Idea of Bad Banks: All you need to know about it!

The four models available for bad banks are: on-balance-sheet guarantee structure, Bad bank spin-off, Special purpose entity model and Internal restructuring unit.

Created On: Feb 27, 2017 14:48 IST
Modified On: Feb 27, 2017 18:14 IST
All about Bad Banks
All about Bad Banks

The problem of NPA is the banking sector has reached a stage from where it is necessary to take some tough calls on the part of the government as well as the RBI. The NPA level of PSBs which account for nearly 70 percent of the total banking sector stands at over 12 percent whereas for some of them it is higher at 15.88 percent. It is in this perspective that the concept of bad bank was introduced by RBI for public opinion and discussion.

Bad Banks: Understanding the basic concept

In order to take care of the spiraling NPA levels in banks, the solution has been muted as the implementation of Bad Bank Model. It is very simple as a concept. A bank divides its assets into good and bad. Good assets or performing assets are those which continue earning whereas bad assets are not able to generate any income. Segregation of these two is very necessary since bad assets can contaminate the good assets. This also helps in the alleviation of uncertainty hovering over the financial strength of an organisation regarding bad assets in the minds of the investors and helping the bank extend more credit to the society in the future. In the context of Basel III capital requirements, it helps in raising capital from the market as well.

So, What is a bad bank? Understanding the Model

Though the idea of the bad bank has been mooted already, there has not been any meaningful and fruitful discussion regarding the structure and operation of the bank. Now, what are models available for consideration in the case of starting a bad bank in India? According to a research paper by Mckinsey and Co. the same can be decided based on two factors:

  • Whether to keep the bad assets on the balance sheet of the banks. Though moving off the assets seems more viable from the point of view of the investors, it is a complicated and expensive process.
  • Whether bad loans and stressed assets are to be housed in banking entity or a special purpose vehicle (SPV) needs to be created for it.

Depending on these factors, there are four models available:

  • On-balance-sheet guarantee structure: This model is very easy to implement since the assets are not taken off from the balance sheet of the bank. But the bank gets a guarantee from the government in case of loss for a part of its portfolio. This is a less expensive model to follow but the government needs to bail out the bank in case of any financial difficulty.
  • Internal restructuring unit: This model asks for creating an internal team in the bank to take care of the bad assets. This unit will be incentivized based on its performance and the financial results of this unit will be displayed separately. This will be beneficial for investors since there will be clear segregation between the Core Assets and the Stressed Assets. However, with present management at the helm, it does not look much effective solution because just like the present situation, the staffs in this unit also try to pass the buck and do nothing at all.
  • Special purpose entity model: In this case, the bad assets are offloaded to a special organization designed for this purpose and these assets are then sold in the market. This helps in shifting the onus from bank bosses to the special entity. However, in India, the NPAs are mainly concentrated in certain sectors such as infrastructure, power etc and that is why this approach may prove to be effective in the Indian context.
  • Bad bank spin-off: This is the most thorough and effective model in the bad bank scenario. In this case, the stressed assets are transferred to a separate banking entity. But this process is very complex and expensive because of the requirement of regulatory compliance, adept staff and IT infrastructure. Hence, it should be used as a last resort. The Public Assets Rehabilitation Authority or PARA that has been conceptualised by the government falls under this category.

The concept of the bad bank has been there for long but in a case of India, setting up of a bank is not going to solve all the problems. It is not a panacea for each and every issue. The approach should be sector specific apart from the fact that political interference should be withdrawn from the decision-making process of the banks. The idea is still hanging fire and the RBI, as well as the government, does not look very eager to implement it anytime soon. The banking sector needs systematic revamp and not a top-down approach such as a bad bank.


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