The backbone of any economy is its Financial System, but what do you do when the Financial Systems in place begins collapsing due to high defaults? How can you restore the public’s faith in financial institutions when a significant portion of their Bank Loans are turning into NPAs? Time and again, the Indian Economy has faced this dilemma and time and again, they’ve come back to the same idea – Bad Banks. This time is no different.
What is a Bad Bank exactly?
The name Bad Banks itself suggests that these are structures that would be created to deal with Bad Loans in the Banking Sector. Let us understand in detail how a Bad Bank works.
Technically, a Bad Bank is an Asset Reconstruction Company which is formed in order to help banking institutions clean up their loan books. When a Bad Bank is formed, the Bank starts dividing its assets (loans given) into 2 categories – Nonperforming assets (NPAs) and other risky liabilities which go into the Bad Banks and healthy assets (healthy loans given) which remain in the Bank’s books.
The concept was pioneered in the US in 1988 and found its way to the Indian Economy first in January 2017 when the idea was floated around to deal with the high level of bad assets that the Banks had on their Balance sheets. At that time, it was suggested that Indian Government set up a Public Sector Asset Rehabilitation Agency (PARA). The RBI suggested creation of 2 entities:
PAMC (Private Asset Management Company) which would be formed using funds from banks as well as global funding companies. PAMC would be formed with an objective of focusing on investments in areas of short-term economic viability.
NAMC (National Assets Management Company) which would be formed with the Government’s support (i.e. Tax Payers’ money) with the objective of investing in bad assets with a long-term turnaround perspective (but short-term stress).
How do Bad Bank Structures work?
Once a Bad Bank is formed, it acts as a separate entity from the Bank. It purchases the bad assets (i.e. non-performing assets and high risk assets) from the Bank at a discounted value and then engages in an effort to recover the money from the borrowers. This cleans up the loan book of Banks and creates an opportunity for higher returns for the Bad Banks. Bad Banks are able to take advantage of these stressed assets as their prime strength is recovery of funds whereas Banks’ strength lies in lending. So Bad Banks are able to obtain a higher recovery rate on these assets than normal Banking institutions.
Why are Bad Banks being considered at this juncture by India’s Policymakers?
Having witnessed a slowing growth in the Indian Economy in FY2019-2020, we found ourselves facing a NBFC Crisis. Some of the biggest brand names in the industry went out of business, leaving banks and other stakeholders in the business frantic as they tried to recover their funds from these companies. Add this to the pre-existing concerns of Bank NPAs rising, the Financial System in India was already being approached cautiously by investors but with the Coronavirus Pandemic in place, there’s definite concern amongst policymakers regarding the lack of faith in these banking institutions due to an expectation of sharp spikes in their NPAs.
Arguments in favour of Bad Banks:
The primary benefit that would be derived from the formation of a Bad Bank is monetization of a Bank’s stressed assets (much more quickly) which could help them enhance future growth by creating liquidity for investments in promising sectors and companies. The Bank’s loan books would look much cleaner as the risky assets are treated as a separate segment altogether and being purchased by the Bad Bank while it focuses on growing its healthy asset base.
A secondary benefit arising from this would be restoration of investors’ faith in the ability of the Banking institutions to provide economic returns. This would help the Bank to raise funds more smoothly, thus providing a larger capital base for future growth of the company.
Arguments against Bad Banks:
One of the biggest arguments against Bad Banks being setup in India is that it would create indiscipline amongst Banking Institutions. Banks would be more liberal to lend funds to companies with lower credibility knowing that if the borrower begins to default, the loans could simply be transferred to the Bad Bank.
Another argument against the Bad Banks Setup is the use of common taxpayers’ money to help make up for defaults by those people and businesses who are capable of paying the debt obligations in full but are unwilling to do so. It is deemed as an inefficient use of taxpayers’ money and creates an ill-will amongst the public regarding the Government’s decision.
Another area of concern is the complexity of setting up and maintaining a bad bank structure. Although in concept it sounds easy to do, the actual process is quite complex with multiple considerations and requirement of government and regulatory support.