Almost a year on, bad bank yet to take off

• Six months after the setting up of the National Asset Resolution Company Limited (NARCL), the proposal for setting up a ‘bad bank’ — a key reform measure of the Budget — is yet to take off.
• The impediments include issues arising from the ownership structure and operational mechanism, with the proposed setting up of two separate entities — the NARCL and the India Debt Resolution Company Limited (IDRCL).
• The Reserve Bank of India’s (RBI’s) approval for the implementation of this dual structure is still awaited.
• The RBI has now indicated that both the acquisition and resolution should be housed under the same legal entity.
• Accordingly, the NARCL and the IDRCL are reworking the arrangement under which both the processes will be under the former’s control.

About

• The NARCL has been set up and issued a license by the RBI to conduct business as an Asset Reconstruction Company.
• Simultaneously, a separate company has been set up to function as an Asset Management Company, named IDRCL, which will provide management and resolution of assets and also help in the operational aspects, relating to price discovery and aim at evolving the best possible recovery and the resolution process.
• The NARCL is majorly owned by public sector banks with 51 percent ownership but in the case of the IDRCL, 51 percent shares are in private hands.

Bad Banks

• A bad bank is simply an entity that specializes in handling bad loans or NPAs.
• It is basically an entity that buys the NPAs of commercial banks and tries to recover at least a part of the value of such NPAs.
• Usually, banks discount the book value of NPAs when they are transferred to a bad bank.
• After that, whatever recovery is possible from the bad loan, becomes the earnings of the bad bank.
• Unlike commercial banks, the bad bank does not undertake deposits, lending, or other usual banking operations.
• Another name for a bad bank is Asset Reconstruction Company (ARC).
• It is a company that buys the bad loans of banks or any other financial institution, to let them clear their books and resume lending.

How do bad loans affect the economy?

• Provisioning: The chief occupation of banks is the business of taking deposits from the savers and lending to the needy.
• This also constitutes its major source of income in the form of bank spread (bank spread is the difference between the interest bank charges from its borrowers and the interest it pays to its depositors).
• Now, bad loans lead to banks’ having to save a part of their operating revenue to account for bad loans.
• This is called Provisioning. The technical term used for provisioning is Capital Adequacy Ratio (CAR) or Capital to Risk (weighted) Assets Ratio (CRAR).
• Loss of Operating earnings: As stated above, banks are required to provision for bad loans out of their operating income.
• This means lesser availability of capital for future lending requirements.
• Since lending constitutes the major source of earning for the banks, therefore, lesser leading ultimately leads to lesser profits.
• Loss of sentiment: Financial sector comprises a significant proportion of share markets.
• Any reduction in the perceived valuation of the banks might lead to loss of share value of the banks, leading to general downfall in the share markets.
• This could result in wiping out of shareholders’ wealth from the financial markets.

Rationale for a bad bank

• Free up resources: A bad bank can take over the bad loans of the bank, thereby freeing up the bank from the provisioning requirements.
• Incremental lending: Banks take advantage of the fact that a major portion of the deposits lies dormant in the bank accounts. This deposit can be used towards lending. Therefore, the more money banks have, the more they can advance to the needy. This is useful for the revival of the credit cycle and boosting investments in the economy.
• Specialisation: A bad bank would be specialized in maximizing the recovery out of a bad loan, as this would be its primary task. In contrast, banks are not in the business of recovery, therefore, their capability to resolve the loans is minimal.
• Economic slowdown: Reports have pointed to a potential increase in stressed assets due to the economic slowdown in India. Combined with the COVID-induced lockdown, this may create a situation in which the NPAs might increase to an unsustainable limit. To resolve such a situation, it is pertinent to be proactive and try to work out a solution that can be optimized to reverse the effects of the slowdown in the country.
• Improved sentiment: Industry needs to come out of the crisis it is facing if India is serious about its stated goal of a $5 trillion economy. This requires a bullish sentiment in the economy. A bad bank can provide such an impetus to the industry by freeing up the books of banks.
• Lesser need for recapitalization of banks: With the formation of a bad bank, it is expected that this amount can be utilized elsewhere, including towards public welfare and infrastructure creation.

Issues associated with the bad bank

• Shifting the problem: A bad bank is expected to take over the debts of commercial banks under itself. However, to what extent it will be successful in resolving the NPA crisis is not clear. * Haircut for the banks: When the bad loans are being taken over by a bad bank, the banks are expected to transfer such a loan at a discount to its original value. Also, banks have been cautious of taking big haircuts because of the scrutiny from the 3 Cs (CBI, CVC, and CAG).
• Losses for the banks: The haircuts taken by the banks would reflect on its profit and loss account and affect its profitability. This might raise questions on both the management of the bank as well as its decision-making regarding both earlier and future haircuts.
• Fear of unethical practices: Since there would be pressure on the bad bank to perform, it is possible that the employees might turn towards unethical practices to boost recovery out of a bad loan.
• Initial funding: Indian Banks’ Association has suggested an initial outlay of ₹10,000 crores for setting up a bad bank. In times of global recession as well as COVID-induced lockdown, this might prove to be tricky for the government as it is already pressed to provide for increased healthcare and vaccine procurement costs, while at the same time, constrained by decreasing revenues due to a general fall in the level of economic activity and tax payouts.

Way Forward

• Improve the fundamentals: Experts have consistently pointed to the need for improving the examination process during the initial stages of the lending process.
• Asset Quality Review: While the spike in NPAs was a result of RBI-mandated Asset Quality Review, it is to be understood that the process was a mere recognition of the extent of the problem facing the financial sector of India.
• Firm steps required to address the crisis: The Government has emphasized the ‘4R strategy’ to yield results in the resolution of the NPA crisis. It constitutes recognition of NPAs, Resolution of bad loans and recovery of value from the assets, Recapitalisation of the banks by the government, and Reforms in the banking sector.
• Apart from that, the government has also come up with various other schemes like the Indradhanush plan and Gyan Sangam (meeting between government officials and the bank officials to understand and resolve the issues plaguing the banking sector.

Conclusion

• Despite its potential benefits, the concept of a bad bank has its own limitations.
• Therefore, the need of the hour is to strengthen the fundamentals of the economy in the first place and emphasize better banking practices.
• At the same time, it would be a fallacy to pin all hopes on the new institution.
• It is important to give it due time whenever it is created and let it create its own path towards the resolution of the NPA crisis facing the country.