Bad bank: good or bad idea?


Bad bank is an idea that has been floated over the years. During the time of every budget, the need for a bad bank gets stronger. In the budget for FY22, Finance Minister announced that an Asset Reconstruction Company Limited and Asset Management Company will be set up to deal with the stressed assets of the public sector banks. In this background, Finance Minister announced the establishment of National Asset Reconstruction Company Ltd (NARCL), a government backed bad bank.

What does NARCL do?

NARCL as a bad bank would buy the stressed assets from the public sector banks, manages them and recovers the money over a period of time. In the present arrangement, NARCL will pay up to 15 percent of the agreed loan value in cash to the banks, and the remaining 85 percent in the form of government-guaranteed security receipts. INR 30,600 crores have been approved by the cabinet for the security receipts issued by the NARCL to buy stressed assets from the banks. In this manner, NARCL is expected to buy INR 2 trillion worth of stressed assets from the banks in different phases.

Need for a bad bank

It is an undisputed fact that banks’ balance sheet should be free from stressed assets. Non-Performing Assets (NPAs) not only impact the profitability of the banks but also the credit growth in the economy. In India, the market share of PSBs stands at 69 percent. And, when we look at the Gross NPA ratio of public sector banks it stood at 11.3 percent in FY20, compared to 4.2 percent for the private banks. As per the latest Financial Stability Report of the RBI, Gross NPA ratio of Scheduled Commercial Banks (SCBs) is expected to reach 9.8 percent by March 2022 and may even reach 11.2 percent under a severe stress scenario. The accumulation of NPAs could negatively impact the bank’s response to the growing credit demand in the economy. Even before the pandemic-induced crisis, bank credit growth in the economy has been subdued. This could be partly explained by the rising NPAs in the banking system.

Presently, to deal with the stressed assets we have mechanisms such as Insolvency Bankruptcy Code (IBC), SARFAESI Act 2002, and Debt Recovery Tribunals (DRTs). Yet, the recovery rate under the above arrangements has not been satisfactory, mainly due to the structural issues.

Does it solve the issue?

One of the major criticism against the bad bank is that it fails to address the root cause of the problem. By establishing a bad bank, government is merely transferring the issue of stressed assets of the PSB to the bad bank. Yet, when the banks are free from the stressed assets, it would be able to step up its lending. However, in certain cases, banks would be taking steep haircuts on these stressed assets. In such a scenario, Government needs to infuse capital into the PSBs to maintain the capital adequacy norms. Thus, the fiscal burden of recapitalisation of banks would remain. For FY22, INR 20,000 crores has been allocated in the budget for the recapitalisation of PSBs.

Another, major issue is that the bad bank could contribute to the moral hazard problem. If there’s an assurance that the stressed assets will be taken over by the NARCL, banks won’t practice due diligence while lending. And the issue of mounting NPAs would continue.

In most cases, PSBs doesn’t have a free hand in deciding its lending. Due to the directives from the government, PSBs are forced to lend without considering the credit worthiness of the borrower. For instance, there has been a considerable increase in the NPAs under the Mudra loan scheme. NPAs as a percentage of Mudra loans disbursed by PSBs, increased to 4.80 percent in FY20 from 3.75 percent in FY19. PSBs were the main channels for the disbursal of MUDRA loans. Also, the majority of the government schemes are majorly channelised through PSBs. The government’s aggressive push to lend to the infrastructure sector during 2006-08 period has been often cited as a major reason for the accumulated NPAs in the banking system.

The cleansing and the revival of the banking sector in the country requires more than the establishment of a ‘bad bank’. The focus should be more on the reforms of PSBs, including governance reforms. Moreover, IBC has a wider scope, and steps should be initiated to strengthen the IBC to make it more effective and impactful.


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