From UPSC perspective, the following things are important :
Prelims level : NPA, Bad Bank
Mains level : Asset reconstructions post NPA buzz
The idea of setting up a bad bank to resolve the growing problem of non-performing assets (NPAs), or loans on which borrowers have defaulted, is back on the table.
Q.What is Bad Bank? Discuss how it is different from an Asset Reconstruction Company (ARC)?
Why in news?
- Commercial banks are set to witness a spike in NPAs, or bad loans, in the wake of the contraction in the economy as a result of the pandemic.
- Hence the RBI recently agreed to look at the proposal for the creation of a bad bank.
- This is in the response to a six-month moratorium it has announced to tackle the economic slowdown.
What is a Bad Bank?
- A bad bank conveys the impression that it will function as a bank but has bad assets to start with.
- Technically, it is an asset reconstruction company (ARC) or an asset management company that takes over the bad loans of commercial banks, manages them and finally recovers the money over a period of time.
- Such bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans.
- The takeover of bad loans is normally below the book value of the loan and the bad bank tries to recover as much as possible subsequently.
Global examples of Bad Bank
- US-based BNY Mellon Bank created the first bad bank in 1988, after which the concept has been implemented in other countries including Sweden, Finland, France and Germany.
- However, resolution agencies or ARCs set up as banks, which originate or guarantee to lend, have ended up turning into reckless lenders in some countries.
Do we need a bad bank?
- The idea gained currency during Rajan’s tenure as RBI Governor.
- The RBI had then initiated an asset quality review (AQR) of banks and found that several banks had suppressed or hidden bad loans to show a healthy balance sheet.
- However, the idea remained on paper amid lack of consensus on the efficacy of such an institution.
- ARCs have not made any impact in resolving bad loans due to many procedural issues.
What is the stand of the RBI and government?
- While the RBI did not show much enthusiasm about a bad bank all these years, there are signs that it can look at the idea now.
- Experts, however, argue that it would be better to limit the objective of these asset management companies to the orderly resolution of stressed assets, followed by a graceful exit.
Former RBI Dy. Governor Acharya suggested two models to solve the problem of stressed assets.
- The first is a private asset management company (PAMC), which is said to be suitable for stressed sectors where the assets are likely to have an economic value in the short run, with moderate levels of debt forgiveness.
- The second model is the National Asset Management Company (NAMC), which would be necessary for sectors where the problem is not just one of excess capacity but possibly also of economically unviable assets in the short to medium terms.
Good about the bad banks
- The problem of NPAs continues in the banking sector, especially among the weaker banks.
- The bad bank concept is in some ways similar to an ARC but is funded by the government initially, with banks and other investors co-investing in due course.
- The presence of the government is seen as a means to speed up the clean-up process.
- Many other countries had set up institutional mechanisms such as the Troubled Asset Relief Programme (TARP) in the US to deal with a problem of stress in the financial system.
Pandemic and the NPAs
- Bad loans in the system are expected to balloon in the wake of contraction in the economy and the problems being faced by many sectors.
- The RBI noted in its recent Financial Stability Report that the gross NPAs of the banking sector is expected to shoot up to 13.5% of advances by September 2021, from 7.5% in September 2020.
- The report warned that if the macroeconomic environment worsens into a severe stress scenario, the ratio may escalate to 14.8%.