Bad Banks – pros and cons

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Source: The Hindu

Syllabus: GS 3 – Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.

Synopsis: The centre is proposing to set up Bad Banks or Asset Reconstruction Company to acquire bad loans from banks.

Introduction

There is a persisting issue of bad loans in the Indian banking sector and the COVID-19 pandemic induced lockdown worsened the situation. Setting up the bad Banks will help Banking sector in dealing with this crisis.

International Experience of bad bank

  • It helps in combining all bad loans of banks under a single exclusive entity. Countries like the US, Germany, and Japan have used this concept.
  • The US implemented the Troubled Asset Relief Program (TARP) after the 2008 financial crisis. It was moulded around the idea of a bad bank. The US Treasury earned nominal profits under the TARP.

What are the problems with a bad bank?

According to the former RBI governor Raghuram Rajan, transferring bad assets from one pocket of the government to another will not lead to success. The reasons are,

  • First, bad banks are backed by the government. The government will pay the high cost for stressed assets (to make bad bank profitable). It is not good for fiscal health of the country.
  • Second, there is a bad loan crisis in PSUs because they are managed by the bureaucrats. Bureaucrats are not like private banks and cannot offer the same commitment to lenders and ensure profitability. If a Bad bank is allowed to manage by bureaucrats, then there is no point to create a bad bank at all.
  • Third, bad banks do not address the root problem. The reason behind the bad loan accumulation is lack of focus on the quality of credit provided by banks. Establishing a bad bank might create a mindset that there is a system in place to recover the loans. This can lead to careless lending by banks in a larger manner and worsen the present bad loan crisis.

Will bad banks help in reviving the credit flow in the economy?

Some experts believe 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 will give banks the freedom to use the freed-up money to give more loans.

  • This gives the impression that banks have unused funds lying in their balance sheets. They could use these funds only if they could get rid of their bad loans.
  • Many public sector banks may be considered to be technically broke. In reality, Their liabilities are far exceeding the assets they have.  So, a bad bank could help them reduce their liabilities by purchasing bad loans.

The way forward

  • A new bad bank set up by the government can improve banks capital safeguards by freeing up capital. It could help banks feel more confident to start lending again.
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