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What is a Bad Bank?

A bad bank is a bank/ entity that acquires risky and illiquid assets of banks and financial institutions. Bad banks help in cleaning the balance sheets of a bank by taking over its bad loans. As a result, banks can now focus on their core business of deposits and lending.

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In addition to cleaning their balance sheets, banks offload bad assets to the bad bank as well. This helps the bank improve its credit ratings and rebuild trust among investors and the public. Also, it helps in protecting the earnings and minimizing losses.

Mellon Bank, based in the United States, established the first bad bank – Green Street National Bank, in 1988 to hold its stressed assets. Subsequently, many countries have adopted the concept.

In Dec 2020, the European Commission expressed its interest to establish bad banks. It aims to remove non-performing assets/loans from banks’ balance sheets to help address the severe economic downturn.

India’s Finance Ministry also expressed its intention to establish a bad bank. However, the greater problem will be selling those stressed assets to potential buyers in order to remedy the crisis.

National Asset Reconstruction Company Ltd. (NARCL) is a bad bank incorporated to take over INR 2 lakh crore worth of Non Performing Assets (NPA) from domestic banks.

What is an NPA?

Non-Performing Asset (NPA) is any loan or advance that is overdue for more than 90 days. Thus, any asset that is unable to generate income for a duration of 90 days for the bank is categorised as a non-performing asset.

How do Bad Banks Work in India?

The main aim of a bad bank is to restore stability to the banking industry, enabling credit flow and reinstating investor trust. Bad banks often acquire risky or troubled assets, such as defaulted assets or loans that have lost value as a result of current market conditions. Furthermore, a bad bank can also acquire financially sound assets to aid banks in their restructuring efforts.

For example, during and after the 2008 financial crisis, the majority of bad banks were incorporated to stabilize the banking industry. Also, to prevent several significant financial institutions from failing as asset values collapsed.

The type of bad bank and its structure largely depends on the goals and financial institutions’ intention to keep assets on their balance sheet. Following are the four types of bad bank structures:

  • Bad Bank Spinoff: This is the most popular form of a bad bank. Here, the bad bank is a separate legal entity that will acquire all the bank’s bad assets.
  • On Balance Sheet Guarantee: Under this structure, banks safeguard a part of their portfolio losses with a guarantee that the government backs them.
  • Internal Restructuring: Under this type of structure, a bank will establish a separate internal unit to isolate its bad assets. This type of structuring is popular when the bad assets account for more than 20% of the bank’s balance sheet.
  • Special Purpose Entity: Under this structure, all the undesirable assets of a bank are transferred to the bad bank. Usually, such a bad bank is sponsored by the government.

Why it is Important for Investors & Depositors?

Banks typically generate income by earning interest on the loans. Borrowers pay regular interest for the principal borrowed. Banks then use this interest income to pay depositors interest on their deposits. Thus, the difference between the interest income and interest expenditure is the bank’s profit. Hence, the interest charged on loans is higher than the interest paid on deposits.

Banks use the deposit amount to lend money to borrowers. As a result, when the borrower is unable to meet their obligation of interest payments or principal repayments, it becomes difficult for the bank to pay depositors. Thus, banks must be efficient at recovering loans to be able to run their business.

Banks do not have to worry if the bad loans are small as they can be adjusted through interest rate tweaks. However, it becomes problematic when bad loans pile up and the bank is unable to cover them through interest rate tweaks.

Due to COVID and economic slowdown, the gross NPAs of banks have witnessed a significant rise. Assocham and Crisil’s report (September 2021) suggests that the Indian public sector banks must strengthen their risk management techniques and practices.

Thus, it is important to incorporate bad banks to take over banks’ bad assets and help them focus on their business. In other words, the banks are expected to concentrate on recoveries of their most recent loans and also further lending. They should no longer worry about recovering from the chronic defaulters.

Bad banks provide lending leverage to banks. To elaborate, bad banks help free the capital from fully provisioned bad assets. Furthermore, the bad bank uses the cash receipts for lending purposes.

Moreover, with the economic slowdown, bad banks help in reviving the credit flow in the market.