Bad Bank- UPSC Current Affairs

Bad Bank

Today’s edition of the Current Affairs Dialog box comprises a discussion on Bad Bank. Navigate through this article to get valuable insights on the topic and enhance your UPSC CSE preparation.

Its relevance to the UPSC CSE syllabus is listed below:

For Prelims: Economic and Social Development-Sustainable Development, Poverty, Inclusion, Demographics, Social Sector Initiatives, etc

For Mains: Indian Economy and issues relating to Planning, Mobilisation of Resources, Growth, Development and Employment

Why in the News?

Recently, the Finance Minister 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.

Probable Question

The creation of a bad bank to tackle Non- Performing Assets (NPAs) is a step in the right direction if backed by long-due governance reforms in Public Sector Banks. Comment.

The Genesis of the Idea of Bad Bank

  • The troubled asset relief program, also known as TARP, implemented by the U.S. Treasury in the aftermath of the 2008 financial crisis, was modelled around the idea of a bad bank. 
  • Under the program, the U.S. Treasury bought troubled assets such as mortgage-backed securities from U.S. banks at the peak of the crisis and later resold it when market conditions improved. 
  • It is estimated that the Treasury through its operations earned a nominal profit of anything between $11 billion to $30 billion, although some contest these figures.

Also read: The International Liquid-Mirror Telescope (ILMT)

Indian Context

  • In Budget 2021-22, the Government announced the setting up of a National Asset Reconstruction Company (a bad bank) and India Debt Resolution Company Ltd (IDRCL) as part of the resolution of bad loans. 
  • NARCL proposes to acquire stressed assets of about Rs. 2 Lakh crore in phases within extant regulations of RBI. 
  • It intends to acquire these stressed assets through 15% Cash and 85% in Security Receipts (SRs).

Need for NARCL-IRDCL Framework

  • Existing Asset Reconstruction Companies (ARCs) have been helpful in the resolution of stressed assets, especially for smaller value loans. Various available resolution mechanisms, including Insolvency and Bankruptcy Code, have proved to be useful.
  • However, considering the large stock of NPAs, additional options/alternatives are needed which led to the creation of the NARCL-IRDCL framework in Union-Budget 2021-22.

About Bad Bank

  • A bad bank is a financial entity set up to buy non-performing assets (NPAs), or bad loans, from banks. 
  • Aim: To ease the burden on banks by taking bad loans off their balance sheets and getting 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.
  • Technically, a bad bank is an asset reconstruction company (ARC) or an asset management company that manages bad loans of commercial banks and finally recovers the money over a period of time. 
  • It is not involved in lending and taking deposits.

Pros

  • One of the key ideas behind formation of bad banks is to de-stress the balance sheets of the banks. 
  • Once Non-Performing Assets are taken over by bad banks; Commercial banks  will be in a position to lend more to consumers. 
  • Moreover, in India, a large portion of NPAs is with the government-owned public sector banks. 
    • In the past, the Government had to infuse fresh capital to prove the financial health of PSBs. The government infusing fresh capital in PSBs means less money for other schemes. 

Cons

  • A 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. 
  •  Unlike a bad bank set up by the private sector, a bad bank backed by the government is likely to pay too much for stressed assets which is bad news for taxpayers who will once again have to foot the bill for bailing out troubled banks.
  • There is a huge risk of 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 exacerbates the bad loan crisis.

Also, watch a detailed video on Bad Banks & National Asset Reconstruction Company Limited by Vivek Singh Sir, our faculty for Economy, to understand the topic better:

Associated Challenges

  • Finding Buyers: It could be a challenge to find buyers for bad assets in an economy struggling to find its feet after a pandemic. 
    • This becomes a more daunting task especially when governments are facing the issue of containing the fiscal deficit.
  • Lack of Governance Reforms: In the wake of the absence of governance reforms in the public sector banks, setting up of Bad banks may serve as an ad-hoc mechanism to tackle NPAs, as these banks may go on doing business the way they have been doing in the past and may end up piling-up of bad debts again.
  • The price at which bad assets are transferred from commercial banks to the bad bank will not be market-determined and price discovery will not happen.

Functioning of Bad Bank

  • NARCL and IDRCL will have an exclusive arrangement that will be as per the scope defined in the ‘Debt Management Agreement’ to be executed between these two entities.
  • This arrangement will be on a ‘Principal-Agent’ basis and final approvals and ownership for the resolution shall lie with NARCL. 
  • Further, the NARCL will purchase bad loans through a 15:85 structure, where it will pay 15 per cent of the sale consideration in cash and issue security receipts (SRs) for the remaining 85 per cent. 
  • The SRs will be guaranteed by the government which essentially aims to cover the gap between the face value of the security receipts and realised the value of the assets when eventually sold to the prospective buyers.

Reason for Accumulation of Bad Loans

  • A key reason behind the bad loan crisis in public sector banks, some critics point out, is the nature of their ownership.
  • 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.
About National Asset Reconstruction Company (NARCL):

NARCL has been incorporated under the Companies Act and has applied to the Reserve Bank of India for a licence as an Asset Reconstruction Company (ARC). NARCL has been set up by banks to aggregate and consolidates stressed assets for their subsequent resolution.PSBs will maintain51% ownership in NARCL.

India Debt Resolution Company Ltd (IDRCL):

IDRCL is a service company/operational entity which will manage the asset and engage market professionals and turnaround experts.

Public Sector Banks (PSBs) and Public FIs will hold a maximum of 49% stake and the rest will be with private-sector lenders.

What are Non- Performing Assets?

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.

News Source: The Hindu

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