Bad Bank

Bad Bank is a financial entity that purchases Non-Performing Assets (NPA) or bad loans from banks. In this article, you will learn definition, history, concepts, advantages, disadvantages, providing key insights for GS Paper-III Economy section of UPSC IAS Exam.

Table of Content

• Table of Content              
• What is a Bad Bank?      
• History of Bad Banks in India:     
• Why Do We Need Bad Banks in India?    
• Bad bank in India             
• Advantages of Bad Banks:            
• Disadvantages of Bad Banks:      
• Conclusion         
• Frequently Asked Questions       
• Reference           

What is a Bad Bank?

• Bad Bank is a financial entity or an Asset Management Company (AMC) or Asset Reconstruction Company (ARC) established to purchase Non-Performing Assets (NPA) or bad loans from banks.
• It helps to relieve banks from the burden of bad loans by taking their bad loans off their balance sheets and allow them to start lending again to customers without constraints. 
• The bad bank then tries to restructure by selling the NPA to investors who might be interested in purchasing it. 
• A bad bank makes a profit in its operations if it manages to sell the loan at a price higher than the amount paid to acquire the loan from a commercial bank.
  • Generating profits is not the primary purpose of a bad bank.

History of Bad Banks in India:

• In 1988, Mellon Bank in the US has pioneered the establishment of the first bad bank to handle its troubled assets.
• The concept of bad bank has spread from the US to various European countries including Sweden, Finland, Germany, and France, among others.
• In India, the Indian Banking Association (IBA) has proposed the concept of a bad bank to the Reserve Bank of India (RBI) and the Ministry of Finance.
  • However, due to a lack of consensus on its effectiveness, it had remained at the prototype stage in India.

Why Do We Need Bad Banks in India?

• In India, there is a significant number of loans that borrowers are unable to repay within the agreed timeframe.
• These loans are considered assets for banks, as the interest paid by borrowers serves as income for the banks.
• When a borrower declares their inability to repay, the loan becomes a NPA or bad debts i.e., it no longer generates any income.
• This situation is widespread across many banks and the entire borrowing population of India.
• Governments have injected fresh capital into banks on a yearly basis, yet the number of defaults has increased.

Bad bank in India

• The proposed name for the bad bank in India is National Asset Reconstruction Ltd (NARC).
• NARC will function as an asset reconstruction company that will sell the distressed loans to buyers who specialize in acquiring debt from financially troubled or bankrupt companies.
• To facilitate the sale of these stressed assets, the government has established India Debt Resolution Company Ltd (IDRCL).
• IDRCL will be responsible for attempting to sell these assets in the market.
• Once the stressed asset is sold, the respective bank will receive the payment in instalments.
• In the event the bad bank is unable to sell the stressed loan at a profit or is unable to sell it at all, the government will cover those losses through guarantee.

Advantages of Bad Banks:

• The bank prevents non-performing assets from affecting the good loans by separating the bad loans from the rest.
• When these two types of loans are kept together, stakeholders cannot accurately assess the financial health and performance of the banks.
  • This hinders lending, trading, borrowing, and capital raising activities.
• By establishing a new bank that recovers non-performing assets, the process of loan recovery will become faster.
  • The specialized nature of this bad bank will contribute in quicker loan recoveries.
• Bad bank alleviates the burden of bad loan recovery from the original bank, which can then focus on its primary business.
• Bad banks can generate profits by maintaining a high margin before acquiring NPA.

Disadvantages of Bad Banks:

• Several factors need to be considered before initiating the transfer of bad loans to a specialized bank such as organizational, structural, and financial aspects, leading to trade-offs that impact the bank’s liquidity, profitability, and overall balance sheet.
  • If these decisions turn out to be incorrect, both the bad bank and its owners will face significant losses.
• Bad bank may choose not to acquire the more challenging loans from other banks by focusing on those loans that are easier to recover.
• There is a possibility that the bank providing the loan may misrepresent or manipulate information, engage in window dressing tactics to conceal the actual condition of the loan account when transferring it to the acquiring bank.
• The meagre amount of margin charged by bad banks to acquire NPA may limit the profitability of the bank originating the loan.
• Commercial banks that are bailed out by a bad bank are less likely try to manage their ways of lending. 
• Bad banks as holders of toxic assets, are susceptible to political interference from politicians that supports chronic debtors.

Conclusion

A robust legal system is essential for the establishment and operation of bad banks. Therefore, a regular bank can only implement a viable and dependable good bank-bad bank scheme if the necessary laws have been enacted. The creation and operation of bad banks incur substantial costs, including transferring toxic assets, restructuring them, and ultimately disposing of them. Many of these costs can be avoided if the toxic assets remain with the regular bank itself. ARC will help to tackle bad loans or bad debts of Indian banks, who can then use this capital to keep running the economy.

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FAQs(Frequently Asked Question)