What is a ‘Bad Bank’? - Recent Proposal by Indian Banking Association

A Bad Bank houses Bad loans or Non-Performing Assets (NPA). The idea of Bad Bank was implemented in countries like Sweden, Finland, France, Germany, Indonesia etc. Even with Bad Bank structure, the Non-Performing Assets (NPA) losses do not go away. It needs to be shared between investors, taxpayers of these banks in general and those of the bad bank.

The bad bank will manage Non-Performing Assets in suitable ways, some may be liquidated, others may be restructured, etc. In the meantime, it would work towards suitably disposing of the toxic assets. This concept has been successfully implemented in many western European countries post the 2007 financial crisis like Ireland, Sweden, France etc.

Aspirants would find this article very helpful while preparing for the IAS Exam.

Recent Proposal of Bad Banks by Indian Banking Association (IBA)

Indian Banking Association (IBA) has submitted a proposal to both the Government and the Reserve Bank of India (RBI) to set up a ‘Bad Bank.’ 

As per IBA estimates the ‘Bad Bank’ would require approximately Rs 10,000 crore of capital initially. The exact quantum of capital and amount of bad loans to be housed in the proposed ‘Bad Bank’ would only be finalised after discussions with the Government and Reserve Bank of India (RBI).

Bad Bank – Origin of Concept

The concept of a bad bank was pioneered at the Pittsburgh-headquartered Mellon Bank in 1988. Bad Bank would set up as a separate entity that would buy the Non-Performing Asset from other banks to free up their books for fresh lending. It is focused on the task of recovery.

A bank may accumulate a large portfolio of debts or other financial instruments which unexpectedly become at risk of partial or full default. A large volume of non-performing assets usually make it difficult for the bank to raise capital, for example through sales of bonds.

In these circumstances, the bank may wish to segregate its “good” assets from its “bad” assets through the creation of a bad bank.

How Does ‘Bad Bank’ Work?

1. Banks will be able to demarcate their assets into good assets and toxic or bad assets.
2. Good assets are ones in which loans are repaid as per schedule, and defaulted ones are classified as toxic assets or bad assets.
3. Toxic assets can be removed from Banks books and transferred to Bad Bank which has the sole purpose of aiding the recovery of risky assets.
4. Hence the banks will clean up and reduce their exposure to risky assets.
5. Bad Bank will absorb all the toxic assets of banks at a price below the book value of these loans.

What is the Need for a Bad Bank?

Investors would see large NPA’s as a sign of Banks ill-health or financial weakness. If the NPA’s are high, then the Bank loses its ability to borrow, lend or conduct business.

Bad Bank Structure – IBA Proposal

The ‘Bad Bank’ will be a 2 tiered structure.

Tier 1:

1. There will be an Asset Reconstruction Company (ARC) backed by the Government which would buy bad loans from banks and issue Security Receipts to the Banks.
2. As per RBI guidelines, ARC will hold Security Receipts of 15%.
3. Banks will get 15% of the cash and will hold 85% of Security Receipts. Hence it is called 15:85 structure.

Tier 2:

1. There will be an Asset Management Company (AMC).
2. AMC would be run by public and private bodies which includes banks as well.
3. Turnaround professionals.

Past Debates on Bad Banks 

The idea of Bad Bank is not new. Currently, this is in the news due to the problem caused by COVID-19. Earlier the topic of Bad Bank was a matter of debate in the banking and finance circles when former Interim Finance Minister Piyush Goyal had put forward the idea when a committee headed by Sunil Mehta was formed to study the feasibility of National Asset Reconstruction Company. Even in 2017 Economic Survey had mooted the idea by suggesting the creation of Public Sector Asset Rehabilitation Agency (PARA). Even former RBI governor Raghuram Rajan had started a debate on Bad Banks in 2015 as a possible solution to the problems of Non Performing Assets.

Question for the Day on the Topic

Consider the following statements

1. Bad Bank would set up as a separate entity that would buy the Non-Performing Asset

from other banks to free up their books for fresh lending.

2. This concept has been successfully implemented in European countries post-2007

financial crisis.

Which of the statements is/are true?

A) Only 1

B) Only 2

C) Both 1 and 2

D) Neither 1 nor 2

Answer: C

A bad bank is a bank that _________

A) Buys the loans of other lenders to clear their balance sheets

B) Cannot recover their losses by any means available

C) Have been taken completely over by another entity

D) Has bad Cash Reserve Ratio

Answer: A)

Candidates can find the general pattern of the UPSC Exams by visiting the UPSC Syllabus 2021 page.

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