India’s Bad Bank gets RBI nod

In News

• A key proposal announced in this year’s (2021) Budget, a bad bank to deal with stressed assets in the loss-laden banking system, has received all regulatory approvals.

About

• The K V Kamath Committee helped the RBI with designing a one-time restructuring scheme.
  • The committee observed that the 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.
• National Asset Reconstruction Company Limited (NARCL) has already been incorporated under the Companies Act.
  • It will acquire stressed assets worth about Rs 2 lakh crore from various commercial banks in different phases.
  • The NARCL will first purchase bad loans from banks.
  • It will pay 15% of the agreed price in cash and the remaining 85% will be in the form of “Security Receipts”.
  • When the assets are sold, with the help of IDRCL, the commercial banks will be paid back the rest.
  • Banks have agreed to transfer 15 accounts with approximately Rs 50,000 crore outstanding to the NARCL in the first phase by the end of the fiscal year (31st March, 2022).
• India Debt Resolution Company Ltd (IDRCL), which has also been set up, will then try to sell the stressed assets in the market.

What is a Bad Bank? Why was it needed?

• Bad bank: an entity where all the bad loans from all the banks can be parked thus, relieving the commercial banks of their “stressed assets” and allowing them to focus on resuming normal banking operations, especially lending.
  • While commercial banks resume lending, the bad bank, or a bank of bad loans, would try to sell these “assets” in the market.
• Commercial banks accept deposits and extend loans: The deposits are a bank’s “liability” because that is the money it has taken from a common man, and it will have to return that money when the depositor asks for it.
  • Moreover, in the interim, it has to pay the depositor an interest rate on those deposits.
• The loans: that banks give out are their “assets” because this is where the banks earn interest and this is money that the borrower has to return to the bank.
• The whole business model: is premised on the idea that a bank will earn more money from extending loans to borrowers than what it would have to pay back to the depositors.
• A scenario: where a bank finds a huge loan not being repaid because, say, the firm that took the loan has failed in its business and is not in a position to pay back either the interest or the principal amount.
  • This will threaten the stability of the whole economy.
• The proportion of bad loans: they are typically calculated as a percentage of the total advances (loans) rise, two things happen.
  • One, the concerned bank becomes less profitable because it has to use some of its profits from other loans to make up for the loss on the bad loans.
  • Two, it becomes more risk-averse. In other words, its officials hesitate from extending loans to business ventures that may remotely appear risky for the fear of aggravating an already high level of non-performing assets (or NPAs).

Significance

• Government guarantee: If the bad bank is unable to sell the bad loan, or has to sell it at a loss, then the government guarantee will be invoked and the difference between what the commercial bank was supposed to get and what the bad bank was able to raise will be paid from the amount that has been provided by the government.
• A commercial bank saddled with high NPA levels, will be benefitted: That’s because such a bank will get rid of all its toxic assets, which were eating up its profits, in one quick move.
  • When the recovery money is paid back, it will further improve the bank’s position. Meanwhile, it can start lending again.
• With the pandemic hitting the banking sector: the RBI fears a spike in bad loans in the wake of a six-month moratorium it has announced to tackle the economic slowdown.

Issues/ Challenges 

• From the taxpayer’s perspective: the most worrisome fact was that an overwhelming proportion of NPAs was with the public sector banks, which were owned by the government and hence by the Indian public.
  • To keep such PSBs in business, the government was forced to recapitalise them, that is, use taxpayers’ money to improve the financial health of PSBs so that they could carry on with the business of lending and funding economic activity.
• The plan of bailing out commercial banks will collapse: if the bad bank is unable to sell such impaired assets in the market. 

Way Forward

• Improve the lending: The only sustainable solution is to improve the lending operation in PSBs.
• Troubled Asset Relief Programme (TARP): Many other countries had set up institutional mechanisms such as the Troubled Asset Relief Programme (TARP) in the US to deal with a problem of stress in the financial system.

Source: IE