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Will Indian Banks' Association's Bad Bank Idea Help Tide Over Rising NPA Issue?

May 9, 2020 7:33 AM 4 min read

India’s financial sector has been reeling from one crisis after another and can’t seem to catch a break. 

First the bad loan debacle, then the shadow-banking mess with demonetisation acting as grease, and now more bad loans thanks to COVID-19 related stress.

In fact, rating agency Crisil estimates that gross non-performing assets (NPAs) of the Indian banking system may rise by as much as 1.5-2.0% this year, hitting 11-11.5%!

Whilst Reserve Bank of India’s (RBI) interventions have surely eased liquidity concerns, loan moratoriums primarily grant the gift of time!

Losses are bound to happen, albeit not immediately but in the coming few quarters.

Perhaps with this in mind, the Indian Banks’ Association (IBA) led by State Bank of India (SBI) is once again mulling the idea of creating a structure akin to a ‘bad bank’ to address this newest crisis.

What is a Bad Bank?

The idea is that bank balance sheets have both good loans (i.e. Where borrowers are able to pay what’s due, on time) and bad loans (i.e. Where borrowers are unable to pay back either on time, or what’s due, or both).

A bad bank would simply ring-fence bad loans from multiple banks into a separate entity.

So what remains of the said multiple banks would be...umm...the ‘good bank’ part. These good banks should find it easier to raise capital from investors and grow. They would have to provision less. Investors would be able to value them more precisely etc etc   

And the big bad bank can now focus on “run-off” or “wind-down” of the ring-fenced loans - either by restructuring them, resolving them or selling them. Everyone’s happy.

At least that’s the theory.


Difference between a Bad Bank and a Good Bank

How Would it Work?

The bad loans sitting on books of banks would be ring fenced and transferred to an Asset Reconstruction Company (ARC) type of entity, which would be funded part by government and part by investors (e.g. Foreign portfolio investors or FPIs, Alternative Investment Funds or AIFs etc.)

The assets parked in the bad bank would be managed by a professional team who would identify the right assets to buy, the price at which to buy them, make decisions on resolution plans and seek suitable buyers for sale.

The idea is to either resolve or recover these assets, or even better sell them to other AIFs (like Hedge Funds or Private Equity (PE) firms) who may then turn them around and sell them further and make a profit.

However, some problems often creep in, primarily finding suitable buyers who are willing to grab on to these distressed assets, and the often complicated process to turn them around.

A Page From History

The idea of a bad bank is not new and has been tossed around quite a number of times in India’s financial history.

In 2015, when the Central Bank set upon an asset quality review of the sector, it was proposed that the NPAs detected as part of the review be parked in a bad bank. However, Raghuram Rajan, the then RBI governor, was opposed to the idea and felt that private ARCs should take the lead in buying bad debt and resolving it.

In July 2018, a group of bankers led by then Punjab National Bank Chairman Sunil Mehta proposed an ARC structure under Project Sashakt to manage stressed loans. The Mehta Committee had suggested that multiple such ARCs be created and investments be sought through AIFs set up by banks.

In November 2019, the Government asked the RBI to set up a fund to buy out stressed assets of the country’s top 25 non-banking finance companies (NBFCs). The RBI however opposed the idea of opening its balance sheet to buy stressed assets of shadow banks.

Each time the idea was floated, it ran into three key hurdles.

First: who would capitalise the bad bank?

Second: how would the criteria and price of bad loan purchases be designed, while ensuring transparency and fairness?

And Third: if banks knew bad loans could be ring-fenced and they are off the hook, there’s a moral hazard that they would continue lending poorly to make short-term returns. How to check for that?

The Bottomline

The creation of a bad bank might be a good idea but at the end of the day, the AMC must ensure that they are able to grope in suitable buyers for these assets, who would then be able to pay the “right” price for them and also be able to turn them around - making them profitable for further sale. Because when the buck stops, someone must be willing to pay up.


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