The name ‘bad bank’ itself suggests that it deals with something bad in the financial sector. The concept is simple. The bank divides its assets into two categories. Into the bad pile go the illiquid and risky securities that are the bane of the banking system, along with other troubled assets such as nonperforming loans. For good measure, the bank can toss in non-strategic assets from businesses it wants to exit, or assets it simply no longer wants to own as it seeks to lessen risk and deleverage the balance sheet. What are left are the good assets that represent the ongoing business of the core bank.
By segregating the two, the bank keeps the bad assets from contaminating the good.
The idea of starting a bad bank by the government was recently proposed in the Economic Survey presented in January under the name ‘Centralized Public Sector Asset Rehabilitation Agency’ (PARA) that could take charge of the largest, most difficult cases, of non-performing assets (NPAs) in the banking system.
The proposed ‘bad bank’ would be a centralised agency that would take over the largest and most difficult stressed loans from public sector banks in order to help clean their balance sheets, and would take politically tough decisions to reduce debt, providing an impetus to further lending to spur economic activity.
Thus far, decisions to solve individual stressed loans have been left to banks themselves, who find it difficult to resolve these cases for many reasons. Banks are required to to recognise the true extent of bad loans but have flexibility to restructure them.
The current framework leaves banks with too much discretion in solving the problems. In most cases, banks simply refinance the debtors, making it costlier for the government as it means the bad debts keep rising, increasing the ultimate recapitalisation bill for the government.
Further, the decision to refinance the banks to continue their lending has also not worked out quite as well, as banks hesitate to lend even with adequate capital in hand till they can’t assess the future impact of bad loans on their books, the economic survey had said. Moreover, private asset reconstruction companies (ARCs) too haven’t proved any more successful than banks in resolving bad debts.
There are many organizational, structural, and financial trade-offs to consider. The effect of these choices on the bank’s liquidity, balance sheet, and profits can be difficult to predict.
