CONTEXT

• Finance Minister has announced the formation of India’s first-ever “Bad Bank
• “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.
• Another entity — India Debt Resolution Company Ltd (IDRCL), which has also been set up — will then try to sell the stressed assets in the market.
• The NARCL-IDRCL structure is the new bad bank.

BAD LOAN & BAD BANK

• Commercial banks accept deposits and extend loans
• 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.
• 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.
• 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.
• In 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 a position to pay back either the interest or the principal amount, BAD LOAN ORIGINATES
• When several banks in an economy face high levels of bad loans and all at the same time, that will threaten the stability of the whole economy.
• It was argued by many that the government needs to create a bad bank — that is, 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 so-called bad bank, or a bank of bad loans, would try to sell these “assets” in the market.

HOW WILL THE NARCL-IDRCL WORK

• 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.
• 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 Rs 30,600 crore that has been provided by the government.

WILL A BAD BANK RESOLVE MATTERS?

From the perspective of a commercial bank

• It will help
• When the recovery money is paid back, it will further improve the bank’s position.

From the perspective of the government and the taxpayer

• Recapitalising PSBs laden with bad loans or giving guarantees for security receipts, the money is coming from the taxpayers’ pocket.
• While recapitalisation and such guarantees are often designated as “reforms”, they are band aids at best.
• The only sustainable solution is to improve the lending operation in PSBs.

OTHER BENEFITS

• Could solve the coordination problem, since debts would be centralised in one agency.
• Effect speedier settlements with borrowers by cutting out individual banks.
• Drive a better bargain with borrowers and take more stringent enforcement action against them.
• Raise money from institutional investors rather than looking only to the Government.

CONCERNS

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.

CONCLUSION

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.