Bad Bank

In News: The proposed bad bank announced in the budget will likely be guaranteed by the government, but capital will have to be provided by lenders themselves

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.

Proposal of a bad bank:

• A bad bank buys the bad loans and other illiquid holdings of other banks and financial institutions, which clears their balance sheet. 
• The banking sector, led by the Indian Banks Association (IBA), had in May submitted a proposal for setting up a bad bank to the finance ministry and the RBI, proposing equity contribution from the government and the banks.
• This was based on an idea proposed by a panel on faster resolution of stressed assets in public sector banks headed by former PNB Chairman Sunil Mehta.
• This panel had proposed an asset management company (AMC), ‘Sashakt India Asset Management’, for resolving large bad loans two years ago.

What is the biggest challenge in setting up a bad bank?

• One challenge private sector ARCs face is that of capital. None of the entities till now has been allowed to tap the capital market for raising funds.
• Some central banks as well as government officials also admitted capital was the biggest challenge in setting up a ‘bad’ bank.
• 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.

Alternatives to a bad bank:

Many industry experts and government officials involved in economic policy-making argue that the enactment of IBC has reduced the need for having a bad bank, as a transparent and open process is available for all lenders to attempt insolvency resolution.

• As per latest available RBI data, as a percentage of claims, banks recovered on average 42.5% of the amount filed through the IBC in 2018-19, against 14.5% through the SARFAESI, 5.3% through Lok Adalats and 3.5% through Debt Recovery Tribunals. 
• The view is that an IBC-led resolution, or sale of bad loans to ARCs already existing, is a better approach to tackle the NPA problem rather than a government-funded bad bank.
• In a speech on February 21, 2017, on ways to resolve banks’ stressed assets, Former RBI Deputy Governor Viral Acharya proposed two models. 
• The first model is a private Asset Management Company (PAMC) which would be suitable for sectors where the stress is such that assets are likely to have economic value in the short run, with moderate levels of debt forgiveness.
• The second model is a National Asset Management Company (NAMC) for sectors where the problem is not just of excess capacity, but possibly also of economically viable assets in the short- to medium-term, such as in the power sector. 
• The NAMC would raise debt for its financing needs, keep a minority equity stake for the government, and bring in asset managers such as ARCs and private equity to manage and turn around the assets, he suggested, while arguing that these structures should not be termed as bad banks.