Explained: What’s good about a “bad bank”

Following one of her key budget announcements, Finance Minister Nirmala Sitharaman announced the formation of India’s very first “Bad Bank”. She stated that the “National Asset Reconstruction Company Limited” (NARCL) has already been incorporated under the Companies Act. He will acquire stressed assets worth around Rs 2 lakh crore from various commercial banks during different phases. Another entity, India Debt Resolution Company Ltd (IDRCL), which has also been formed, will then attempt to sell the stressed assets in the market. The NARCL-IDRCL structure is the new bad bank. For this to work, the government allowed the use of Rs 30,600 crore as collateral.

What is a bad bank? Why was this necessary?

In each country, commercial banks accept deposits and grant loans. Deposits are the “responsibility” of a bank because it is the money it has taken from an ordinary man, and it will have to return that money when the depositor asks for it. In addition, in the meantime, it must pay the depositor an interest rate on these deposits.

In contrast, the loans that banks give are their “assets” because this is where the banks earn interest and it is money that the borrower has to return to the bank.

The whole business model is based on the idea that a bank will make more money making loans to borrowers than it should pay depositors back.

Imagine then a scenario where a bank finds that a huge loan is not repaid because, say, the company that took out the loan has gone bankrupt and is unable to repay the interest or the amount of the loan. main.

Every bank can take some such hits. But what if these “bad debts” (or loans that will not be repaid) increase alarmingly? In such a case, the bank could sink.

Now imagine a scenario where several banks in an economy are facing high levels of bad debt and all at the same time. This will threaten the stability of the entire economy.

In normal operation, as the proportion of bad debts – they are usually calculated as a percentage of total advances (loans) – increases, two things happen. First, the affected bank becomes less profitable because it has to use part of its profits from other loans to offset the loss on bad debts. Second, it becomes more risk averse. In other words, its officials are reluctant to give loans to business ventures that may seem remotely risky for fear of aggravating an already high level of non-performing assets (or NPAs).

Figures 1 and 2

In India, as Figures 1 and 2 show, the level of NPAs has increased alarmingly since 2016. This is largely due to the fact that the RBI has forced banks to clearly recognize bad debts on their books. . The fact is that several banks have witnessed a gradual deterioration in their loan portfolios since the 2008-09 global financial crisis.

From a taxpayer’s perspective, the most worrying fact was that an overwhelming proportion of NPAs were with public sector banks, which were owned by the government and therefore owned by the Indian public. To keep these PSOs in operation, the government was forced to recapitalize them, i.e. to use taxpayer money to improve the financial health of PSOs so that they could continue their lending and funding activity. financing of economic activity.

But with each passing year, NPAs have continued to rise – not helped by the fact that the economy itself has started to lose its growth momentum since the start of 2017.

Many argued that the government should create a bad bank, that is, an entity where all bad loans from all banks can be parked, thereby relieving commercial banks of their “stressed assets” and allowing them to concentrate on resuming normal banking operations, in particular credit.

As commercial banks start lending again, the so-called bad bank, or bad debt bank, would try to sell these “assets” in the market.

bad bank, what is a bad bank, bad bank explained, nirmala sitharaman bad bank, india bad bank, nirmala sitharaman press conference, Indian Express Source: Kotak Institutional Equities Research

How will the NARCL-IDRCL work?

NARCL will first buy bad loans from banks. He will pay 15% of the agreed price in cash and the remaining 85% will be in the form of “security receipts”. When the assets are sold, with the help of the IDRCL, the commercial banks will be reimbursed for the remainder.

If the bad bank is unable to sell the bad loan or has to sell it at a loss, the state guarantee will be invoked and the difference between what the commercial bank was supposed to get and what the bad bank was able to. raise will be paid from the Rs 30,600 crore which has been provided by the government.

Will a bad bank solve the problems?

From the perspective of a commercial bank struggling with high APN levels, this will help. This is because such a bank will get rid of all its toxic assets, which were eating away at its profits, in one fell swoop. When the recovery money is paid back, it will further improve the bank’s position. In the meantime, he can start lending again.

From the point of view of the government and the taxpayer, the situation is a little more confused. After all, whether it’s recapitalizing bad debt PSBs or giving collateral for collateral receipts, the money is coming out of the pockets of taxpayers. Although recapitalization and such guarantees are often referred to as “reforms”, they are band-aid at best. The only lasting solution is to improve the loan operation in the PSBs.

Finally, the commercial bank bailout plan will collapse if the bad bank is unable to sell these impaired assets in the market. If that happens, guess who will have to bail out the bad bank itself? Indeed, the taxpayer.

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