiveness.
- National Asset Management Company (NAMC)– This is for the sectors where the NPA problem is in excess capacity and also of economically unviable assets in the short to medium terms.
The government can roll out the Bad Bank for the PAMC to instil public confidence and assess the performance of Bad banks and later can extended to NAMC category.
Third, K V Kamath Committee also suggested to set up Bad bank to revive sectors such as Trade, Textile, NBFCs, Steel and construction, etc.
The Problem of NPA is huge in India. Without reducing the problem of NPA India cannot become a trillion-dollar economy. The UK Asset Resolution (UKAR), a bad bank has recovered nearly 50 billion pounds of loans in UK. So, the Bad Banks is key to reduce the NPA’s, and it is high time for India to follow the path.
NPAs: A loan whose interest and/or instalment of principal have remained ‘overdue ‘(not paid) for a period of 90 days is considered as NPA.
Stressed assets = NPAs + Restructured loans + Written off assets
Restructured asset or loan: These are assets which got an extended repayment period, reduced interest rate, converting a part of the loan into equity, providing additional financing, or some combination of these measures
Written off assets: These are assets which the bank or lender doesn’t count the money the borrower owes to it. The existing shareholders face a total loss on their investments unless there are buyers in the secondary market who may ascribe some value to these.