What is a bad bank?
Bad banks are typically a bank that is set up to purchase bad loans and other holdings of any bank or financial institution. The bad bank usually comes into play during times of financial crisis to absolve issues and maintain the reputation of banks. While many consider bad banks to be a boon, some consider otherwise. Many believe that bad banks allow and encourage financial institutions to take undue risks. However, RBI’s decision to not allow fraudulent loans to be sold to bad banks has mitigated this risk.
There are 4 main models for bad banks.
- On-balance guarantee that is used by the bank to protect itself against losses that could occur from its portfolio.
- Transparent internal restructuring enables banks to create a completely different and separate unit to hold bad assets.
- SPE (Special Purpose Entity) through which the bad assets are typically transferred to another entity.
- Bad bankspinoff allows banks to create a whole new and independent bank in order to hold the bad assets. This completely isolates the bank from risky assets and helps mitigate risks.
Shaktikanta Das, the Governor of Central Bank has announced that bad banks should be brought into play to help with the capital that is tucked in sources of loans. This would further enable ARCs to be more efficient.
What is the main purpose behind bad banks?
The ultimate reason behind introducing bad banks is to use them as a one-time clean-up tool for bad loans offered by banks. The primary aim is to clean up the balance sheets of many banks. While this initiative is useful in clearing bad debts, using this methodology, in the long run, can do more harm than good. For instance, it could lead to several banks increasing their offering to risky lenders with the concept of the bad bank as a backup if loans are not repaid.
This is the main reason why the Union Budget of FY 22 announced bad banks to facilitate the capacity of an asset management establishment, or an asset reconstruction company (ARC). So, as an alternative to selling bad loans, the banks would be required to transfer their loan assets to the asset reconstruction company. Finally, the RBI (Reserve Bank of India) went through a stress test in the month of January 2021 where the NPA ratio was expected to grow up to 14.8% by the month of September 2021, in comparison to a mere 7.5% during the month of September in 2020.
Benefits of bad bank
One of the main benefits of introducing bad banks is to get the operations of banks back on track. The main reason that increased the need for bad banks is the lack of resolution of the bulk of assets by ARCs (Asset Reconstruction Companies). It has been proved important to monitor the movement of funds between ARCs and banks. The cause behind this being the increased and continuous supply of NPAs (Non-Performing Assets) to ARCs.
One of the key benefits of introducing bad banks is that it would make the existing asset reconstruction companies much more effective. However, a set of rules have been established around the functioning of bad banks. The new ARC / bad banks have been asked to enforce a mandate that they should follow clear and defined NPA goals, establish a clause that defines their lifespan, enforce laws around private property, while also including a commercial highlight in transparency, disclosure, and governance requirements.
Can it help our financially stressed economy?
Finally, when it comes to our economically stressed economy, there are several factors that come into play. Even before the Covid-19 pandemic, there have been various channels of stress for financial institutions that have contributed to the crisis. However, in the current pandemic-struck world, RBI has offered several means of relaxation for borrowers. The most popular one being the moratorium on bank loans.
Ultimately, bad banks can have a positive impact on financial institutions as they can temporarily help relieve the stress imposed on banks. This could help drastically in the current situation as the stress has been exacerbated by the pandemic. Finally, irrespective of bad banks being capable of relieving banks of their stress, this should not be considered as a permanent solution as shifting the stress from one entity to another cannot solve the problems arising from stressed assets.