Bad Bank

Bad Bank

News: Recently, the Ministry of Finance has announced that the National Asset Reconstruction Company (NARCL) along with the India Debt Resolution Company (IDRCL) will take over the first set of bad loans from banks and try to resolve them.

About:
• A bad bank is a financial entity set up to buy Non-Performing Assets (NPAs), or Bad Loans, from banks. The aim of setting up a bad bank is to help ease the burden on banks by taking bad loans off their balance sheets and get them to lend again to customers without constraints.
• After the purchase of a bad loan from a bank, the bad bank may later try to restructure and sell 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 what it paid to acquire the loan from a commercial bank.
• However, generating profits is usually not the primary purpose of a bad bank - the objective is to ease the burden on banks, of holding a large pile of stressed assets, and to get them to lend more actively.

Advantages:
• Single Entity - It can help consolidate all bad loans of banks under a single exclusive entity. The idea of a bad bank has been tried out in countries such as the U.S., Germany, Japan and others in the past.
• Availability of Free Capital - By taking bad loans off the books of troubled banks, a bad bank can help free capital of over Rs 5 lakh crore that is locked in by banks as provisions against these bad loans. This will give banks the freedom to use the freed-up capital to extend more loans to their customers.
• Improving Capital Buffer - It can help improve bank lending not by shoring up bank reserves but by improving banks’ capital buffers. To the extent that a new bad bank set up by the government can improve banks’ capital buffers by freeing up capital, it could help banks feel more confident to start lending again.

Limitations:
• Mere Transfer of Ownership - Bad bank backed by the government will merely shift bad assets from the hands of public sector banks, which are owned by the government, to the hands of a bad bank, which is again owned by the government. There is little reason to believe that a mere transfer of assets from one pocket of the government to another will lead to a successful resolution of these bad debts when the set of incentives facing these entities is essentially the same.
• Moral Hazard - Commercial banks that are bailed out by a bad bank are likely to have little reason to mend their ways. After all, the safety net provided by a bad bank gives these banks more reason to lend recklessly and thus further exacerbate the bad loan crisis.
• Lack of Incentives to manage the crisis - Unlike private banks, which are owned by individuals who have strong financial incentives to manage them well, public sector banks are managed by bureaucrats who may often not have the same commitment to ensuring these lenders’ profitability. To that extent, bailing out banks through a bad bank does not really address the root problem of the bad loan crisis.