While the problem of bad loans has been a perennial one in the Indian banking sector, the COVID-19 pandemic-triggered lockdown last year and the moratorium subsequently extended to borrowers by the Reserve Bank of India (RBI) have worsened the crisis. With banks expected to report even more bad loans this year, the idea of a ‘bad bank’ has gained particular significance.
- What is a bad bank?
- Stress test and NPAs in banks
- Pros and cons of Bad Banks
- Revival of credit flow post covid
What is a Bad Bank?
- A bad bank is a financial entity set up to buy non-performing assets (NPAs), or bad loans, from banks and other financial institutions
- Technically, a bad bank is an Asset Reconstruction Company (ARC).
- Once it is formed, banks divide its assets into two categories — one with non-performing assets and other risky liabilities and the other with healthy assets, which help banks grow financially.
- The aim of setting up a bad bank is to help ease the burden on banks by taking bad loans off their balance sheets and get them to lend again to customers without constraints.
- After the purchase of a bad loan from a bank, the bad bank may later try to restructure and sell the NPA to investors who might be interested in purchasing it.
- The objective is to ease the burden on banks, holding a large pile of stressed assets, and to get them to lend more actively.
- A bad bank makes a profit in its operations if it manages to sell the loan at a price higher than what it paid to acquire the loan from a commercial bank.
- However, generating profits is usually not the primary purpose of a bad bank
RBI Stress Test and NPAs in Banks:
- The idea of a bad bank gathered momentum after the RBI’s latest Financial Stability Report (FSR).
- According to RBI, the total size of bad loans in the balance sheets of Indian banks has declined over the last few years. NPAs at a gross level was just around ₹9 lakh crore as of March 31, 2020, down significantly from over ₹10 lakh crore two years ago.
- But, analysts point out that it is mostly the result of larger write-offs rather than due to improved recovery of bad loans or a slowdown in the accumulation of fresh bad loans.
- The size of bad loan write-offs by banks has steadily increased since the RBI launched its asset quality review procedure in 2015, from around ₹70,000 crore in 2015-16 to nearly ₹2.4 lakh crore in 2019-20.
- Also the size of fresh bad loans accumulated by banks increased last year to over ₹2 lakh crore from about ₹1.3 lakh crore in the previous year.
- So, the Indian banking sector’s problems seem to be far from over.
- Further, due to the lockdown imposed last year, the proportion of banks’ gross non-performing assets is expected to rise sharply.
- FSR said that macro stress tests indicate that the GNPA ratio of all scheduled commercial banks may increase from 7.5 per cent in September 2020 to 13.5 per cent by September 2021 under the baseline scenario.
- The GNPA ratio may escalate to 14.8 per cent under a severe stress scenario. This highlights the need for proactive building up of adequate capital to withstand possible asset quality deterioration
Global examples of Bad Banks:
- The idea of a bad bank has been tried out in countries such as the United States, Germany, Japan and others in the past.
- The troubled asset relief program, also known as TARP, implemented by the U.S. Treasury in the aftermath of the 2008 financial crisis, was modelled around the idea of a bad bank.
- Under the program, the U.S. Treasury bought troubled assets, such as mortgage-backed securities, from U.S. banks at the peak of the crisis, and later resold them when market conditions improved.
- According to reports, it is estimated that the Treasury through its operations earned nominal profits.
Pros and cons of Bad Banks:
Advantages in setting up a bad bank are as follows:
- It helps to consolidate all bad loans of banks under a single exclusive entity.
- The burden of recovering those loans is reduced for the stressed banks and financial institutions.
- It can also help revive credit flow in the economy. By taking bad loans off the books of troubled banks, a bad bank can help free capital of over ₹5 lakh crore that is locked in by banks as provisions against these bad loans. This will give banks the freedom to use the freed-up capital to extend more loans to their customers.
- It could help banks feel more confident to start lending again.
- As Bad banks main work is recovery they are specialised in that. So, the speed of recovery will be more.
- Bad banks can make profits as they usually keep a higher margin before acquiring the bad loans.
Many critics have pointed to several problems with the idea of a bad bank to deal with bad loans. They argue that :
- A bad bank backed by the government will merely shift bad assets from the hands of public sector banks to the hands of a bad bank, both of which are owned by the government.
- A mere transfer of assets from one pocket of the government to another will not lead to a successful resolution of the bad debts
- a bad bank backed by the government is likely to pay too much for stressed assets. It is bad news for taxpayers, who will once again have to foot the bill for bailing out troubled banks.
- If Banks know that poor decisions could lead to a bad bank bailout, they may take undue risks. Thus, the creation of the Bad Bank could lead to Moral Hazard.
- The safety net provided by a bad bank gives these banks more reason to lend recklessly, and thus, further worsen the NPA crisis.
Revival of credit flow post covid
- Some experts believe that a bad bank can help free capital of over ₹5 lakh crore that is locked in by banks as provisions against the bad loans.
- This will give banks the freedom to use the freed-up capital to extend more loans to their customers.
- This gives the impression that banks have unused funds lying in their balance sheets that they could use if only they could get rid of their bad loans.
- However, banks’ reserve requirements for their capital position need to be taken into account while assessing the credit flow situation.
- This is because the cause of lack of aggressive lending by banks may not the lack of sufficient reserves which banks need to maintain against their loans.
- Instead, it may simply be the precarious capital position that many public sector banks find themselves in at the moment.
- In fact, many public sector banks may be considered to be technically insolvent.
- An accurate recognition of the true scale of their bad loans would show their liabilities as far exceeding their assets.
- So, a bad bank could help improve bank lending by improving banks’ capital buffers.
- To the extent that a new bad bank set up by the government can improve banks’ capital buffers by freeing up capital, it could help banks feel more confident to start lending again.
Mould your thought: What is a Bad Bank? Identify the pros and cons of establishing a Bad Bank in Indian context.
Approach to the answer:
- Define Bad Bank
- Write about the NPA crisis and stress test results
- Discuss the advantages of Bad Bank
- Mentions the disadvantages