Bad bank conveys the impression that it will function as a Bank but has bad assets to start with. Technically, a Bad Bank is an asset reconstruction company (ARC) or an asset management company that takes over the bad loans of commercial Banks, manages them and finally recovers the money over a period of time. The Bad bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans. The takeover of bad loans is normally below the book value of the loan and the Bad bank tries to recover as much as possible subsequently. Banks drive the nation’s economy; however many times the borrowers find it difficult to service their loans. It requires the lenders to set aside the capital to cover the losses. When the Bad bank comes into the picture to help them free up to start lending.
Significance of Bad Bank
· Bad Bank will seek to provide financial stability in the banking sector. It will hold problem loans for public sector banks which can then be sold on to investors at a reduced price.
· The Bad Bank does not involve itself in lending and taking deposits, but it helps to make commercial banks clear their balance sheets and resolve bad loans.
·The process of taking over bad loans is generally below the book value of the loan
·Bad Bank tries to recover as much as possible from those bad loans
·Mellon Bank based in the USA was the first one in this field. It is referred to as the first Bad Bank in 1988.
·A Bad Bank aids a bank to segregate its good assets from the bad ones which make it easier to raise capital through equity or debt.
·Toxic assets separation helps in generating some confidence among potential investors so that they can then clearly examine the financial health of the lender.
·Sour loans when transferred to a Bad Bank can help lenders prioritize their financing business and the specialized institution deals with maximizing loan recovery.
Requirement of Bad Bank
· The high level of provisioning by public sector banks of their stressed assets calls for measures to clean up the bank books. An Asset Reconstruction Company Limited and Asset Management Company would be set up to consolidate and take over the existing stressed debt and then manage and dispose of the assets to Alternate Investment Funds and other potential investors for eventual value realization.
· Lockdown that was imposed due to pandemic to curb covid spread has crimped the earnings of the businesses and individuals. It impaired their ability to repay loans which caused a hike in non-performing assets of banks. The corporate sector has come under the debt of INR 15.52 lakh crore. Despite the regulatory forbearance as a loan moratorium, borrowers are finding it difficult to service their loans. This then requires lenders to set aside their capital to cover such losses.
· A Bad Bank can provide them with the freedom to restart lending. The RBI in its recent FSR informed that the gross NPAs in the banking sector was expected to shoot up to 13.5% of advances by September 2021, from 7.5% in the previous year.
· According to an estimate, non-performing assets totaling Rs 899,803 crore will be transferred to the bad bank. In the present pandemic-affected market, the RBI has provided various relaxations to borrowers in the form of an option to avail a loan moratorium or loan restructuring. However, a similar relaxation has not been provided to banks, who are expected to continue to repay their obligations. Therefore, transfer of stressed assets from a bank’s books could provide banks with the much-needed respite. Broadly speaking, banks would be able to focus on lending instead of loan recovery
Bad Bank Structure (IBA) Proposal
Indian Banking Association (IBA) has submitted a proposal to both the Government and the Reserve Bank of India (RBI) to set up a ‘Bad Bank.’ As per IBA estimates the ‘Bad Bank’ would require approximately Rs 10,000 crore of capital initially. The exact quantum of capital and amount of bad loans to be housed in the proposed ‘Bad Bank’ would only be finalized after discussions with the Government and Reserve Bank of India (RBI).
The ‘Bad Bank’ will be a 2 tiered structure.
· There will be an Asset Reconstruction Company (ARC) backed by the Government which would buy bad loans from banks and issue Security Receipts to the Banks.
· As per RBI guidelines, ARC will hold Security Receipts of 15%.
· Banks will get 15% of the cash and will hold 85% of Security Receipts. Hence it is called 15:85 structures.
· There will be an Asset Management Company (AMC).
· AMC would be run by public and private bodies which includes banks as well.
· Turnaround professionals.
How to make good assets with a ‘Bad Bank
· For faster recovery of bad loans, ARCs need to be made more competitive by boosting their capital base through consolidation while the economy is bouncing back, the banking sector, considered its lifeline, looks for an anchor for revival. Although the Budget provides a glimmer of hope, the rise of the banking sector depends on various other factors. One of the major announcements for the sector is establishment of an Asset Reconstruction Company (ARC, also referred to as a Bad Bank) to improve bank balance-sheets. The need for cleaning up the debt from banks’ books assumes importance as it will help them raise capital and boost public confidence in the banking sector.
· Though the ARC can help banks reduce their NPAs (non-performing assets) and widen the capital base, it is still a makeshift solution. There is need for a lasting solution in the form of structural changes. It can be implemented in the mid-term by way of prudent lending and in the long-term by bringing in policies to make the debt market more active. This will not only help in getting rid of the twin balance-sheet problem but also bring in efficiencies by adopting market mechanism (this will also help in faster recovery of bad loans by employing the existing ARCs and avoiding the procedural delays).
Challenges of Bad Bank
The major issue would be of finding buyers in the pandemic hit economy. The government is itself facing fiscal deficits at present without governance reforms, the Public sector banks would continue doing business in the same way as in the past. It may also end up piling-up bad debts again. Union Government has already infused almost 2.6 lakh crore in banks through recapitalization so now bad banks would do no better as per many economists. Bad banks can also ease off the banks of their moral responsibility and let them lend without any commitment to clear their NPAs.
The bad bank serves several purposes. For one, it helps expedite the pace of debt restructuring by reducing the number of lenders who must agree to a proposed deal. It also makes it easier for foreign funds to build controlling positions in the debt of a firm by allowing them to negotiate with a single seller. Generally speaking, placing non-core assets in a separate division can help make a restructuring more efficient and transparent by providing investors with financial disclosures to better track the progress of a lender’s overhaul and hold management accountable. Shedding the assets in the bad bank then frees up capital that can be used to bolster a firm’s financial strength or be redeployed to more profitable businesses. If it’s a separate entity, it can also allow a bank to clean up its balance sheet, stem losses and protect depositors.