What is a Bad Bank? Know its significance, role and benefits here

Why in News?

The Indian economy has recently shifted into a technical recession. It has contracted during the first two quarters of this fiscal year. The economy is expected to shrink 7.5% the coming year. 

What is a Bad Bank? 

Banks drive the nation’s economy, however many times the borrowers find it difficult to service their loans. It requires the lenders to set aside the capital to cover the losses.

This is when the bad bank comes into the picture to help them free up to start lending. A bad bank is an Asset Reconstruction Company in other words.

Key Points: Bad Bank

1. The bad bank does not involve itself in lending and taking deposits, but it helps to make commercial banks clear their balance sheets and resolve bad loans.
2. The process of taking over bad loans is generally below the book value of the loan
3. Bad bank tries to recover as much as possible from those bad loans
4. Mellon Bank based in the USA was the first one in this field. It is referred to as the first bad bank in 1988. 
5. A bad bank aids a bank to segregate its good assets from the bad ones which make it easier to raise capital through equity or debt.

What is the Significance?

The toxic assets separation helps in generating some confidence among potential investors so that they can then clearly examine the financial health of the lender.

Sour loans when transferred to a bad bank can help lenders prioritize their financing business and the specialized institution deals with maximizing loan recovery.

The requirement of bad bank :

The lockdown that was imposed due to pandemic to curb covid spread has crimped the earnings of the businesses and individuals. 

It impaired their ability to repay loans which caused a hike in non-performing assets of banks. The corporate sector has come under the debt of INR 15.52 lakh crore.

Despite the regulatory forbearance as a loan moratorium, borrowers are finding it difficult to service their loans. This then requires lenders to set aside their capital to cover such losses. A bad bank can provide them with the freedom to restart lending.

The RBI in its recent FSR informed that the gross NPAs in the banking sector was expected to shoot up to 13.5% of advances by September 2021, from 7.5% in the previous year.

Challenges of Bad Bank:

The major issue would be of finding buyers in the pandemic hit economy. The government is itself facing fiscal deficits at present

Without governance reforms, the Public sector banks would continue doing business in the same way as in the past. It may also end up piling-up bad debts again.

Union Government has already infused almost 2.6 lakh crore in banks through recapitalisation so now bad banks would do no better as per many economists. 

Bad banks can also ease off the banks of their moral responsibility and let them lend without any commitment to clear their NPAs.

Go  through the Static and GK Quiz January 20, 2021 here