What is a bad bank? Can it help create good banks in India? Critically analyse. (250 Words)

Mentors Comment:

The idea of forming a ‘bad bank’ in India was initially floated in 2017 when the Economic Survey suggested setting up a Public Sector Asset Rehabilitation Agency (PARA). Along with it, RBI floated the idea of  PAMCs and NAMCs on the lines of Bad Banks. Therefore, it’s an important topic, given the challenge of NPA in our banking sector.

In the intro, discuss the challenges of NPA facing the banking sector in India.

The first part of the answer will discuss the bad bank and its salient features and how it is supposed to work.

Then discuss how it will be beneficial to commercial PSBs and what are the challenges that it will face. 

Provide various suggestions that can help for better functioning of bad banks and the banking sector overall. One important thing to remember is that bad bank is not the ultimate step for NPA challenge. It’s one of many steps and preferably the last step in that direction. The most important step that govt needs to take is better regulation, monitoring, and functioning of PSBs, capital infusion and structural reforms in the economy to tackle the NPA problem.

 

Answer:

The government of India is planning to set up a Bad Bank to rescue the banking system from the rising non-performing assets. The total stress in the Indian banking system is about Rs. 14 lakh crore, i.e., this is the amount for which loans have been given to industry and for which there is now no certainty of repayment. Public sector banks share a disproportionate burden of this stress.

What is Bad Bank:

  • A Bad Bank is an Asset Reconstruction Company (ARC). 
  • Once it is formed, banks divide their assets into two categories (a) one with non-performing assets and other risky liabilities and (b) others with healthy assets, which help banks grow financially.
  • ARC or Bad Bank buys bad loans from the commercial banks at a discount and tries to recover the money from the defaulter by providing a systematic solution over a period of time. 
  • The bad bank will manage these Non-Performing Assets in suitable ways, some may be liquidated, others may be restructured, etc.
  • RBI, too, came up with a suggestion to form two entities to clean up the bad loan problems ailing PSBs -PAMC (Private Asset Management Company) and NAMC (National Assets Management Company). 
  • PAMC would be formed by roping in banks and global funding companies. 
  • This would invest in areas where there’s a short-term economic viability. 
  • NAMC would be formed with government support, which would invest in bad assets with short-term stress but good chances of turnaround and economic benefit.

Benefits of setting up a bad bank

  • The major benefit of forming a bad bank is asset monetization. It’s the process of turning a non-revenue-generating item into cash.
  • Bad assets would stay in the risky category, while the good one stays in the other category, saving them from mixing together. 
  • Since 40% of the NPA is concentrated only in 60 firms, so better we create a centralized agency PARA, which will work as a Bad Bank and absorb the losses from the PSBs.
  • Since a bad bank specializes in loan recovery, it is expected to perform better than commercial banks, whose expertise lies in lending.
  • The recent IBC amendments make it complex for foreign players to take part in resolution. 
  • Experts believe a vehicle like AMC or ARC that could address the stressed loan issue, till the bankruptcy code stabilizes, could be beneficial. 
  • A single government entity will be more competent to take decisions rather than 28 individual PSBs.
  • Capacity building for a complex workout can be better handled by the government which has regulatory control and has management skill sets in public sector enterprises.
  • Foreign investors with both risk capital and risk appetite would be more in a government-led initiative, knowing that regulatory risks would stand considerably mitigated in various stages of resolution, including take-outs.

Challenges with Bad Bank:

  • A banking institution has to keep in mind its choices of assets to be transferred into the risky category, business case, portfolio strategy, and the operating model.
  • Each of these choices must be made while considering the impact on funding, capital relief, cost, feasibility, profits, and timing. 
  • The government support is also necessary to help banks understand regulatory and tax-related issues.
  • Once the NPA problem is settled, the Bankers may become complacent and again resume reckless lending.
  • A one-size-fits-all approach to designing a bad bank can be very expensive and less effective. 
  • At least Rs. 25,000 to Rs. 30,000 crore of capital will be required to set up a bad bank in the initial stages.

Way Forward:

  • Bad Bank should be based on a set criterion as any such exercise creates a moral hazard that should be eschewed.
  • There have to be strict performance criteria for the banks selling such assets. 
  • The criteria for buying assets should be transparent and a pecking order must be drawn up where probably the restructured assets get priority.
  • A competitive approach should prevail among the banks so that they work hard to qualify for the sale of bad assets to the bad bank. This, in fact, will ensure better governance standards too.
  • Set up a bad bank to deal with NPAs at some of the weaker PSBs, instead of one that picks up NPAs from all PSBs. 
  • It would prove less controversial if the government had a majority stake in it..
  • The government must infuse more capital into the better-performing PSBs. 
  • It must also create, through an act of Parliament, an apex Loan Resolution Authority for tackling bad loans at PSBs. 

The resolution of bad loans and restoring the health of PSBs is among the biggest challenges the economy faces today. It’s a challenge that requires a response on multiple fronts. A bad bank cannot be the sole response. The most efficient approach would be to design solutions tailor-made for different parts of India’s bad loan problem and use Bad Bank only as a last resort once all other methods fail.

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