Context : The National Asset Reconstruction Company Ltd. (NARCL), set up to take over large bad loans of more than ₹500 crore from banks, will pick up the first set of such non-performing assets (NPAs) in July.
What are Bad Banks?
- A bad bank is a bank that is set up to buy the bad loans and other illiquid holdings of another financial institution.
- The entity holding significant nonperforming assets 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.
- Bad banks were also considered during the financial crisis of 2008 as a way to shore up private institutions with high levels of problematic assets.
What are the pros and cons of setting up a bad bank?
- A supposed advantage in setting up a bad bank, it is argued, is that 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. Eg troubled asset relief program, also known as TARP, implemented by the U.S. Treasury in the aftermath of the 2008 financial crisis
- Many critics, however, have pointed to several problems with the idea of a bad bank to deal with bad loans. 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. 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.
- Contra opinion states that 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. While this may be good news for public sector banks, which have been reluctant to incur losses by selling off their bad loans at cheap prices, it is bad news for taxpayers who will once again have to foot the bill for bailing out troubled banks.
Will a ‘bad bank’ help ease the bad loan crisis?
- A key reason behind the bad loan crisis in public sector banks 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.
- Further, 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 exacerbate the bad loan crisis.
Will it help revive credit flow in the economy?
- Some experts believe that by taking bad loans off the books of troubled banks, a bad bank can help free capital of over ₹5 lakh crore that is locked in by banks as provisions against these bad loans. This, they say, will give banks the freedom to use the freed-up capital to extend more loans to their customers. This gives the impression that banks have unused funds lying in their balance sheets that they could use if only they could get rid of their bad loans. It is, however, important not to mistake banks’ reserve requirements for their capital position. This is because what may be stopping banks from lending more aggressively may not be the lack of sufficient reserves which banks need to maintain against their loans.
- Instead, it may simply be the precarious capital position that many public sector banks find themselves in at the moment. In fact, many public sector banks may be considered to be technically insolvent, as an accurate recognition of the true scale of their bad loans would show their liabilities to be far exceeding their assets. So, a bad bank, in reality, could 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.