WHAT IS A BAD BANK?
Published by: PALAK GUPTA
In January 2017, the Economic Survey of India suggested setting up a ‘Public Sector Asset Rehabilitation Agency‘. In 2018, the then finance minister Piyush Goyal suggested setting up a panel to assess Bad Bank’s viability in India. These steps were taken keeping in mind the huge number of bad loans in the banking sector. For the country’s growth and development, lending has to take place and to accelerate the process bad bank establishment is thought of as a possibility. As of 2020 Indian public sector banks collectively owe 6.8 trillion Indian rupees as non performing assets.
What is The Indian Banks Association?
Indian Banks' Association (IBA) was formed on 26 September 1946. It is an association of Indian banks and financial institutions and represents the management of banking in India. It is based in Mumbai. With an initial membership representing 22 banks in India in 1946, IBA at the moment represents 247 banking companies functioning in the country.
IBA was formed for development, coordination and strengthening of Indian banking, and assist the member banks in various ways including implementation of new systems and adoption of standards among the members.
Indian Banks' Association is managed by a managing committee, and the current managing committee consists of one chairman, 3 deputy chairmen, 1 honorary secretary and 26 members.
Why is it in the news?
State Bank of India and the Indian Banks’ Association have proposed for a bad bank again. To recover from COVID it is necessary to have it if India’s broken banks are to start lending again and to fuel growth. India requires a bad bank jointly owned by the banks themselves.”
The”Chief Economic Advisor, K Subramanian is of the opinion that there already are 28 asset reconstruction companies in operation and banks have not been able to sell their bad loans to these entities.
The proposed structure of a bad bank is based on the earlier recommendations of a panel headed by former PNB chairman Sunil Mehta, called ‘Sashakt’ two years ago.”
What is a Bad Bank, what are its roles and when was it first introduced?
A bad bank is termed so simply because it deals with the bad loans, or in financial parlance - non-performing assets (NPAs).
Non-performing asset (NPA) is a loan whose borrower has stopped repaying interest or principal amount since last 90 or has not repaid 3 EMIs. These NPAs are also called bad loans.
To understand this concept well let’s say Bank X gave loans to several individuals and corporates that could not repay the bank. After some time, these loans and the interest on it keeps getting accumulated, and Bank X keeps providing more money against the bad exposure it took, because it realises that chances are it may never get back this money.
These NPAs really hurt the bank. Investors see large NPAs as a sign of the bank’s financial weakness. The higher the NPAs, the more impaired the Bank X’s ability to borrow, lend, or conduct business in general.
To fix this problem, the bad bank model was first proposed in 1980s. US-based Mellon Bank created a bad bank back in 1988 to hold its toxic assets by spinning off its own capital, and five of its own board members into the Grant Street National Bank.
Grant Street Bank did not take deposits from the public as normal banks do, but simply served the purpose of resolving or liquidating bad debt to recover as much money as it could, and was eventually liquidated itself a few years down the line after it had served its purpose.
Subsequently, several other countries also implemented the idea.
In this case, Bank X could segregate its assets into the good assets -- loans which are being repaid as per schedule, and the bad or toxic assets -- which are in default, and it realises will not be easy to recover. The latter can be taken out of the bank’s books and transferred to a bad bank, which would only serve the purpose of helping in the recovery of these risky assets.
There are both pros and cons to this idea:
The pros of having a bad bank are as follows:
Cleaning up the banks’ balance sheets and making them financially healthy, separation of good and bad assets allows the bank to focus on its core activity of lending, and leaves the resolution to experts.
A government-led initiative may perhaps make it more palatable or even attractive an opportunity for investors to invest their money- both domestic and foreign.
As a result, as in the example given earlier, Bank X will clean up its own balance sheet, reduce its exposure to risky assets, and thereby protect itself.
A bad bank, therefore, is expected to help the banks by absorbing all their bad assets, usually at a price below the book value of these loans, and manage them, in a bid to finally recover the money over a period of time.
The cons of having a bad bank are as follows:
• The”first and foremost problem that arises is that of capital required to buy the NPAs from the PSB even at discount rates. The Bad Banks would have to infuse a huge amount of capital for buying off the loans. The government proposed that the required capital would be arranged from the cash reserves of the RBI. This again is a cumbersome and risky proposal.
• The bad loans are mainly due to 25-30 business houses/promoters in the economy. They account for about”50% of the total NPAs. So, just to tackle these 25-30 entities, forming a separate entity would be too costly a”proposition.
• Though Bad Banks have been successful in a lot of countries, India differs from them in a significant manner. In other countries, the NPAs are from bankrupt companies mostly, but in India, NPAs are mostly due to loss-making companies. If given the right financial help and restructuring, these companies could easily be revived.
• Bad Banks will only be helpful in case of wilful defaulters and not for non-wilful defaulters. The Bankers themselves would have to deal with the non-wilful defaulters.
• India has diverse companies and NPAs, depending on”a single entity and its efficiency to get rid of such behemoth of a task would be illogically”optimistic.
• The Insolvency & Bankruptcy Code (IBC) already exists in India to tackle NPAs. A better implementation of the IBC could easily help with the NPAs.”
What is the need to create a bad bank in India?
At present, Indian public sector banks collectively owe 6.8 trillion Indian rupees as non performing assets. primarily because of the Covid-19 stress. Quick solutions have to be looked for.
A bad bank is established to “buy toxic assets from a good bank at a price that is determined by a bad bank. It is controlled by the government, and apart from the government, other private players invest in its equity. It may raise loan from other banks. These transactions happen at arm’s length and a bad bank is managed by professionals with domain knowledge.
In India, the 29 ARCs are in the business of buying bad assets but the model has not yielded desired results. ARCs act”merely as recovery agents because they lack the bandwidth to reconstruct any company under stress which is sold as going concern. The efficacy of the ARC model is under question.
If the economy has to come back on track, then lending has to resume in a big way. Setting up a bad bank, undoubtedly, is a way forward.
In this case, not only the price was higher, but profit, if any, will go to government. The cost to the exchequer will, therefore, be either zero or minimal. A bad bank can deal with the work as it will have the bandwidth to solve such cases and can take help of the experts to manage the situation.
So long as Public sector banks managements remain beholden to politicians and bureaucrats, their deficit in professionalism will remain and subsequently, prudential norms in lending will continue to suffer. Therefore, the debate regarding setting up a bad bank must be preceded by proper implementation of holistic reforms in the banking sector.
On paper the idea is simple, but its implementation is more complicated -- perhaps the reason why this idea has only been toyed with and not actually implement by policymakers in India.
“The faster the problem of bad loans is tackled, the better for the economy.”