idea-of-creating-a-bad-bank-need-and-significance-summary

Context: Recently, the Reserve Bank of India (RBI) Governor has agreed to look at the proposal for the creation of a bad bank.

More on the news: 

  • The idea of setting up a bad bank to resolve the growing problem of non performing assets (NPAs) or bad loans, is under consideration since long back. 
  • The commercial banks are expected to witness a spike in NPAs further, in the wake of the contraction in the economy as a result of the Covid-19 pandemic.

A bad bank:

  • About: 
    • An asset reconstruction company (ARC): Technically, a bad bank is an ARC or an asset management company that takes over the bad loans of commercial banks, manages them and finally recovers the money over a period of time. 
      • A bad loan or a bad debt is an amount owed to a creditor that is unlikely to be paid or which the creditor is not willing to take action to collect because of various reasons.
    • Not involved in lending and taking deposits: But helps commercial banks clean up their balance sheets and resolve bad loans. 
  • Need for a bad bank: 
    • Hidden bad loans: An asset quality review (AQR) of banks (during Raghuram Rajan’s tenure as RBI Governor) found that several banks had suppressed or hidden bad loans to show a healthy balance sheet. 
    • ARCs have not made any impact: In resolving bad loans due to many procedural issues. 
    • The pandemic hitting the banking sector: In its Financial Stability Report, the RBI noted that the gross NPAs of the banking sector are expected to shoot up to 13.5% of advances by September 2021, from 7.5% in September 2020.
    • A professionally-run bad bank: Funded by the private lenders and supported by the government, can be an effective mechanism to deal with NPAs. 
  • Proposal for the bad bank:
    • The Indian Banks Association (IBA): Had submitted a proposal (in May 2020) to the finance ministry and the RBI. 
      • The proposal was for setting up a bad bank with equity contributions from the government and the banks.
    • Sunil Mehta panel: The above proposal was based on an idea of the panel for the faster resolution of stressed assets in public sector banks.
      • The panel had proposed an asset management company (AMC), ‘Sashakt India Asset Management’, for resolving large bad loans two years ago.
  • Government’s proposal: Following three steps are seen as adequate to tackle the challenge of bad loans by the government -
    • Asset reconstruction company: The bad loan resolution should happen in a market-led way, as there are many asset reconstruction companies already operating in the private space.
    • Capital infusion drive: In the last three financial years, the central government has infused equity of Rs 2.65 lakh crore into state-owned banks.
    • Insolvency resolution under the IBC: Insolvency and Bankruptcy Code (IBC), 2016 provides a time-bound process for resolving insolvency in companies and among individuals.

Way ahead:

  • Recommendations of Viral Acharya (former RBI Deputy Governor):
    • It would be better to limit the objective of these asset management companies to the orderly resolution of stressed assets. 
    • Two models to solve the problem of stressed assets -
      • A private asset management company (PAMC): Which is said to be suitable for stressed sectors where the assets are likely to have an economic value in the short run. 
      • National Asset Management Company (NAMC): Which would be necessary for sectors where the problem is not just one of excess capacity but possibly also of economically unviable assets in the short to medium terms. 
  • Presence  of the government to speed up the clean-up process: The bad bank is funded by the government initially, with banks and other investors coinvesting in due course. 
    • The presence of the government is seen as a means to speed up the clean-up process. 
  • Former RBI Governor Raghuram Rajan: Had opposed the idea of setting up a bad bank in which banks hold a majority stake. If the bad bank were in the public sector, the reluctance to act would merely be shifted to the bad bank. 

Asset reconstruction company:

  • It is a special type of financial institution that buys the debtors of the bank at a mutually agreed value and attempts to recover the debts or associated securities by itself. 
  • The asset reconstruction companies or ARCs are registered under the RBI and regulated under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI Act, 2002). 
  • The ARCs take over a portion of the debts of the bank that qualify to be recognised as Non-Performing Assets.