In the recent budget proposed by Finance Minister Nirmala Sitaraman, the establishment of Bad Banks has been announced. This aims to resolve the NPA issues mounting up amongst Public sector banks for the last two decades.

This article provides information on NPAs, Bad Bank – concept, merits, and demerits.

A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets and a banker is a person who deals with others’ money.  

Non-Performing Assets and Bad Bank

Bank accepts deposits from the depositors, who will receive interest as an incentive, and this money, in turn, will be lent as a loan for the development of the nation and the wellbeing of the general public.

As it is the institution absorbing the excess liquidity and lending it for growth and wellbeing, it is playing a significant role in maintaining financial stability in the economy and growth of the country.

What is NPA?

Deposits received from depositors will be used by banks for lending activities, and these loans are assets to the banks, as banks are to receive principal and interest on it.

Money or Assets provided by banks to companies or individuals as loans, sometimes remain unpaid by borrowers. This becomes Non-Performing Assets to the banks, it is not generating any revenue.

A Non-Performing asset (NPA) is a loan or advance for which the principal or interest payment remained overdue for a period of 90 days. It is also called bad assets or bad loans.

Issues of NPA in the Indian Banking System

The stockpile of bad loans has had cascading effects on the economy at large. Stressed assets of banks are making it difficult for new lending, which constrains new investments and projects that can drive the growth of the economy.

It also raises the cost for the government to finance the public sector banks. High Non-Performing Assets reduces the profitability of banks, which forces them to increase lending rates to maintain their profitability.

Also, high-interest rates are a mirage for an individual’s affordability in the inflated economy, ultimately downturns the growth of the economy. Public sector banks account for 90% of the total NPA in India, with private sector banks accounting for the remainder.

A solution to this was proposed in India’s economic survey report 2017, chief economic advisor Arvind  Subramanian, who had suggested the creation of a public sector asset rehabilitation agency that will work as a bad bank to absorb the losses from the public sector banks.

Bad Bank

A bad bank is technically an Asset Reconstruction Company that buys bad loans from the commercial banks at a discount from its book value and the original bank or the institution may clear the balance sheet after transferring those assets.

It tries to recover the money from the defaulter by providing a systemic solution to the mounting up issues. It relieves the stress of banks in recovering loans and banks can focus on lending activities.

Recently RBI governor Shashikant Das agreed to the proposal for the creation of a bad bank to curb the spike in bad loans or non-performing assets in the wake of contraction in the economy as a result of the COVID-19 pandemic.

RBI noted in its recent financial stability report that the gross NPAs are expected to shoot up to 13.5% of advances by September 2021, which was 7.5% in September 2020. And in the budget proposed on February 1^st, 2021 by Finance Minister Ms. Nirmala Sitaram, the establishment of Bad Bank is announced.

In the global landscape, the concept of Bad bank was conceived and implemented initially by Mellon bank in 1988. This concept is widely used in Finland, Ireland, France, Belgium, etc.

In the USA as a part of the economic stabilization act of 2008, a bad bank was suggested to address the subprime mortgage crisis.

Points differentiating Bad bank from a normal bank

• Banks are financial institutions that act as intermediaries between people with surplus money and who need funds. But Bad banks are entities floated to recover Non-Performing Assets of all Public sector banks. This institution does not engage in receiving deposits or lending credit like a normal bank. The function of bad banks begins once loans lent by banks turn irrecoverable.
• Banks perform various other services like insurance, safe custody, depository services, etc to their customers required for smooth functions of the economy. Whereas bad banks do not offer any such services to retail customers.

Merits of Bad Bank

1. Speed recovery of loans: Bad Bank is a specialized institution formed with the main purpose of the recovery of the non-performing loans, so it escalates the speed of recovery of non-performing assets and thereby ensures funds for economic growth.
2. Focus on main business: With the creation of such a bank, the burden of recovery of bad loans will be reduced from the original bank’s side, which can then focus on its main business and credit growth.
3. Smooth flow of operation: Bad bank purchases NPAs at a discount from its book value, which brings liquidity to conduct smooth operations in the bank.
4. Reduces cost of funding: Recovery of bad loans reduces the cost of finance to the government.
5. Clean Balance Sheet: This also cleans up the balance sheet of the original bank boosting confidence of its stakeholders.

Demerits of Bad bank

1. Ambiguity in the implantation: The idea of creating such a bank for managing the bad loan is a simple one, but in practicality, it is quite complicated. Many factors like funding of bad banks, structure, functions, and operational boundaries are to be decided.
2. Mode of investment: All these days through Equity mode, the Government of India has directly funded in Public Sector banks. The effect of bad banks on the profitability of banks is also required to be considered before the implementation of the concept in India. Funding and recapitalization of these banks are also questionable.
3. Moral hazard: Former RBI Governor Raghuram Rajan claims that it may lead to moral hazard, enabling banks to continue with their reckless lending practices. Banks may fund projects that may not be viable to promote credit growth.
4. Unethical recovery practices: Liquidity, profitability, risk, capital, recovery all these factors essential for survival, may force bad banks to follow unethical practices in the recovery process.
5. Focus only on easy recoverable loans: It is possible that such a bank may not go for acquiring the critical loans of the other bank, which are somehow difficult to recover for it and may concentrate only on acquiring the easily recoverable loans.
6. Curtails profits: Acquiring Nonperforming Assets at a discount value from its book value may curtail the profits of the original bank.

Closing Thoughts

The concept of a bad bank appears lucrative but has several roadblocks in the implementation process. Multidimensional analysis is required to decide on Private Public Participation, organizational, structural, functional, and financial aspects as it affects the liquidity, risks, and profitability of banks.

The greatest challenge would be to find buyers for bad assets in a pandemic hit economy. Therefore, a policy of the government should aim at not only cleaning up balance sheets of PSUs but also resolve long-standing liquidity and profitability issues faced by banks to accelerate growth in the post COVID era.