The government is said to be considering a proposal from the banking lobby, the Association of Indian Banks (IBA), and the feasibility of the proposal is currently under consideration. Following the IBA’s proposal, the bad bank will have an ARC-AMC model and an alternative investment fund (AIF) will be set up to buy stressed assets from the banking system.
Logically, the government will initially invest in the proposed bad bank, while in due course, banks and outside investors will accumulate money. The creation of a bad bank backed by government and industry is promoted as a critical banking reform in Asia’s third economy. Indian banks had underperforming assets (NPA) of Rs 9 lakh crore at the end of December.
What is a bad bank?
A bad bank is essentially an entity that gathers all the bad assets in the banking sector, buys it at a reduced price from the banks, and tries to find buyers by implementing a recovery plan. The purpose of creating a bad bank is not much different from that of a typical asset reconstruction company (ARC).
The idea of a bad bank is not new, in 2018 the government announced a plan for PSO called “Project Sashakt”‘, which had a five-point plan to settle bad loans in public sector banks. The government then discussed a model, with the guiding principles of an Asset Management Firm (AMC) resolution approach, under which an independent AMC would be established to focus on asset recovery, job creation and protection.
The functions of this new company will be aligned with the Bankruptcy and Insolvency Code (IBC) process and IBC laws, the government then did not call it a bad bank and made it clear that it would not be involved in the bad asset resolution process and that the process would be led by the banks.
Along with this, a resolution approach based on an alternative investment fund (AIF) for loans over Rs 500 million under which an AIF would raise funds from institutional investors was also discussed. Banks will also have the option to participate if they want to participate on the rise. The idea could not be implemented for various reasons.
In 2018 the then interim Finance Minister Piyush Goyal last revived this idea, when he set up a committee under PNB Chairman Sunil Mehta to study the feasibility of national Asset Reconstruction Company, or in other words, a bad bank.
The 2017 Economic Survey examined this idea, suggesting the creation of a Public Sector Asset Rehabilitation Agency (PARA). Before that, the 2015 Asset Quality Review conducted by Reserve Bank under Governor Raghuram Rajan — which forced banks to recognise problem accounts as non-performing assets — had also sparked a debate on bad bank as a possible solution.
In short, the idea is not novel and has been suggested by various people at different points of time.
Understanding Bad Bank
No, it is not an evil or corrupt bank, nor any of these things, a bad bank is so simply named because it harbors bad debts or, in financial terms, unprofitable assets (NPA), the concept is simple.
Suppose that Bank X makes loans to various people and companies who have not been able to repay the bank and who have not paid EMI’s. Over time, these loans accumulate, interest continues to accumulate, and Bank X continues to provide more money for the bad exposure it had, as it realizes that it is likely that bank will never get that money back.
It could be argued that these bad debts, or NPAs, could simply continue on the books of Bank X and that would be it. In practice, however, these NPAs could actually harm the bank.
Investors, or any other counterpart, consider the large NPAs as a sign of the bank’s poor health or financial weakness. The higher the NPAs, the more Bank X is able to borrow, lend or do business in general.
To solve this problem, the bad bank model was first proposed in the 1980s by Mellon Bank. In the United States, he created a bad bank in 1988 to conserve toxic assets by holding his own capital and five of his own members of the board of directors of Grant Street National Bank.
Grant Street Bank did not accept deposits from the public as normal banks do, but simply served to settle or settle bad debts to recover as much money as possible, and finally settled a few years after reaching its goal.
Subsequently, Sweden, Finland, France, Germany, Indonesia and several other countries implemented the idea. In this case, Bank X could separate its assets into good assets (loans repaid on time and bad or toxic assets) that are in default and realize that it will not be easy to recover them.
These can be removed from the bank’s books and transferred to a bad bank, which would only serve to facilitate the recovery of these risky assets. As a result, Bank X will offset or deleverage its own balance sheet, reduce its exposure to risky assets, and therefore close.
Therefore, a bad bank should assist banks by absorbing all of their bad assets, generally at less than the book value of these loans, and managing them, with the goal of finally recovering the money over a period of time.
On paper, the idea is simple, but its implementation is more complicated, perhaps the reason why this idea has only been used by policy makers in India.
There are advantages and disadvantages to this idea. Supporters of the idea argued that in addition to cleaning bank balance sheets and making them financially healthy, separating good and bad assets allows the bank to focus on its core lending activity and leaves the resolution to the experts.
Other than that, a government-led initiative may provide an opportunity for investors to invest their money, domestic and foreign, more acceptable, if not attractive.
One of the main challenges of such a bad bank is also capital, which has been difficult to mobilize in the past. Opponents of the idea argue that a single approach to resolution through this bank may not be possible.
In his book “I do what I do”, former RBI Governor Raghuram Rajan, during whom the idea was hotly debated, said: “I just saw this (bad banking idea) as loans from mobile pocket from government (public sector banks) to another (bad bank) and they didn’t see how it would improve things.
he said “In fact, if the bad bank was in the public sector, reluctance to act would simply go to the bad bank. Otherwise, if the bad bank was in the private sector, the reluctance of public sector banks to sell loans to the bad bank with a haircut would always prevail significant. Again, this will not solve anything”.
At the time of Governor Urjit Patel, Lieutenant Governor Viral Acharya had talked about creating a PAMC (Private Asset Management Company) that would look like a private equity fund managed by a team of professional asset managers, and NAMC (National Asset Management Company) which would be a quasi-governmental organization, in particular to house toxic assets whose recovery can take much longer.
Although these ideas have not taken shape, the discourse continues and the Association of Indian Banks now also offers a similar two-level structured Bad Bank, which includes a fully-funded asset reconstruction company that would buy bad debts to banks and issue them security receipts.
The ARC model works according to the 15:85 structure notified by the RBI, according to which the bank receives 15% in cash and 85% security receipts, while the ARC has SR (security receipts) worth by 15 percent.
The second part of this two-level structure is the asset management company, which would be in charge of public and private organizations, including banks, restructuring professionals and would manage the assets etc.
IBA has also offered an alternative investment fund, or FIA, which will help create a market to trade these security titles on the secondary market. The bottom line is that even with a bad banking structure, the losses of the NPA do not disappear and must be shared between the investors, the taxpayers of these banks in general and those of the bad bank.