Bad Bank
The story so far:
Finance Minister Nirmala Sitharaman recently 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.
NPA Data & trends:
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.
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.
• Structure
NARCL:
NARCL has been incorporated under the Companies Act
o NARCL will acquire stressed assets worth about Rs 2 lakh crore from various commercial banks in different phases.
o Public Sector Banks (PSBs) will maintain 51% ownership in NARCL.
IDRCL:
Another entity, India Debt Resolution Company Ltd (IDRCL), will then try to sell the stressed assets in the market.
o PSBs and Public Financial Institutes (FIs) will hold a maximum of 49% stake in IDRCL. The remaining 51% stake will be with private-sector lenders.
• Working of Bad Bank
• 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.
• 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.
How will the NARCL-IDRCL work?
• The NARCL will first purchase bad loans from banks. It will pay 15% of the agreed price in cash and the remaining 85% will be in the form of “Security Receipts”. When the assets are sold, with the help of IDRCL, , the commercial banks will be paid back the rest.
Government’s Guarantee
• 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 and the difference between what the commercial bank was supposed to get and what the bad bank was able to raise will be paid by the government.
What are the pros and cons of setting up a bad bank?
• 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.
o 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. Under the program, the U.S. Treasury bought troubled assets such as mortgage-backed securities from U.S. banks at the peak of the crisis and later resold it when market conditions improved. It is estimated that the Treasury through its operations earned a nominal profit of anything between $11 billion to $30 billion, although some contest these figures.
• Many critics, however, have pointed to several problems with the idea of a bad bank to deal with bad loans.
o Former RBI governor Raghuram Rajan has been one of the fiercest critics of the idea, arguing that a 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.
• Other analysts believe that 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.
Will a ‘bad bank’ help ease the bad loan crisis?
• 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.
• There is a huge 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.