BAD BANKS

Subject: Economy

Context: It is reported that the former RBI Governor D Subbarao made a strong case for setting up a bad bank saying it is not just necessary but unavoidable in the present circumstances when NPAs are likely to balloon and much of the resolution will have to take place outside the IBC framework.

Concept:

Bad Bank:

A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution.

The entity holding significant nonperforming assets will sell these holdings to the bad bank at market price. By transferring such assets to the bad bank, the original institution may clear its balance sheet—although it will still be forced to take write-downs.

A bad bank structure may also assume the risky assets of a group of financial institutions, instead of a single bank.

Bad banks are typically set up in times of crisis when long-standing financial institutions are trying to recuperate their reputations and wallets. While shareholders and bondholders generally stand to lose money from this solution, depositors usually do not.

Banks that become insolvent as a result of the process can be recapitalized, nationalized, or liquidated. If they do not become insolvent, it is possible for a bad bank’s managers to focus exclusively on maximizing the value of its newly acquired high-risk assets.

Some criticize the setup of bad banks, highlighting how if states take over non-performing loans, this encourages banks to take undue risks, leading to a moral hazard.

The 2017 Economic Survey examined this idea, suggesting the creation of a Public Sector Asset Rehabilitation Agency (PARA).

Before that, the 2015 Asset Quality Review conducted by Reserve Bank under Governor RaghuramRajan, which forced banks to recognise problem accounts as non-performing assets, had also sparked a debate on bad bank as a possible solution.

In short, the idea is not novel and has been suggested by various people at different points of time.

Why be concerned about bad loans?

Indian banks’ pile of bad loans is a huge drag on the economy.

It’s a drain on banks’ profits. Because profits are eroded, public sector banks (PSBs), where the bulk of the bad loans reside, cannot raise enough capital to fund credit growth.

Lack of credit growth, in turn, comes in the way of the economy’s return to an 8% growth trajectory. Therefore, the bad loan problem requires effective resolution.

Is the current framework equipped to handle NPAs?

If there is no appetite for AMCs, AIFs and ARCs to take over bad loans, it could be because the owners of those assets want a price higher than the fair market value.

ARCs will buy those pools of stressed assets only if they see continued viability of those pools being recovered and if they are able to get higher returns than the original purchase price