13 Oct 2016 | GS3 | What do you understand by the term “Bad Bank”? How will the Bad bank deal with the problem of NPA in India? What are the major issues/challenges in implementing the idea of bad banks?

GS3 (Indian economy)

What do you understand by the term “Bad Bank”? How will the Bad bank deal with the problem of NPA in India? What are the major issues/challenges in implementing the idea of bad banks?

Best answer

Udyan Ilu wrote the best answer for this question and got a score of 4/10 (if the best answer is an image, it cannot be uploaded here, hence scroll down to see those). The answer is being reproduced below for everyone’s convenience. Of course these answers can always be improved. (Best answer  of a particular only involves those given on that day, later answers may not have been checked)

A bad bank is a corporate structure to isolate illiquid and high risk assets held by a bank or a financial organisation, or perhaps a group of banks or financial organisations.A bank may accumulate a large portfolio of debts or other financial instruments which unexpectedly increase in risk, making it difficult for the bank to raise capital, for example through sales of bonds. In these circumstances, the bank may wish to segregate its “good” assets from its “bad” assets through the creation of a bad bank. The goal of the segregation is to allow investors to assess the bank’s financial health with greater certainty. After transferring NPAs of banks, perhaps only PSBs, to the bad bank. The bad bank will manage these NPAs in suitable ways — some may be liquidated, others may be restructured, etc. Getting NPAs off the books will help the PSB management focus on new business instead of having to expend their energies on trying to effect recoveries. A bad bank will be better focussed on the task of recovery. If it’s a private entity, it can also bring in superior expertise. It would appear that the bad bank concept has many things going for it.
Challenges for Bad Bank in India-
1.First who will have the majority stake in the bad bank? Will it be the government or private investors? Let us suppose it’s the former. Given the size of NPAs at PSBs, the capital required by a bad bank for acquiring NPAs will be substantial. If the government is to be the majority owner, how does it find the required funds? Second, a government-owned bad bank will be subject to the same constraints in managing bad loans as PSBs. Third, managing the sheer size and diversity of bad loans acquired from multiple PSBs will be a tall order. Last, a government entity may not be able to pay specialists what it takes.Here only a government-owned bad bank appears to be transferring the problem from one part of the government to another.
2. Now consider the second possibility, namely, that private investors have a majority stake in the bad bank. These could be long-term investors such as sovereign wealth funds and pension funds. In this case, the price at which PSB loans are sold to the bad bank could become a major issue. If the price is too high, the bad bank will not viable. If it’s too low, PSBs will be accused of selling their loans too cheaply to private investors — we will have the makings of an ‘NPA scam’.
3.There are other issues with transferring NPAs to a bad bank. a big chunk of NPAs at PSBs pertains to projects that are viable. These projects have not gone through to completion for reasons that are mostly extraneous to the project, such as problems in land acquisition or environmental clearance. With restructuring and additional funding, they can be completed and would create significant capacities.Selling these loans to a bad bank, on the other hand, would be a time-consuming process. It would impede fresh flow of funds into these projects. Their debt would rise as the interest piles up. Bad banks were typically intended for situations where projects were not viable. They were not meant for a situation such as ours where projects are viable.

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