The Concept Of Bad Bank

The Idea of setting up a bad bank in India in order to solved its stressed loan problem has been invoked by the economic survey and finance ministry. here, we have discussed this concept in detail.

Created On: Apr 6, 2017 11:09 ISTModified On: Apr 11, 2017 12:07 IST

Idea of Bad BankWhat is a bad bank?

The idea of bad bank has been there since the problem of bad loans started growing rampantly. The concept of ‘bad bank’ would be a centralized agency that would take over the largest and most difficult stressed loans from public sector banks in order to help clean their balance sheets, and would take politically tough decisions to reduce debt, providing an impetus to further lending to spur economic activity.
The concept of bad bank is simple. It is about dividing a bank’s assets into two categories, good and bad. After the separating them into two categories, a bank can avoid the contamination of good assets by the bad. It also reduces the concerns of investors and helps the bank focus on future lending by improving transparency and health.

History of the Bad Bank concept

As above, we have understood that the concept of a “bad bank” involves the takeover of assets from public sector lenders, thereby making them to focus on their normal commercial activities.
First time, the concept of bad bank was pioneered at the Pittsburgh-headquartered Mellon Bank in 1988 in response to problems in the bank’s commercial real-estate portfolio.
According to McKinsey & Co, the concept of a “bad bank” has been applied in previous banking crises in France, Sweden, and Germany.
In India, over the years the RBI has introduced multiple schemes to solve the problem of bad loans. Most important schemes of them are Flexible Refinancing of Infrastructure (5/25 scheme), Strategic Debt Restructuring (SDR), Asset Reconstruction (ARC), Sustainable Structuring of Stressed Assets (S4A) and Asset Quality Review (AQR).

The Stressed loan problem in India

The main reason behind the bad loan problem is the lending boom that India’s banks embarked on in the period 2004-08. In this period, India saw economic growth reach the 9-10% range.
It is not the case that by itself did not create a problem of the current magnitude. It is the government’s fiasco to resolve the bad loan problem over the past several years that has worsen the problem.
Apart from it, the “twin balance sheet problem” continues to exist in India. On the banking side, stressed assets stand at over 12% of the total loans in the banking system.
 Public sector banks, which own almost 70% of banking assets in India, have a stressed-loan ratio of almost 16%.
At public sector banks (PSBs), bad loans were 12% of all advances. Another 3% of loans in the aggregate (and 4% at PSBs) have been restructured.
The Economic Survey (2016-17) states that market analysts are saying that 4-5% of loans are bad loans that have not been recognized as such.
Thus, total stressed assets or NPAs, or restructured loans and unrecognized bad loans would amount to a staggering 16% of all loans and nearly 20% of loans at PSBs.

Setting up a bad bank

Establishing a bad bank is a very complex process. It should not be considered a silver bullet which will solve all the problems in the Indian banking sector. More significantly, a one-size-fits-all approach to designing a bad bank can be less effective and very expensive.
As The Economic Survey (2016-17) suggested PARA for solving NPA problem. But just setting up one PARA will not be enough to get the banking sector back on track.
The most efficient approach would be to design solutions tailor-made for different parts of India’s bad loan problem.
It is important for banks to decide whether or not to keep the bad assets on the bank’s balance sheet. Moving assets off the balance sheet is better for investors and counterparties.
 It provides more transparency into the bank’s core operations. But it is more complex and expensive.
It is also important to decide whether the bad-bank assets will be housed and managed in a banking entity or a special purpose vehicle (SPV).
There are four basic bad-bank models: on-balance-sheet guarantee, internal restructuring unit, special-purpose entity and bad-bank spin-off.

1. On-balance-sheet guarantee


In the on-balance-sheet guarantee structure, the bank gets a loss-guarantee from the government for a part of its portfolio. This model is less expensive, simple and can be implemented quickly. The transfer of risk is limited and bad assets continue to remain on the bank’s balance sheet, contaminating its core performance.

This approach is useful for assisting a bank in trouble.For example we can consider the case of the Indian Overseas Bank (IOB).Till December 2016, the bank reported gross non-performing assets (NPAs) of 22.42%, net NPAs of 14.32% and a net loss of Rs554 crore. Since May 2016, the stock price of IOB has dropped more than 20%. In this case, an on-balance-sheet guarantee by the government can restore confidence in the bank.

2. Internal restructuring unit

An internal restructuring unit is similar to setting up an internal bad bank. The bank specifies bad assets in a separate internal unit, assigns a separate management team and provides them clear incentives.This works as a signaling mechanism to the market.

It also increases the bank’s transparency, if the results are reported separately.It is explicit that this model depends on the existing management team to restructure assets.

3. Special-purpose entity

In this kind of structure, bad assets are offloaded into a SPV, securitized and sold to a diverse set of investors.The model is best for a small, homogeneous set of assets.

The bad loan problem in India is concentrated in a few sectors like infrastructure and basic metals. An effective solution would be to transfer bad loans from these distressed sectors into sector-specific SPVs, securitize them and sell them in an auction. If the pricing is determined by the market, PSU bankers will receive less blame for losses to the exchequer.

4. Bad-bank spin-off

A bad-bank spin-off is the most familiar, effective and thorough bad-bank model. In a spin-off design, the bank shifts bad assets into a separate banking entity, which ensures maximum risk transfer.This model is expensive and complex because it requires setting up a separate organization, equipped with IT systems, a skilled management team, and a regulatory compliance set-up.

The problem pertaining to asset valuation and pricing will be the most severe in this model.The Public Sector Asset Rehabilitation Agency (PARA) proposed by the Economic Survey 2016-17 falls in this category.

Challenges in Implementation

Now we know that the concept of a bad bank is simple, but the implementation can be very complicated. Economic and Banking experts have unanimously agreed that the structure and design of the bank would be most significant factor in the success of bad bank. Several financial and organizational choices are available while designing a bad bank.
The concept of ‘bad bank’ has its own critics, they think that such an approach would simply shift the soured debt from banks to another firm. They have argued that the focus needed to be on how to restructure the bad loans.
There is another factor of reputation which makes the problem of bad bank funding very difficult. Due to the fear of vigilance inquiries, bankers will not be willing to sell stressed assets to the bad bank at a substantial hair cut.
In such cases, the bad bank will have to pay more to acquire the assets and thus increase the funding burden on the government
Apart from it, political and macroeconomic viability will play a key role while considering the implementation of the bad bank.


By considering the whole band bank and bad loan scenario, it can be said that solutions to the NPA problem will have to be designed keeping in mind the political economy of India.
 Regular communication about running efforts to bring fraudulent defaulters to justice can help in boosting confidence in the bad bank initiative.
For making bad bank a viable solution, the government and the RBI will have to ascertain that it does not get labeled as a “bailout” of crony capitalists and corrupt bankers at the cost of taxpayers.
For this purpose, we need a larger and multiple and oversight committee to speedily vet loan write-offs. It is advisable constitute a Loan Resolution Authority by an Act of Parliament.
The government would be required to provide adequate capital to the banks to cover write-offs and also facilitate fresh loan growth. If all these measures would be met then it can be possible that India could get rid of the bad loan problem.

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