Bad Bank : Solution to the banking crisis?

Bad Bank

In times when rising NPA’s (non-performing assets) are continuously deteriorating the Indian banking system, a solution ought to be found. Indian banks, may it be government banks or private banks, are piled up with bad loans or non-performing assets. This would have major implications, as it would heavily disrupt the smooth flow of credit and would ultimately slow down economic growth, especially economic revival after the Covid-19. So, what’s the solution? The government is indeed taking steps like infusing capital in these banks, but to what extent? The question remains to be answered. These conditions have raised the demand for setting up a Public Sector Asset Rehabitilaziton Agency (PARA), referred to as a bad bank.

Bad Bank
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What’s a Bad Bank?

A bad bank is generally an asset reconstruction agency. A bad bank is an institution that is set up for the purpose of accumulating bad loans or non-performing assets from other financial institutions. In general, the bad bank would buy the bad loans from other banks. These bad banks are specialized in recovering the loans. Their main motive is to recover as much as possible. 

Suppose a bank extends a loan of 500 crores to a company. But however, the company is able to return only 300 crores. So, the 200 crores would be considered as NPA and the lending institution would believe that these 200 crores could not be retrieved. So, the bank would try its best to recover that 200 crores, maybe by IBC (Insolvency and Bankruptcy Code) or various other measures. But with the advent of bad banks, this 200 crores of bad loan could be sold off to this institution, whose main motive would be to recover this.

Bad Bank
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What’s in for the bad banks?
If you’re asked to buy a ship with a hole in it for 1000, would you buy this drowning one for 1000? Surely not. The bad bank would surely not buy that 200 crores of the bad asset for 200 crores. The agency would buy it for a discounted price, depending on the quality of that asset. After taking over this asset, the agency would try its best to recover this and get the best value out of it. But it’s a quite complicated process, as maybe the bad bank would not succeed in recovering it. Or might get only 50 crores out of it. So, the bad bank would require a good and regular flow of capital for their efficient functioning.

So, the concept of a bad bank would not work well without effective capital provisions. A bad bank would initiate its operations with a good capital reserve.

Bad Bank in India

Bad Bank
Image by -Yadnya Investment Academy – Invest Yadnya

As discussed earlier, the Indian Banking system is continuously deteriorating and the pandemic has made the conditions even worse. As businesses collapsed and people are finding it difficult even to meet their basic requirements, how are they supposed to pay back their debts? There were numerous PILs demanding the loan moratoriums should be extended and some even demanded that they should not be asked to pay the regular EMI’s and even the loans. But it’s certain that such steps as forgiving the loans would lead to the collapse of various banks.

So in order to safeguard the banks from this chaos, the IBA (Indian Banks Association) has drafted the proposal for setting up a Public Sector Asset Rehabitilaziton Agency (PARA), which would be funded by the government of India.

Setting up a bad bank could be a blessing in disguise for the banks in India, but as we know, every thesis has an antithesis!

Bad Banks: The antithesis

Before going on the cons of setting up a bad bank, let’s sum up the pros – The creation of a bad bank would help the banks to clean their balance sheets, and continue their lending practices smoothly, as there’s a bad bank that is ready to buy up the bad loans. Hence, the bad bank would let the banks concentrate on lending and the specialized institution would do the job of recovering.

Image by – Randomwalks

Would the bad bank really solve the problem?

Let’s assume that the bad loan has been transferred to the bad bank and that the agency is highly specialized in retrieving the loans, but does the agency actually know the debtor as well as the bank does? So, this gives rise to the fact that even though the agency is specialized, the bank knows its customers better and is in a better position to retrieve the loan rather than the separate entity.

Another question arises, even if we set up a bad bank, would there be a substantial reduction in the NPA generation by the banks? Even if the bad banks help the banks in cleaning off their balance sheets and start fresh lending, it cannot be assured that the banks would not generate NPAs in such large amounts. The root of the problem is that loans extended are getting converted into bad loans. And this conversion is not a recent phenomenon, the pandemic has just made the conditions worst. So, there’s an argument that the government and the RBI, instead of providing short-term measures to the banks for cleaning their balance sheets, must take some concrete measures to solve the root cause of the problem. The process which is giving rise to the NPAs must be stopped. Hence, the need of the hour is major structural reforms. 

The Moral Hazard problem – Various economists including former RBI governor Raghuram Rajan have raised the concern of moral hazard. If there’s an entity backing up banks for their defaults, then this would just give an incentive to the banks to continue their reckless lending practices.
“How can the bank’s balance sheet be clean if the intentions are wrong? If your system is wrong and you aren’t taking the responsibility?”
-K.A Badrinath, senior journalist

Image by – The Wall Street Journal

Well, whether the bad bank would be set up in India or not remains to be seen as the RBI hasn’t made any new moves or proposals towards it. But one thing is for sure, that the benefits of setting up a bad bank would outweigh the implications.

Check out the solution-oriented article about the Indian Banking System

Bad Bank : Reconstructing the Reconstructors

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