Of what good is a bad bank?

News: Union Finance Minister recently 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.

The decision to set up a bad bank was taken by the Union government during the Budget presented last year in the aftermath of the nationwide lockdowns, and the moratorium was subsequently extended to borrowers by the Reserve Bank of India (RBI).

What is a ‘bad bank’?

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.

How does a bad bank generate profit for itself?

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.

What are the pros and cons of setting up a bad bank?

Advantages

– 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.

Disadvantages

Former RBI governor Raghuram Rajan has been one of the fiercest critics of the idea.

– He argued that 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.

Other analysts believe 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.

– Private banks are owned by individuals who have strong financial incentives to manage them well. On the other hand, 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. The safety net provided by a bad bank gives banks more reason to lend recklessly and thus further exacerbate the bad loan crisis.

Will it help revive credit flow in the economy?

Read here.

Source: This post is based on the article “Of what good is a bad bank?” published in The Hindu on 7th June 22.