What is a Bad Bank?

5 August 2022
6 mins read
What is a Bad Bank?

There is a famous saying, “If you want to know the health of any economy, just check the nerves of its banking sector.”

Current Banking Situation in India

Before jumping directly to what a bad bank is, let’s take a step back, and understand why it came into existence. According to a recent study conducted by S&P Global Ratings, the stressed assets or NPAs (Non-Performing Assets) are estimated to be in the range of 11-12% in this fiscal year. The onset of the Coronavirus pandemic wreaked havoc on small and medium-sized businesses. Many small companies are now finding it hard to repay the money that they have borrowed from the banks.

NPAs have always been an issue in the Indian financial system and the central bank has come out with many solutions to curb them. One of the solutions that the Finance Ministry has come out with is that of a bad bank. While presenting the last Union Budget, the finance minister announced the setting up of this bank. We will throw some light on the meaning of bad bank in this article, along with its pros and cons. Let’s get started!

What exactly is a Bad Bank?

A bad bank is a bank or more of an Asset Management Company (AMC) or an Asset Reconstruction Company (ARC) that is known to buy bad loans from commercial banks. It usually buys these loans below their book value and then overtakes the task of resolving these bad debts with the borrowers. Now, the big question is how this deal will help those commercial banks?

Their balance sheets are cleared once they sell these non-performing assets to the bad bank. They can now focus on increasing their loan book with fresh loans and earn more interest income on these new loans. The provisioning will also go down significantly to giving some breathing space to the banks. Additionally, the capital requirements (capital adequacy ratio) can be met when fresh capital is infused in these commercial banks. Also, the bad banks are not allowed to lend money or borrow from anyone.

History of Bad Bank as a Concept

Mellon Bank in the US established the first bad bank back in 1988 to take care of its bad assets. The bad banks have completely changed since then and evolved a lot over the years. Starting from the US, this concept travelled to many European countries such as Sweden, Finland, Germany, and France, to name a few. In India, the Indian Banking Association (IBA) had suggested the idea of a bad bank to the RBI and the Ministry of Finance. It remained as a prototype owing to a lack of consensus on its need and efficiency in India.

As of today, when COVID-19 has hit many borrowers, the government announced a moratorium of six months and interest deferment on many existing loans. Experts fear the spike in NPAs going forward, and thus, the talks around the bad bank have started again in India. At the start of this year, the sitting RBI Governor Shaktikanta Das hinted towards considering the idea of a bad bank. The Finance Minister echoed the same thoughts in her budget speech this year.

Is Bad Bank the answer to NPA woes in India?

Firstly, this is a subjective question that is open to multiple interpretations. Having said that, this concept of the bad bank and its comparison with Asset Reconstruction Companies (ARCs) will change since bad banks will be owned by the government.

When it comes to the timing of starting a bad bank, this is the right time for two reasons. First, the bad loans will increase with the relaxations given to borrowers during this pandemic. Secondly, the discount rates offered by ARCs have shot up in the range of 40-60% of the book value of bad loans. This hurts the commercial banks a lot, further debilitating their balance sheets. This process was also time-consuming as much of the time was lost in valuation, due diligence, and negotiation between the bank and the ARC. The bad bank’s meaning, which IBA put forth, is to buy these bad loans from the banks at their book value. It will save time and losses for the ailing commercial banks.

Current Developments around Bad Bank in India

IBA, in May 2020, has prepared and sent a draft proposal highlighting the bad bank meaning to the central bank and the government. They had suggested equity infusion for the bad bank by both the parties, i.e., banks and the government. IBA also presented this draft proposal at the Financial Stability and Development Council (FSDC) meeting. Consensus has been an impediment here as well since the government wants a market-driven resolution process.

There is a concern that the bad bank will turn even worse if no resolution happens after buying these loans from commercial banks. In that scenario, the government will have to bear its cost. Thus, things are progressing steadily around the idea of bad banks. It will be successful once a clear plan is chalked out in terms of the bad bank’s structure, its business model, the extent of government intervention, resolution of stressed assets processes, etc. Currently, there are a lot of apprehensions that are being discussed and debated to get a robust framework around the bad bank.

Impact on Economy

One thing is certain, the banks (especially public sector banks) have to clean their balance sheets, get rid of twin balance sheet issues to become more efficient in their operations. Government cannot bail them out every time with capital infusion or mergers with other strong public banks. A permanent solution has to be planned and executed for the lending cycle to start since private investment by corporations (which is a key component of GDP) depends a great deal on bank loans. Stronger banks lead to more money in the market, which creates employment opportunities, more production, and thus, an increase in the size of the Indian economy.

We hope you got a fair idea of what a bad bank is and the current developments around it in India.