Bad Bank: NARCL-IDRCL

ECONOMY/ GOVERNANCE

• 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: NARCL-IDRCL

Context: Following up the Union Budget announcement, government has incorporated “National Asset Reconstruction Company Limited” (NARCL) under the Companies Act. 

• It will acquire stressed assets worth about Rs 2 lakh crore from various commercial banks in different phases. 
• Another entity — India Debt Resolution Company Ltd (IDRCL), which has also been set up — will then try to sell the stressed assets in the market. 
• The NARCL-IDRCL structure is the new bad bank. 
• To make it work, the government has provided Rs 30,600 crore to be used as a guarantee.

What is a bad bank? 

• In every country, commercial banks accept deposits and extend loans. 
• The deposits are a bank’s “liability” because that is the money it has taken from a common man, and it will have to return that money when the depositor asks for it.
• Moreover, in the interim, it has to pay the depositor an interest rate on those deposits.
• In contrast, the loans that banks give out are their “assets” because this is where the banks earn interest and this is money that the borrower has to return to the bank.
• The whole business model is premised on the idea that a bank will earn more money from extending loans to borrowers than what it would have to pay back to the depositors.
• A loan can turn bad when the borrower is unable to repay it back. In such case two things happen. 
  • One, the concerned bank becomes less profitable because it has to use some of its profits from other loans to make up for the loss on the bad loans.
  •  Two, it becomes more risk-averse. In other words, its officials hesitate from extending loans.
• If such “bad loans” in a bank rise alarmingly, the bank could close down.
• When several banks in an economy face high levels of bad loans and all at the same time, it will threaten the stability of the whole economy.
• From the taxpayer’s perspective, the most worrisome fact was that an overwhelming proportion of bad loans was with the public sector banks (PSB), which were owned by the government and hence by the Indian public. 
• To keep such PSBs in business, the government was forced to recapitalise them — that is, use taxpayers’ money to improve the financial health of PSBs so that they could carry on with the business of lending and funding economic activity.
• Despite recapitalisation, the problem of bad loans did not subside. Therefore, it was argued by many that the government needs to create a bad bank — that is, an entity where all the bad loans from all the banks can be parked

Why was Bad Bank needed?

Advantage of having bad bank was 

• Relieving the commercial banks of their “stressed assets” and allowing them to focus on resuming normal banking operations, especially lending.
• While commercial banks resume lending, the so-called bad bank, or a bank of bad loans, would try to sell these “assets” in the market.

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.
• 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 from the Rs 30,600 crore that has been provided by the governmen

Will a bad bank resolve matters?

• From the perspective of a commercial bank saddled with high bad loans, it will help. That’s because such a bank will get rid of all its toxic assets, which were eating up its profits, in one quick move. 
• When the recovery money is paid back, it will further improve the bank’s position. Meanwhile, it can start lending again.
• From the perspective of the government and the taxpayer, the situation is a little more complex. After all the money for security receipts is coming from the taxpayers’ pocket. 
• Lastly, the plan of bailing out commercial banks will collapse if the bad bank is unable to sell such impaired assets in the market.

Conclusion

While recapitalisation and such guarantees are often designated as “reforms”, they are band aids at best. The only sustainable solution is to improve the lending operation in PSBs.

Connecting the dots:

• Banking Health: NPAs and COVID-19
• Recapitalisation Bonds