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Bad bank

Topics Covered: Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

Bad bank:


Context:

The Indian Banks’ Association (IBA) has begun identifying bad loans which can be transferred to the Centre’s proposed bad bank.

  • The IBA has written to banks asking them for a list of all bad loans worth Rs 500 crore and above to “identify magnitude of the problem” and “get clarity over initial capital required for the entity”.

Background:

Finance Minister Nirmala Sitharaman had proposed setting up of a bad bank during her Union Budget 2021 speech on February 1. She said the proposed entity would take over stressed loans from banks to sell to alternative investment funds (AIF).

Concept of Bad Bank:

  • A bad bank is a bank 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.

Why be concerned about bad loans?

  1. Indian banks’ pile of bad loans is a huge drag on the economy.
  2. It’s a drain on banks’ profits. Because profits are eroded, public sector banks (PSBs), where the bulk of the bad loans reside, cannot raise enough capital to fund credit growth.
  3. Lack of credit growth, in turn, comes in the way of the economy’s return to an 8% growth trajectory. Therefore, the bad loan problem requires effective resolution.

Benefits:

  1. This helps banks or FIs clear-off their balance sheets by transferring the bad loans and focus on its core business lending activities.
  2. Large debtors have many creditors. Hence bad bank could solve the coordination problem, since debts would be centralised in one agency.
  3. It can effect speedier settlements with borrowers by cutting out individual banks.
  4. It can drive a better bargain with borrowers and take more stringent enforcement action against them.
  5. It can raise money from institutional investors rather than looking only to the Government.

What are the Concerns or demerits of such banks?

Suppose, say for example, a bank sells bad loans. Then, it has to take a haircut because when Rs 100 goes bad, the actual amount that can be expected is lower than Rs 100 and that leads to haircut. When it takes haircut that will impact the P&L (Profit & Loss).

So, till that particular aspect is not addressed, creating a new structure may not be as potent in addressing the problem.

Way forward:

The K V Kamath Committee, has said companies in sectors such as retail trade, wholesale trade, roads and textiles are facing stress.

  • Sectors that have been under stress pre-Covid include NBFCs, power, steel, real estate and construction.
  • Setting up a bad bank is seen as crucial against this backdrop.

InstaLinks:

Prelims Link:

  1. What is an Asset Reconstruction Company?
  2. What is a bad bank?
  3. Who can set up a bad bank in India?
  4. What are stressed assets?
  5. What are non performing assets?

Mains Link:

Discuss the merits and demerits of setting up of bad banks.

Sources: the Hindu.