What are Bad Banks and how do they function?

by Teesta Bose (edited by Shivansh Raman)

In the budget session of FY 2022-23, Finance Minister Nirmala Sitharaman announced the approval of bad banks. The name seems to give the impression of an evil corporation, however, it is just meant to take the load off of bad loans from the main banking structure. The loans that are not being repaid by the borrowers of a bank are termed as bad debts. These debts are clubbed together, and a separate body of banking is formed to look into them, called the “Bad Bank”. The idea of a bad bank originated in 1988 at Mellon Bank, Pittsburgh, USA. It has been implemented in many countries like France, Germany, Sweden, China, etc.

What are these assets or “bad” loans that we are talking about? The term NPAs might ring a bell. An NPA (non-performing asset) is a loan, whose borrower has stopped paying interest and principal on the loan, for more than 90 days or three months. The percentage of non-performing loans of the total loans in a country reflects the health of its banking system. If this percentage is very high, it means the banks are having trouble recovering their loans and making profits. India had a maximum of 9.89% of NPAs in 2017.

Essentially, the difference between the interest earned through providing loans and interest paid on deposits is the profit earned by a bank. And the deposits of money kept with a bank is used by them to give loans. So, when loans are not repaid, it is difficult for a bank to earn and return deposits to customers. A small amount of unpaid loans doesn’t affect the day-to-day functioning of a bank, however, if the quantity of unpaid loans increases, it becomes a problem drowning the whole banking sector. The gross NPA of public banks alone as of September 2021 was Rs. 5,40,442 crores. The number of NPAs have doubled in the last seven years. With the post COVID moratoriums and recoveries, the total of Rs. 8.40 lakh crores worth of NPAs in 2020, declined to Rs. 7.80 lakh crores in 2021. The Indian Banking Association (IBA) hence pushed an application at the end of last year to RBI, to set up NARCL or National Asset Reconstruction Company Ltd. For Rs. 6000 crores.

Two entities have been created for asset reconstruction and asset management that will handle the stressed debts and bring in investments for the realized value of these assets. The National Asset Reconstruction Company Ltd. or NARCL will be owned in majority by the public sector banks, and the India Debt Resolution Company Ltd. or IDRCL will be owned in majority by the private sector banks. NARCL will aggregate and consolidate the stressed assets with the banks. They will acquire stressed assets from the banks by making an offer through a 15:85 structure. The NARCL will pay 15% of the price in cash and the rest 85% will be issued as “Security Receipts” or SRs.

These receipts are backed by the government and its guarantee is the difference between the face value of the asset and the final value that will be realized during the purchase or liquidation of the asset. The government-backed guarantee helps improve the value of the SRs, and the cabinet last September approved a 5-year guarantee of Rs. 30,600 crores to be used by NARCL as security receipts to acquire stressed assets. The NARCL will then work with IDRCL on debt resolution and process. IDRCL will manage the stressed assets, work on the valuation and pricing for the assets in the market and attract foreign and domestic prospective investors for the assets. The NARCL and IDRCL will work according to the Principal-Agent arrangement, where the final decision for resolution approval will be given by the NARCL as the Principal. Since the majority ownership of NARCL is by public banks, this agreement pays heed to regulatory concerns around the bad bank framework. There are 38 accounts identified, adding to a sum of Rs. 82,845 crores, will be transferred to the NARCL under two phases. In the first phase, 15 accounts will be transferred, amounting to Rs. 50,335 crores, on or before 31st March 2022. The NARCL will be led by Mr Padmakumar Nair, Chief General Manager of SBI’s Stressed Assets Vertical and IDRCL will be led by Mr Manish Makharia, SBI’s Head of Alternate Investment Fund. Mr Subrata Biswas, a nominee on the Board of NARCL will be its interim chairman and Mr Diwakar Gupta will continue to chair the IDRCL.

It will be challenging for the bad banks to come at the right valuation of these stressed assets and sell them to investors in a dynamic economy, keeping in mind the supply-chain disruption and rising inflation due to the pandemic as well as the current Russia-Ukraine scenario. Although the creation of bad banks doesn’t mean the end of bad loans in future, it does lighten the books for banks that might be charging high-interest rates on loans due to a shortage of deposits.