Bad Bank

ECONOMY/ GOVERNANCE

Topic:

• GS-3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment. 
• GS-2: Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

Bad Bank

Context: With commercial banks set to witness a spike in NPAs, or bad loans, in the wake of the contraction in the economy as a result of the Covid-19 pandemic, Reserve Bank of India (RBI) Governor Shaktikanta Das recently agreed to look at the proposal for the creation of a bad bank.

What’s a bad bank and how does it work?

• Idea of Bad Bank: Technically, a bad bank is an asset reconstruction company (ARC) or an asset management company that takes over the bad loans of commercial banks, manages them and finally recovers the money over a period of time. 
• Utility of Bad Bank: The bad bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans in 
• Working of Bad Bank: The takeover of bad loans is normally below the book value of the loan (provides certain margin to ARC). The bad bank subsequently tries to recover as much as possible using its expertise in stressed asset resolution.
• Support of Government: The bad bank concept is in some ways similar to an ARC but is funded by the government initially, with banks and other investors co-investing in due course. The presence of the government is seen as a means to speed up the clean-up process. 
• US-based Mellon Bank created the first bad bank in 1988.

Merits of Having Bad Bank–

1. Banks’ Burden is Reduced: The burden of recovering those loans is reduced for other banks.
2. Specialisation leads to faster recovery: Speed of recovery will be better as Bad Bank’s main work is recovery and they are specialised in that.
3. Positive Impact on Financial Sector: Bad Bank will help improve the banking sector’s health and fasten the recovery aspects of ailing by putting back frozen assets back into economic circulation.
4. Increased Profitability of Banks: Bad Bank increases profitability of other banks as they can focus more on lending, acquiring more customers and upgrading technology without spending too much time on recovery or resolution of bad loans
5. Feasibility: Bad banks can make profits as they usually keep high margin before acquiring the bad loans. The concept of Bad Bank has been implemented in other countries including Sweden, Finland, France and Germany. 

Demerits of Bad Bank-

1. Shifting of Problem: Former RBI Governor Raghuram Rajan had opposed the idea of setting up a bad bank in which banks hold a majority stake. He was of the opinion that bad bank idea as merely shifting loans from one government pocket (the public sector banks) to another (the bad bank).
2. Reckless Lending: Other banks may not concentrate on the quality of loans as they always an option of shifting bad loans to ARC/ Bad Bank. This leads to doling out loans without proper diligence leading to reckless lending
3. Efficacy Debate: Bad banks may not acquire critical loans which are difficult to recover and only concentrate on easily recoverable loans. As a result, troubled Commercial banks continue to face the issue of bad loans. There is also the fear that it end up as another case of throwing good money after bad.
4. Profitability of Banks: High margin of Bad banks may curtail the profits of other banks which can in turn impact their lending capabilities. 
5. Moral Issues: Due to pressure bad banks may employ some unethical ways to recover loans. Another issue is that other banks may not show the actual position of loan accounts by doing window dressing.

What has been the stand of the RBI with regard to resolving stressed loans?

• Viral Acharya, when he was the RBI Deputy Governor, had said it would be better to limit the objective of these asset management companies to the orderly resolution of stressed assets, followed by a graceful exit. 
• Acharya suggested two models to solve the problem of stressed assets. 
  • The first is a private asset management company (PAMC), which is said to be suitable for stressed sectors where the assets are likely to have an economic value in the short run, with moderate levels of debt forgiveness. 
  • The second model is the National Asset Management Company (NAMC), which would be necessary for sectors where the problem is not just one of excess capacity but possibly also of economically unviable assets in the short to medium terms.
• While the RBI did not show much enthusiasm about a bad bank all these years, there are signs that it can look at the idea now. Recently, Governor Das indicated that the RBI can consider the idea of a bad bank.

Do we need a Bad Bank now?

