- GS 3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.
- Recently, Ministry of Finance has launched a Bad Bank for stressed assets as a measure to clean up bank books.
What is a bad bank?
- It is place like an Asset Reconstruction Company (ARC) where a struggling financial institution can put assets it wants off its own books to eventually sell or unwind.
- Bad Bank then takes such bad loans, manages them and finally recovers the money.
- Unlike commercial banks, bad bank is not involved in lending and taking deposits.
- Many global lenders set up such divisions after the 2008 financial crisis.
- In 1988, US-based Mellon Bank created the first bad bank after which the concept was replicated in many developed and developing countries.
- Last year, China appointed a new state-owned bad-loan manager to overcome the ill-effects of the pandemic.
- Even in India, it is not a new concept.
- Under the SARFAESI Act, 2002, ARCs were created to buy bad loans from banks and recover cash from the defaulted borrowers.
How it will work?
- Banks will, at first, transfer those assets to the said bad bank with a 100% provision on its book and then, based on their experience, they will decide on transferring assets with less than 100 per cent provisioning at a later date.
- It is being envisaged that out of the total amounts recovered, certain percentage will be in the form of security deposits.
- Although these receipts will reside in the bank balance sheets, they will bear a zero-risk weight, and will carry full government guarantee for a specified period of time.
- It helps expedite the process of debt restructuring by reducing the number of lenders who must agree to a proposed deal.
- It makes easier for foreign funds to build controlling positions in the debt of a firm by allowing them to negotiate with a single seller.
- placing non-core assets in a separate division can help the process of restructuring become more efficient and transparent as it will provide investors with financial disclosures to better track the progress of a lender’s overhaul and hold management accountable.
- Putting the assets in the bad bank frees up capital that can be used to bolster a firm’s financial strength or be redeployed to more profitable businesses.
- In case it is a separate entity, it can also allow a bank to clean up its balance sheet, stem losses and protect its depositors.
- Creation of bad bank is more like shifting the problem rather than solving it. Creating bad bank without governance reforms in banking sector will not give the desired result.
- Government, from time to time, infuses money through bank capitalisation to compensate the write-offs. In such a situation, the reason for the creation of bad bank is unjustified.
- The price at which bad banks will buy the bad loans will not be market-determined. It will inhibit price discovery.
- Banks will continue reckless lending practices, without any commitment to reduce NPAs. It might create a moral hazard in the economy.
- Creation of a bad bank is a necessary but not sufficient measure to reform the banking sector. It must be supported by other governance measures to help banking sector contribute more to the economy.