What is a Bad Bank? Is it important for an economy?

What is a Bad bank? And why are we talking about it?

Recently, the Indian Banks’ Association (IBA) proposed to the Government of India the creation of a bad bank. Sounds bizarre, right? Why would anyone create a bad bank? Don’t worry if you don’t know, we’ll know in the next few minutes.

A bad bank is set-up to buy the bad loans (non-performing assets) and illiquid assets of other banks. It buys these bad loans from troubled banks at a discount and tries to recover the money from the defaulters or by selling them off. It is established when the banking sector is burgeoned with high non-performing assets (NPAs). High NPAs increase banks’ provisions for NPAs i.e. the money that banks are supposed to keep aside for probable defaults.

Now, from where do banks make these provisions?

Definitely not from customer deposits, so the only other source is their own capital. Doing so, gradually erodes off their capital, resulting in increased risk. Provisioning also reduces a bank’s lending capacity as the capital set aside can’t be lent. And then, slow recovery of bad loans adds insult to this injury. The result is thin net interest margins i.e. the difference between interest earned on loans and interest paid on deposits. Due to decreased interest margins and perceived risk, consumer confidence in banks is eroded and that’s the last thing that any bank wants.

To ensure sustained consumer confidence in the banking sector, Governments set-up bad banks to buy bad loans and clean the balance sheet of banks.

Another benefit that bad banks provide is that the firms that have defaulted may be saved from liquidation. And hence, closure, as it won’t be dragged into the Insolvency and Bankruptcy Court.

While the concept may be new to us, it has long been used in the financial world. Post the Global Financial Crisis in 2008, the government of Ireland had set up a bad bank named National Asset Management Agency (NAMA) to bail out insolvent Irish banks. Apart from NAMA, several other bad banks have been established in the past.

Or Is It?

The present proposal by IBA has come in the wake of rising NPAs in the Indian banking sector. These are expected to balloon to ₹11 lakh crore by the end of this fiscal. The proposal as a solution to the NPA problem may seem all easy and rosy but there is a problem with it. The reason why banks want the government to set up a bad bank instead of selling its stressed loans to existing asset reconstruction companies (ARC) is the pricing. ARCs demand large discounts on these loans, which the banks are reluctant to give.

As the bad banks are government-funded, they don’t bargain hard on the pricing, resulting in a price higher than a market discovered price which would have been decided by the supply-demand dynamics and be reflective of the intrinsic value of the loans and their recovery potential. The proposal asks for the pricing of stressed loans at book value minus minimum regulatory provisions.

Book value of a loan is the loan amount that is yet to be recovered. If the bad bank buys these loans at book value and fails to recover money from the defaulters, it will practically panic to find buyers for the loans when it tries to recover the money by selling them.

Not really a solution

Therefore, the creation of a bad bank will result merely in the transfer of the bad loans from one entity to another. Which again is leaving the underlying issue unaddressed. Much worse, it will be the case in the Indian banking sector… PSU banks account for 86% of the total NPAs in the sector. This would mean the transfer of government money from one part to another, as the fiscally strained government will not borrow to fund the bad bank.

The problems with bad banks don’t end here. The creation of bad banks can lead to a moral hazard… Banks may go on lending without due diligence, without any commitment to reduce the NPAs, knowing that a bailout will come if things go bad.

Now, when you think about it…

The idea of bad banks is not such a good one. Instead, the government should make structural changes to ensure that banks behave responsibly and the resolution process becomes efficient. It is always better to change what is bad to good, rather than separating the two.

The piece was put together by Shivam Ghule, drop a thank you, when you can. You can take a look at more Finance concepts, if you’d like.

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