• The idea gained currency during Raghuram Rajan’s tenure as RBI Governor. 
• The RBI had then initiated an asset quality review (AQR) of banks and found that several banks had suppressed or hidden bad loans to show a healthy balance sheet. 
• However, the idea remained on paper amid lack of consensus on the efficacy of such an institution.
• Now, 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.

How serious is the NPA issue in the wake of the pandemic?

• The RBI noted in its recent Financial Stability Report that the gross NPAs of the banking sector are expected to shoot up to 14.8% of advances by September 2021, from 7.5% in September 2020
• Among bank groups, the NPA ratio of PSU banks, which was 9.7% in September 2020, may increase to 16.2% by September 2021 under the baseline scenario.
• The K V Kamath Committee, which helped the RBI with designing a one-time restructuring scheme, also 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. 
• This effectively means Rs 37.72 crore (72% of the banking sector debt to industry) remains under stress. This is almost 37% of the total non-food bank credit.
• The panel led by Kamath, a veteran banker, has said companies in sectors such as retail trade, wholesale trade, roads and textiles are facing stress. Sectors that have been under stress pre-Covid include NBFCs, power, steel, real estate and construction. Setting up a bad bank is seen as crucial against this backdrop

Why is it crucial to tackle toxic loans?

• Banks and other financial institutions are the key drivers of economic growth, as they are the formal channels of credit. 
• As things stand, lenders, particularly the state-owned ones, are saddled with massive bad loans. 
• Growing NPAs has made Banks risk-averse and eroded their capacity to lend to help spur economic recovery from the shock of the covid-19 pandemic that has roiled the world. 
• Banks will find it tough and exorbitantly expensive to raise capital from the market if the asset-quality trajectory remains uncertain, delaying and even jeopardizing, economic growth.

Has the banking system made any proposal with regard to Bad Bank?

• The banking sector, led by the Indian Banks’ Association, had submitted a proposal in May 2020 for setting up a bad bank to resolve the NPA problem, proposing equity contribution from the government and banks. 
• The proposal was also discussed at the Financial Stability and Development Council (FSDC) meeting, but it did not find favour with the government which preferred a market-led resolution process. 
• The banking industry’s proposal was based on an idea proposed by a panel on faster resolution of stressed assets in public sector banks headed by former Punjab National Bank Chairman Sunil Mehta. 
• Sunil Mehta panel had proposed a company, Sashakt India Asset Management, for resolving large bad loans two years ago. 
• The idea of a bad bank was discussed in 2018 too, but it never took shape. 
• During the pandemic, banks and India Inc were also pitching for one-time restructuring of loans and NPA reclassification norms from 90 days to 180 days as relief measures to tackle the impact of the lockdown and the slowdown in the economy.
• Currently, loans in which the borrower fails to pay principal and/or interest charges within 90 days are classified as NPAs and provisioning is made accordingly.

Will a bad bank solve the problem of NPAs?

• Complements Previous Measures: Despite a series of measures by the RBI for better recognition and provisioning against NPAs, as well as massive doses of capitalisation of public sector banks by the government, the problem of NPAs continues in the banking sector, especially among the weaker banks.  Having a Bad Bank will complement other measures taken by RBI & government to clean up banking sector.
• Helps solve economic aftershocks of Pandemic: As the Covid-related stress pans out in the coming months, proponents of the concept feel that a professionally-run bad bank, funded by the private lenders and supported the government, can be an effective mechanism to deal with NPAs. 
• Experience from Other Countries: Many other countries had set up institutional mechanisms such as the Troubled Asset Relief Programme (TARP) in the US to deal with a problem of stress in the financial system in the wake of 2008 financial crisis.

Conclusion

Banks and other financial institutions are the key drivers of economic growth. However, many borrowers may find it difficult to service their loans, requiring lenders to set aside capital to cover those losses. A bad bank can free them up to start lending. However, adequate measures need to be put in place so as to overcome the pitfalls of bad bank