Course Correction for the Bad Bank

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Last Updated21/01/2022

The problem stems from a two-company setup: a PSB-controlled asset reconstruction business (ARC) acting as the bad bank, and a private sector company tasked with collecting bad loans and identifying credible investors to help distressed borrowers.
PSBs want RBI to recognise, perhaps even regulate, the private company so that loan resolution deals aren’t questioned by agencies like the CBI.
But the law does not provide for RBI regulation of a private company that resolves loans without being an ARC.

A bad bank is a company that acts as an aggregator of bad loans or non-performing assets (NPAs) and buys them at a discount from banks all over the country, then attempts to recover and resolve them.
These loans are classified as non-performing and are either about to fail or have already done so. Bad loans have a detrimental influence on a bank's balance sheet.
The bad bank functions similarly to an Asset Reconstruction Company (ARC), in that it absorbs bank debts and manages them to recover as much money as possible.

Economic Upheavel: With the epidemic affecting the banking industry, the RBI is concerned about combating the economic downturn which could result in an increase in bad loans.
Role of Government: Professionally administered bad banks, supported by the government and funded by private lenders, can be an excellent tool for dealing with non-performing assets (NPA).
Rising NPAs: According to the RBI's latest Financial Stability Report, gross NPAs in the banking industry are predicted to rise to 13.5 percent of advances by September 2021, up from 7.5 percent in September 2020.
International Examples: Many other countries had put in place institutional mechanisms to deal with the financial system's stress.

Mobilising Capital: Finding buyers for bad assets in a pandemic-affected economy will be difficult, especially when governments are grappling with the issue of fiscal deficit reduction.
Not Addressing the Underlying Issue: Shifting loans from one government pocket (public sector banks) to another.
Market determined Prices: Price discovery will not occur since the price at which bad assets are transferred from commercial banks to the bad bank will not be market-determined.
Moral Hazard: Former RBI Governor Raghuram Rajan stated that a bad bank might create a moral hazard, allowing banks to pursue risky lending practises without any commitment to eliminate nonperforming assets (NPAs).

So long as public sector bank managements are subservient to politicians and bureaucrats, they will continue to lack professionalism, and prudential lending standards will suffer.
As a result, while having a bad bank is a fine concept, the primary challenge is addressing the underlying structural problems in the banking sector and proposing appropriate adjustments.