Insolvency and Bankruptcy Code

Government sets up ‘bad bank’ to clear the NPA mess

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Bad Banks

Mains level : Asset reconstruction initiaitives by the govt

Paving the way for a major clean-up of bad loans in the banking system, the Union Cabinet has cleared a ₹30,600-crore guarantee programme for securities to be issued by the newly incorporated ‘bad bank’ for taking over and resolving non-performing assets (NPAs) amounting to ₹2 lakh crore.

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 a 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.

Bad Banks to be established

  • The NARCL-IDRCL structure is the new bad bank.
  • The National Asset Reconstruction Company Limited (NARCL) has already been incorporated under the Companies Act.
  • It will acquire stressed assets worth about Rs 2 lakh crore from various commercial banks in different phases.
  • Another entity — India Debt Resolution Company Ltd (IDRCL), which has also been set up — will then try to sell the stressed assets in the market.

How will the NARCL-IDRCL work?

  • The NARCL will first purchase bad loans from banks.
  • It will pay 15% of the agreed price in cash and the remaining 85% will be in the form of “Security Receipts”.
  • When the assets are sold, with the help of IDRCL, , the commercial banks will be paid back the rest.
  • If the bad bank is unable to sell the bad loan, or has to sell it at a loss, then the government guarantee will be invoked.
  • The difference between what the commercial bank was supposed to get and what the bad bank was able to raise will be paid from the Rs 30,600 crore that has been provided by the government.

Will a bad bank resolve matters?

  • From the perspective of a commercial bank saddled with high NPA levels, it will help.
  • That’s because such a bank will get rid of all its toxic assets, which were eating up its profits, in one quick move.
  • When the recovery money is paid back, it will further improve the bank’s position.
  • Meanwhile, it can start lending again.

Why 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.
  • While commercial banks resume lending, the so-called bad bank, or a bank of bad loans, would try to sell these “assets” in the market.

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.

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