Bad Bank "EMPOWER IAS"

In news:

• The idea of setting up a bad bank to resolve the growing problem of non-performing assets (NPAs), or loans on which borrowers have defaulted, is back on the table.

 

Why in news?

• Commercial banks are set to witness a spike in NPAs, or bad loans, in the wake of the contraction in the economy as a result of the pandemic.
• Hence the RBI recently agreed to look at the proposal for the creation of a bad bank.
• This is in the response to a six-month moratorium it has announced to tackle the economic slowdown.

 

What is the Bad Bank?

• A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution.
• The entity holding significant NPAs will sell these holdings to the bad bank at market price.
• By transferring such assets to the bad bank, the original institution may clear its balance sheet—although it will still be forced to take write-downs.
• A bad bank structure may also assume the risky assets of a group of financial institutions, instead of a single bank.

 

Rationale of Bad Bank

• Easing Provisioning Requirement: High level of non-performing assets (NPAs) makes the lending difficult for banks, as they have to keep supplementary capital (provisioning requirement) under the Basel Accord. This reduces its capital base and the resulting losses erode depositor confidence — the lifeblood of any bank.
• Bad bank by way of absorbing NPAs, will ease the provisioning requirement by the banks and help them to get on with business as usual.
• Re-assuring Trust: Moreover, the creation of a bad bank allows the segregation of a bank’s good assets from its bad assets. This allows investors to assess its financial health with greater clarity and for banks to grow financially.
• Aside from this, a government-led initiative may perhaps make it more palatable or even an attractive opportunity for investors to invest their money- both domestic and foreign.
• International Precedent: The 2007-2010 financial crises led to the creation of bad banks in many countries.
• In the US, as part of the Emergency Economic Stabilisation Act of 2008, a bad bank was suggested to address the subprime mortgage crisis (real estate loans default).
• In Ireland, the National Asset Management Agency was established in 2009 to respond to the financial crisis.
• Concerns About IBC Code: Many lenders are concerned over huge haircuts they have to endure after a resolution through the Insolvency and bankruptcy code.
• Also, NPAs in the power sector can't be resolved through the IBC system as factors like the lack of coal linkages and the absence of purchase power agreements make them unfit for a resolution through the IBC.
• The bad bank structure could help banks park their money to separate agencies to find a solution in a long time.
• Moreover, banks feel the assets having future demand-supply issues face liquidation under the IBC, a problem that can be solved under the bad bank.
• Thus, a bad bank may save a defaulting firm from liquidation and closure.

 

Associated Challenges

• Mobilising Capital: Finding buyers for bad assets in a pandemic hit economy will be a challenge, especially when governments are facing the issue of containing the fiscal deficit.
• Not Addressing the Underlying Issue: Without governance reforms, the Public sector banks (accounted for 86%, of the total NPAs) may go on doing business the way they have been doing in the past and may end up piling-up of bad debts again.
• Also, the bad bank idea is like shifting loans from one government pocket (the public sector banks) to another (the bad bank).
• Provisioning Issue Tackled Through Recapitalization: Union Government, in the last few years, has infused nearly Rs 2.6 lakh crore in banks through recapitalisation.
• Those who oppose the concept of bad banks hold that the government has on its part recapitalised the banks to compensate for the write-offs and hence, there is no need for a bad bank.
• Market-related Issues: 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.
• Moral Hazard: Former RBI Governor Raghuram Rajan had said that a bad bank may create a moral hazard and enable banks to continue reckless lending practices, without any commitment to reduce NPAs.

 

What are the alternatives to a bad bank?

• Many industry experts and government officials involved in economic policy-making argue that the enactment of IBC has reduced the need for having a bad bank, as a transparent and open process is available for all lenders to attempt insolvency resolution.
• As per latest available RBI data, as a percentage ofclaims, banks recovered on average 42.5% of the amount filed through the IBC in 2018-19, against 14.5% through the SARFAESI, 5.3% through Lok Adalats and 3.5% through Debt Recovery Tribunals. The view is that an IBC-led resolution, or sale of bad loans to ARCs already existing, is a better approach to tackle the NPA problem rather than a government-funded bad bank.
• In a speech on February 21, 2017, on ways to resolve banks’ stressed assets, Former RBI Deputy Governor Viral Acharya proposed two models. The first model is a private Asset Management Company (PAMC) which would be suitable for sectors where the stress is such that assets are likely to have economic value in the short run, with moderate levels of debt forgiveness.

 

Global examples of Bad Bank

• US-based BNY Mellon Bank created the first bad bank in 1988, after which the concept has been implemented in other countries including Sweden, Finland, France and Germany.
• However, resolution agencies or ARCs set up as banks, which originate or guarantee to lend, have ended up turning into reckless lenders in some countries.

 

Do we need a bad bank?

• The idea gained currency during Rajan’s tenure as RBI Governor.
• The RBI had then initiated an asset quality review (AQR) of banks and found that several banks had suppressed or hidden bad loans to show a healthy balance sheet.
• However, the idea remained on paper amid lack of consensus on the efficacy of such an institution.
• ARCs have not made any impact in resolving bad loans due to many procedural issues.

 

What is the stand of the RBI and government?

• While the RBI did not show much enthusiasm about a bad bank all these years, there are signs that it can look at the idea now.
• Experts, however, argue that it would be better to limit the objective of these asset management companies to the orderly resolution of stressed assets, followed by a graceful exit.

 

Key suggestions

• Former RBI Dy. Governor Acharya suggested two models to solve the problem of stressed assets.

1. The first is a private asset management company (PAMC), which is said to be suitable for stressed sectors where the assets are likely to have an economic value in the short run, with moderate levels of debt forgiveness.
2. The second model is the National Asset Management Company (NAMC), which would be necessary for sectors where the problem is not just one of excess capacity but possibly also of economically unviable assets in the short to medium terms.

 

Good about the bad banks

• The problem of NPAs continues in the banking sector, especially among the weaker banks.
• The bad bank concept is in some ways similar to an ARC but is funded by the government initially, with banks and other investors co-investing in due course.
• The presence of the government is seen as a means to speed up the clean-up process.
• Many other countries had set up institutional mechanisms such as the Troubled Asset Relief Programme (TARP) in the US to deal with a problem of stress in the financial system.

 

Pandemic and the NPAs

• Bad loans in the system are expected to balloon in the wake of contraction in the economy and the problems being faced by many sectors.
• The RBI noted in its recent Financial Stability Report that the gross NPAs of the banking sector is expected to shoot up to 13.5% of advances by September 2021, from 7.5% in September 2020.
• The report warned that if the macroeconomic environment worsens into a severe stress scenario, the ratio may escalate to 14.8%.