What Are Bad Banks?

What Are Bad Banks?

Rising Non-Performing Assets (NPAs) are no less than a financial pandemic hovering upon the Indian Economy for quite a long now. Finally, in what looked like a concrete measure to address the NPA issue, the government announced the establishment of a ‘Bad Bank‘. We know the term ‘Bad Banks’ is just being tossed around like any other word, but in this story, we will simplify the term for you and see if it can solve the NPA crisis.

Crux of the Matter

Simplifying The Term
In Budget 2021, the FM had proposed setting up a government backed Asset Reconstruction Company (ARC) for buying the stressed assets from the banks.

Such ARCs that ‘isolate high risk and illiquid assets’ like bad loans are called ‘Bad Banks.’

In simple terms, the proposed Bad Bank is a financial enterprise set up to purchase Bad Loans (Non Performing Assets) from other Banks.

Why The Setup?
As of September 2020,
9.7% of PSB loans, and
4.6% of private sector banks’ loans were NPAs.

The total NPAs amounted to ₹7 lakh crores!

The aim of the Bad Bank is to ease accounting burden of NPAs on banks by clearing their stressed balance sheets

How Will It Work?
1. ARC will buy NPAs from Banks.
2. This newly set up ARC will then be a holding company to an Asset Management Company (AMC).
3. The AMC in turn will recover money from the acquired NPAs by selling them.

Bankers estimate a corpus of ₹15,000 crores will be required for buying loans of ₹3 lakh crores. The funding is expected to be provided jointly by the Government and Banks.

Funding Mechanism
The ARC will be paying 15% cash upfront to the Banks. For the remaining 85%, a Security receipt will be issued by the ARC, payment of which would depend upon the amount recovered from selling the NPAs.

The Pros
– Consolidates all the bad loans under one single entity further easing the recovery hurdles.
– The goal is not to make a profit but to lessen the burden of the bank by arresting their losing market share.

– It is a mere shifting of assets from one entity to another – just accounting wizardry.
– Indirectly, it may incentivize commercial banks to operate recklessly given the safety net of Bad Banks that will keep absorbing NPAs.
– This is not the first time an ARC has been set up (although it’s a first govt ARC), so the historical data suggests that banks were able to recover only 30% of the amount of NPAs sold to ARCs.

Did you know that cabs were expected to be the reason for the increase in NPAs during the lockdown? Strange, right? Then quench your curiosity here.

  • A special-purpose entity is a legal entity created to fulfill narrow, specific or temporary objectives. SPEs are typically used by companies to isolate the firm from financial risk.
  • The first bank to use the bad bank strategy was Mellon Bank, which created a bad bank entity in 1988 to hold $1.4 billion of bad loans. Initially, the Federal Reserve was reluctant to issue a charter to the new bank, but Mellon’s CEO, Frank Cahouet, persisted and the regulators eventually agreed. 
  • Many companies see a business opportunity in buying NPAs. Buying NPAs from financial institutions with a discount, can be a lucrative business. Companies pay from 1% to 80% of the total loan and become the legal owner (creditor). The discount depends on the age of the loan, secured/ unsecured, age debtor, personal/ commercial debt, area of residence, etc.