A series of bad debts ultimately leads to the creation of a ‘Bad Bank’. But let us understand bad debts first. When an individual or corporation is unable to repay their loan amount to a bank, it gets classified as bad debt. In the long run, when several bad debts spiral out of manageable limits, a separate bank needs to be created to manage these bad debts collectively. This new bank created to take the hit for the bad debts of all the banks in a country or nation is called a ‘Bad Bank’.
Recently, Union Finance Minister Nirmala Sitharaman took stock of the mounting problem of surging bad debts in India’s banking sector. After much deliberation, she announced the creation of the ‘Bad Bank’. To put it simply, the ‘Bad Bank’ will be responsible for acquiring bad debts from multiple banks worth two lakh crore rupees. According to the proposal, the Union cabinet has approved a whopping 30,600 crore for the National Asset Reconstruction Company (NARCL). One of the main reasons for the formation of ‘Bad Bank’ is to destress the banks’ balance sheets.
Interesting Fact: Did you know that this is not the first time that India has launched a “Bad Bank” after facing a bad loan crisis? In fact, there have been 28 privately owned firms functioning as ‘Bad Banks’ in the past two decades alone!
But what’s so different about the ‘Bad Banks’ created this time around?
The government has formed two companies under Nirmala Sitharaman’s jurisdiction.
The first will be state-owned and tasked with acquiring the bad loans. The second will be partly privately owned and will strive to sell the assets.
What will be the impact of ‘Bad Banks’ on Micro, Small and Medium Enterprises (MSMEs)?
Owing to the tremendous amount of bad debt that banks all over the country have generated over the past few decades, our nation’s financial institutions are getting progressively hesitant to loan large amounts to individuals and corporations. The scepticism has, in turn, impacted MSMEs who are in genuine need of loans to scale their businesses. ‘Bad Banks’ will help banks get rid of bad assets by shifting them to the ‘Bad Bank’ and cleaning up their books. The ‘Bad Bank’ will release capital for the banks and help them restart lending. This will eventually benefit MSMEs to take their businesses to new heights.
Similar structures have been explored in the past. In most instances, the Asset Reconstruction Companies (ARCs) tend to generate capital. In this scenario, 51% of the ownership lies with the public sector banks (PSBs). Considering that they take even a haircut on their balance sheets, they can easily expect monetary profits through their ownership of the ARC. Eventually, it may so happen that the overall haircuts may be reduced further, and the recovery process will be improved in the event of the institution’s effective functioning. The ‘Bad Bank’ configuration is favourable for delivering a final solution to the stress faced by the banking sector, and it builds on the other reforms introduced since 2015.
A ‘Bad Bank’ may relieve banks of their stress temporarily and help them trigger their lending processes again. That being said, we must not disregard other structural reforms that will help with greater governance and supervision during the lending process. This will, in turn, help improve the price discovery process for an impaired asset.