Introduction 

• Bad banks, formally called Asset Reconstruction Companies (ARC), are specialized financial institutions that buy the stressed and non-performing assets (NPA) of the bank to help clean up their balance sheet.
• Establishment and Regulations of ARC

• Incorporated under the Companies Act and registered with RBI under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002. 

• Regulated by RBI as a Non-Banking Financial Company (NBFC) under RBI Act, 1934.

New Bad Bank Structure

• Announced in Budget 2021-22 – It proposes the following dual structure of the New Bad Bank:

• Incorporated under the Companies Act & has been set up by the banks. Public Sector Banks (PSBs) to maintain 51% ownership in it.

• It will acquire bad debts from the lead bank and pay 15% upfront in cash, and issue the balance 85% as government-guaranteed tradable security receipts (SR).

• IDRCL is a service company to manage the asset and engage market professionals and turnaround experts. PSBs & Public Financial Institutions - 49% stake; Private sector lenders - 51% stake.

• Role of Government Guarantee - Government guarantee will be invoked if the bad bank is unable to sell bad loan, or sells it at a loss. Government will not hold any equity in the Bad Bank.

Benefits of a Bad Bank

• Provides additional option - Existing ARCs have helped in resolution of NPAs for smaller value loans. But considering the large stock of legacy NPAs, NARCL will enable resolution of large NPAs above ?500 crore
• Reduced Burden on Banks: As the bad bank sells these "assets" in the market, commercial banks can resume lending.

• Quicker resolution - The aggregation of bad assets at one place will make it easy for the buyer to deal with one unified ARC rather than dealing with multiple lenders, improving the chances of resolution.
• Solving Economic Aftershocks of the Pandemic: After the COVID-19 pandemic, a private-lender-backed bad bank can manage NPAs and their economic impact.

• Multiplier impact – With the existing undercapitalized ARCs reluctant to take up NPAs, the New Bad Bank aims to fill this void, entailing several economy wide benefits:

• Improved banks’ liquidity, free up management bandwidth to focus on core business etc. ???? enhanced lending to productive sectors to ‘jump start’ economy & employment ???? accelerates bank recovery.

Concerns with Bad Bank

• Governance concerns & Implementation delays – No clarity on exactly how the new bad bank will be structured and how its functioning will be governed.

• There is a concern that bad banks may prioritize easily recoverable loans and neglect critical loans that are difficult to recover. 

• No sunset clause - It is not clear whether the bad bank has a finite end date. 

• For e.g., in the US, the bad banks had a sunset clause and worked with a finite timeline (a reason for their success).

• Uncertainty over the secondary market - Banks will have the freedom to sell the security receipts, but secondary market for such securities is not yet evolved. 
• Does not address core issue - The bad bank will not help in preventing future NPAs, nor does it aim to improve the ‘credit culture’ of the PSBs.

• Former RBI Governor Raghuram Rajan opposed the idea of a bad bank in which banks hold a majority stake.

• Lack of buyer demand - The success of the bad bank depends on its ability to sell the stressed assets in the market. However, the current economic distress and lack of liquidity may discourage the buyers.
• PSBs will be both shareholders & customer - It leads to the danger of the bad bank being nothing more than a means to shift some bad debt from one book to another.

• It also means a mere shift of bad loans from government owned banks (PSBs) to government backed Bad Bank (NARCL). 

• Profitability of Banks: Bad banks' high margins may reduce other banks' profits, affecting their lending.
• Moral Issues: Under the pressure to recover loans, bad banks may resort to unethical practices. 

Way forward

• Multi-pronged measures - For the bad bank to work as intended will require strong and impartial leadership, a high degree of financial expertise, and roping in relevant professionals with right skill set.
• Setting up an NPA transaction platform - that would act as a central repository of data on stressed assets from participating banks. This will serve to enhance liquidity by making transaction data standardized & transparent & allowing investors to take informed decisions.
• Learning from successful international experiences
• Malaysia government-owned Bad bank, Danaharta, established after the Asian crisis in 1998.
• US launched Troubled Asset Relief Program (TARP) just after the Lehman crisis in 2008.
• UBS of Switzerland transferred bad assets to a government fund after the Global Financial Crisis.
• Sunset Clause - After a predefined period, when the company’s operations are no longer deemed necessary, it should be wound up.
• Holistic reforms - The bad bank is a one-time solution and cannot be in perpetuity. Holistic banking sector reforms, including improved governance of PSBs, is critical to avert another cycle of bad loans.

Conclusion

Establishing a bad bank can help reduce NPAs and strengthen the banking sector, but public sector banks need comprehensive governance and lending reforms. A bad bank and other measures can reduce NPAs and ensure a resilient banking system that supports economic growth.