Of what good is a bad bank? (UPSC Current Affairs)

Relevance: GS – Indian Economy & Issues Relating to Planning, Mobilization of Resources, Growth, Development & Employment-Banking Sector and NBFCs

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Why in the news?

• Finance Minister Nirmala Sitharaman stated that the National Asset Reconstruction Company (NARCL) and the India Debt Resolution Company (IDRCL) will take over and endeavor to resolve the first set of bad loans from banks.
• It's worth noting that the health of Indian banks' balance sheets has greatly improved in recent years, with their gross non-performing assets (GNPA) ratio falling from 11.2 percent in FY18 to 6.9 percent in Q2FY22.

What is a ‘bad bank’?

• A bad bank is a financial firm created to purchase non-performing assets (NPAs), or bad loans, from financial institutions.
• The goal of establishing a bad bank is to relieve banks of their burden by removing bad loans from their balance sheets and allowing them to lend to clients without restrictions again.
• Following the purchase of a bad loan from a bank, the bad bank may attempt to restructure and sell the non performing asset (NPA) to investors.
• A bad bank generates money if it can sell a loan for more than it paid for it when it bought it from a commercial bank.
• However, the major goal of a bad bank is not to make money; rather, it is to relieve banks of the burden of holding a big pile of stressed assets and encourage them to lend more aggressively.

Not a Novel concept

• The concept of a bad bank has already been tested in countries such as the United States, Germany, Japan, and others.
• The troubled asset rescue programme, better known as TARP, was designed around the concept of a bad bank and executed by the US Treasury in the aftermath of the 2008 financial crisis.
• During the financial crisis, the US Treasury purchased distressed assets such as mortgage-backed securities from US banks and later resold them when market circumstances recovered.

Challenges for bad banks

• When it comes to the bad bank, the majority of these problematic assets have already been completely funded and recorded on bank books.
• In addition, there is a significant risk of moral hazard ,commercial banks that have been bailed out by a bad bank are unlikely to change their practises. After all, the safety net provided by a bad bank encourages these banks to lend irresponsibly, exacerbating the bad loan situation.
• The most crucial aspect of these assets will be how banks arrive at a valuation for their transfer to the bad bank.
• The sale of stressed assets to potential buyers while also correcting the system's fundamental dilemma.
• Furthermore, public sector banks will be both stockholders and customers of the bad bank, posing the risk of the bad bank becoming nothing more than a conduit for transferring bad debt from one book to another.
• Former RBI governor Raghuram Rajan has been a vocal opponent of the notion, claiming that a government-backed bad bank would simply transfer problematic assets from public sector banks to a bad bank, which would then be owned by the government.
• Other analysts say that, unlike a bad bank established by the private sector, a government-backed bad bank will overpay for stressed assets.
• While this is excellent news for public sector banks that have been hesitant to take losses by selling off their poor loans at low rates, it is bad news for taxpayers who will once again be on the hook for bailing out insolvent institutions.
• We must not overlook the fact that a bad bank will not be able to prevent future NPAs

Benefits

• It will assist lenders in moving problematic assets to a bad bank and cleaning up their books.
• Banks will be able to re-start lending after the bad bank releases capital.
• It will be more goal-oriented, and thus better able to collect debts from borrowers.
• It is believed that establishing a bad bank can assist in the consolidation of all bank bad debts into a single exclusive business.
• Because it is backed by the government, it will not be hampered by governance flaws, a slow-moving legal system, or poorly constructed regulations, among other concerns that plague ARCs.
• Overall, it will provide a significant boost to the macroeconomic environment.

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