Whose good bank is bad?

the story So Far: Finance Minister Nirmala Sitharaman on Monday announced that National Asset Reconstruction Company (NARCL) in association with India Debt Resolution Company (IDRCL) will take the first set of bad loans from banks and try to resolve them. While the problem of bad loans has been a perennial one in the Indian banking sector, the decision to set up a bad bank was taken by the central government during the budget presented last year following the nationwide lockdown, and was subsequently put on hold by the Reserve of India. Extended by the Bank (RBI) to the borrowers.

It is to be noted that the health of Indian banks’ balance sheets has improved significantly over the years, with their Gross Non-Performing Assets (GNPA) ratio declining from a peak of 11.2% in FY18 to 6.9% in Q2FY22 .

What is ‘Bad Bank’?

A bad bank is a financial entity that has been set up to purchase non-performing assets (NPAs), or bad loans, from banks. The objective of setting up a bad bank is to help banks reduce their burden by removing bad loans from their balance sheets and re-lending them to customers without any hindrance. After purchasing a bad loan from the bank, the bad bank may later try to restructure the NPA and sell it to investors who are interested in buying it. A bad bank makes a profit in its operations if it manages to sell the loan at a higher price than it paid to get a loan from a commercial bank. However, making a profit is not usually the primary objective of a bad bank – its purpose is to reduce the burden on banks, keep a large pile of stressed assets and lend them more actively.

What are the advantages and disadvantages of setting up a bad bank?

It is argued that a potential advantage in setting up a bad bank is that it can help consolidate all the bad loans of banks under a single specific entity. The idea of ​​a bad bank has been tried in the past in countries such as the US, Germany, Japan and others.

The Troubled Asset Relief Program, also known as TARP, implemented by the US Treasury after the 2008 financial crisis, was modeled around the idea of ​​a bad bank. Under the program, the US Treasury bought troubled assets such as mortgage-backed securities from US banks at the height of the crisis and later resold them when market conditions improved. It is estimated that the Treasury generated modest profits of anything between $11 billion and $30 billion through its operations, although some dispute these figures.

However, many critics have pointed to several problems with the idea of ​​a bad bank to deal with bad loans. Former RBI governor Raghuram Rajan has been one of the staunch critics of the idea, arguing that a bad bank backed by the government will only transfer bad assets out of the hands of public sector banks, which are owned by the government. Bad bank in the hands of one, which is again owned by the government. There is no reason to believe that the transfer of assets from one pocket to another of the government will lead to successful resolution of these bad debts, when the set of incentives before these entities is essentially the same.

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 much higher for stressed assets. While this may be good news for public sector banks, which are reluctant to sell their bad loans at cheaper rates, it is bad news for taxpayers who have to once again bail out troubled banks. Bill has to be paid.

Will a ‘Bad Bank’ help ease the bad loan crisis?

Some critics say that a major 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 often do the same to ensure the profitability of these lenders. Don’t have commitment. To that extent, bailing out banks through a bad bank doesn’t really address the core problem of the bad credit crisis.

In addition, there is a substantial risk of moral hazard. Commercial banks that have been 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 more reason for these banks to lend carelessly and thus further exacerbate the bad credit crisis.

Will it help revive credit flow in the economy?

Some experts believe that by removing bad loans from the books of distressed banks, a bad bank can help free up more than ₹5 lakh crore of capital, which can be used by banks as provisions for these bad loans. has been discontinued. He says this will give banks the freedom to use the freed-up capital to lend more to their customers. This gives an impression that banks have unused funds lying in their balance sheets which they can use only if they can get rid of their bad loans. However, it is important not to mistake the reserve requirements of banks for their capital position. This is because what can prevent banks from lending more aggressively, may not be a lack of sufficient reserves that banks need to maintain against their loans.

Instead, it may simply be the precarious capital situation that many public sector banks find themselves in at the moment. In fact, many public sector banks may technically be considered insolvent, as accurate identification of the true scale of their bad loans would indicate their liabilities far exceed their assets. Therefore, a bad bank may, in fact, help improve bank lending not by increasing the bank’s reserves but by improving the banks’ capital buffer. To the extent that a new bad bank set up by the government can improve banks’ capital buffers by freeing up capital, it can help banks feel more confident to start lending again.