A bad bank, although the term may suggest otherwise, does not operate like a conventional bank. Instead, it deals with bad assets or non-performing assets (NPAs). A bad bank is technically an Asset Reconstruction Company (ARC) or an Asset Management Company (AMC), which takes over the bad loans of commercial banks, manages these loans, and recovers the money over time.
The primary function of a bad bank is not lending or accepting deposits. Instead, it assists other banks in cleaning their balance sheets and resolving NPAs. The bad bank acquires bad loans usually below their book value and aims to recover as much as possible later. Mellon Bank in the United States established the first bad bank in 1988, and since then, several other countries like Sweden, Finland, France, and Germany have adopted the concept.
The Need for a Bad Bank in India
The proposal to establish a bad bank in India has arisen due to certain factors. Following the economic slowdown induced by the pandemic, the Reserve Bank of India (RBI) expects a surge in bad loans. Professionally managed bad banks, funded by private lenders and backed by the government, could be a potential solution to deal with the escalating NPAs. The government’s involvement can potentially expedite the process of cleaning up these bad assets.
According to the Financial Stability Report (FSR) by the RBI, it is estimated that the gross NPAs will rise to 13.5% of advances by September 2021 from 7.5% in September 2020. The K V Kamath Committee has noted that sectors like retail trade, wholesale trade, roads, and textiles are under stress, and numerous companies within these sectors are facing significant financial difficulties due to the pandemic.
Challenges in Establishing a Bad Bank
However, the creation of a bad bank is fraught with challenges. Finding buyers for bad assets in an economy hit by the pandemic will be tough. Additionally, without proper governance reforms, public sector banks, which currently account for 86% of total NPAs, might continue accumulating bad debts.
Although the government has already infused around Rs 2.6 lakh crore into the banks through recapitalization, critics argue that moving loans from the public sector banks to a bad bank is simply a shifting of debts. They also suggest that since the government has recapitalized the banks, there is no need for a bad bank. Another challenge is the pricing of bad assets; it may not be determined by the market, preventing price discovery. Lastly, such a move may also create a moral hazard, enabling reckless lending practices without reducing NPAs.
Previous Proposals and The Way Forward
The concept of a bad bank is not new in India. In May 2020, the Indian Banks’ Association proposed setting up a bad bank to tackle the NPA problem. Similarly, in 2017, the Economic Survey proposed a Public Sector Asset Rehabilitation Agency (PARA) for buying out high-value NPAs from Indian banks.
While a bad bank could assist in resolving the NPA issue, it cannot be the only solution. A comprehensive and tailored approach to India’s bad loan problem is necessary. The proposal of establishing a bad bank should be backed up by the implementation of holistic banking sector reforms, as detailed in the Indra Dhanush plan launched in 2015. Furthermore, adopting a multi-faceted response that offers solutions tailor-made for different parts of India’s bad loan problem can provide a more efficient approach, where the bad bank can serve as a last resort when all other methods fail.