top of page

BAD BANKS- Why is the Government exploring the possibility?

Recently, the Indian Banking Association[1] suggested the idea of setting up a bad bank. This proposal was suggested by the panel headed by Mr. Sunil Mehta, former PNB chairman. Due to the unprecedented pandemic, the economy has been significantly impacted, therefore, it has been suggested that setting up a bad bank will help the credit flow in the economy.

A bad bank is similar to an Asset Reconstruction Company (hereinafter referred to as “ARC”). It takes over the non-performing assets (hereinafter referred to as “NPA”), from an existing bank and takes the task of managing these overtaken toxic assets by trying to recover the cost of such assets over time. Once the stressed assets are separated from the balance sheet of the existing bank, it can focus on its regular functions. This reduces the stress on existing banks and gives them a boost to inject more credit into the economy. The takeover of loans also reduces the provisioning requirement increasing the bank’s ability to lend funds.

However, this is not a new concept; it was pioneered in the late 1980s. In 1980, Latin-American financial crisis was largely triggered by the steep fall in real estate and oil prices. The financial crisis left many banks on the verge of bankruptcy. Mellon Bank[2] in Pennsylvania was one of the most impacted banks during this period. To recapitalize its assets, the bank created another bank to hold its stressed assets. This creation led to the birth of Grant National Street Bank (hereinafter referred to as “GNSB”). The sole purpose of GNSB was to liquidate the stressed assets of Mellon bank and then liquidate itself. GNSB bought the stressed assets of Mellon Bank worth $1.4 billion on a book value of $ 640 million. The bank was successful in liquidating the assets of the Mellon Bank and finally liquidated itself in 1995. The success of Mellon Bank led many countries to explore this option.

McKinsey, in its report titled “Understanding the Bad banks[3],” provides for four organisational structures. The following list comprises of such different types of bad banks Schemes: -

· On Balance Sheet Guarantee- Under this scheme, the bank gets a loss guarantee from the government or public institution. In return for the guarantee, the bank has to part away with some of its portfolios. These assets however remain on the balance sheet of the bank and affect its functioning.

· Internal Restructuring Unit Scheme- This scheme is similar to setting up an internal bad bank. All the bad assets are transferred to the internal unit which is specially made to hold the bad assets. This scheme does not take the NPAs off the balance sheet.

· Off-balance Sheet Special Purpose Entity- This scheme allows the bank to take the NPAs off the balance sheet. The NPAs are taken off the balance sheet by special purpose vehicles which are then further securitized and sold. The special purpose entity under this structure is usually public-funded.

· Bad bank Spin-Off- Under this scheme, a special entity is established by the name of a bad bank. The NPAs are taken off the balance sheet of the existing bank and are dealt with by the bad bank. This scheme is usually referred to as a good bank-bad bank scheme. This model is very complex and expensive and requires a proper regulatory framework.

Recently, the IMF has predicted an 11.5% GDP[4] growth projection for India. To bolster this growth, the banking industry should be able to provide the credit required. In the recent budget announcement, the government has made its intentions clear about the establishment of a bad bank. This option is being explored after RBI expressed its fear over a spike in NPAs to 13.5% by September 2021 as compared to 7.5% in September 2020. The Hon’ble Finance Minister Ms. Nirmala Sitharaman stated in her budget speech that NPAs worth Rs. 899,803 crores will be parked in bad banks. The Hon’ble Minister also stated clearly that the centre will not finance this entity but is planning to provide guarantee[5] against security receipts provided by the bad bank. This will help the banks to clear their books of bad loans and thus make more funds available for lending. It is predicted that the aggregation of debt will help realize a better value for the NPAs. In addition to that, the bad banks hire specialized personnel that help in the speedy disposal of the assets. Once the balance sheets of the bank are cleaned, it will alleviate pressure from the capital of the bank thus enabling the bank to undertake regular functions without the risk of failure.

This strategic move does not come without criticism. Many experts believe that this move will further encourage banks to finance high-risk projects and that the banks will continue their “reckless lending practices.” Moreover, the selling of assets at discounted prices also lowers the value of similar assets held by other banks. This forces other banks to liquidate their assets at discounted prices too. Not only that, but a strong system of bad banks be built, only if the legislature enacts competent and necessary laws.

In India, there are currently over 40 active ARCs operating. These ARCs are regulated by the Reserve Bank of India and are registered under The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. No ARC can commence its operations without fulfilling the Net Owned Funds[6] (hereinafter referred to as “NOF”) threshold set by the RBI. The minimum NOF required by any ARC to commence its operations is set at Rs. 100 crores. RBI in its circular[7] dated July 16, 2020, also released Fair Practices Code (hereinafter referred to as “FPC '') for ARCs. To ensure that transparency is maintained in the sale of secured assets, the RBI states that the applications shall be publicly solicited. The prospective buyer must be within the guidelines of Section 29A of the Insolvency and Bankruptcy Code[8], which essentially means that the buyer must not be an undischarged insolvent, willful defaulter under the Banking Regulation Act, 1949, etc.

However, rigorous legislation is required to regulate the banks efficiently.

In conclusion, the government is looking forward to taking this big step towards getting the economy back on track. The advantages far outweigh the criticism. And currently, this looks like the only option in sight to recover from the impact of the pandemic.

References: -

Author ~ Weindrila Sen

Jitendra Chauhan college of law.

Co - Author ~ Aarushi Pandey

GLC, Mumbai

42 views0 comments


bottom of page