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Union Budget 2021 – What is Asset Reconstruction Company or Bad Bank?

Union Budget 2021 – What is Asset Reconstruction Company or Bad Bank?

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  • GS3 || Economy || Economic reforms || Public Sector Reforms

Why in the news?

Faced with the prospect of dramatic rise in stressed assets of public sector banks (PSBs), government has proposed to set up a bad bank under the ARC (Asset Reconstruction Company) and AMC (Asset Management Company) model in which ARC will aggregate all stressed assets and transfer them to AMC for resolution. 

Background:

  • The idea of a bad bank is not new to India
  • The Economic Survey 2016-17 had first propounded the idea of setting up bad banks to tackle the rapidly emerging Non-Performing Assets (NPAs) in the banking sector.
  • The Survey had suggested the idea of setting up bad banks in the backdrop of revealed weaknesses of earlier measures such as Strategic Debt Restructuring (SDR) scheme(2015), Sustainable Structuring of Stressed Assets (S4A) (2016) etc.
  • The Economic survey had named it “Public Sector Asset Rehabilitation Agency” or “PARA” and it was mandated to take charge of the largest, most difficult cases, and make politically tough decisions to reduce debt.
  • Recently, former RBI Governor Raghuram Rajan and his deputy Viral Acharya also significantly mentioned about bad banks in their September 2020 paper “Indian Banks: A Time to Reform?”.
  • Moreover, according to the RBI, there are currently 28 Asset Reconstruction Companies (ARCs)- a type of bad bank that are already working in the private sector.

What is ‘Bad bank’?

  • Bad banks are financial institutions which acquire bad loans from the banks and other financial institutions, usually at a discount, and work to recover through a variety of measures, including sale of assets or a turnaround steered by professionals management.
  • Relieved of NPA burdens, banks can solely focus over their core interest areas.

Why India fails to resolve stressed assets?

According to the RBI’s Financial Stability Report, the Gross NPA ratio of Scheduled Commercial Banks (SCBs) was likely to rise from 7.5% in September 2020 to 13.5-14.8% in September 2021 – which would mean Rs 15-16.5 lakh crore of stressed assets in the SCBs.

Reasons:

  • Political interference in functioning of the public sector banks (PSBs): It poses the biggest challenge to resolving banking stressed assets. From the appointment of executive heads and their boards to loan disbursals, decisions are directed and influenced by the government of the day.
  • Lack of professional management: Lack of independent and professional management leads to many governance failures, like poor risk management, reporting of bad loans, evaluation and monitoring of projects and firms bankrolled, etc.
  • Impacts of fiscal and monetary policies for reviving growth: RBI in its report highlighted that the fiscal and monetary measures taken to revive the economy had “unintended consequences” of creating “macro-financial risks” to the economy.
  • Routine write-offs and restructuring: The routine write-off of loan defaults by big corporate entities and repeated recapitalisation of PSBs in compensation that further incentivises loan defaults.
  • Nature of the debts itself: The economic survey 2016-17 said stressed debts were heavily concentrated in large companies making it inherently difficult to resolve”.
  • Weakening role of RBI: The RBI’s supervisory role too has come under scrutiny since 2018 when several banks and non-banking firms started collapsing or faced serious cases of financial frauds, like the PMC Bank, Punjab National Bank, ICICI Bank, Yes Bank, Lakshmi Vilas Bank, IL&FS, HDIL, DHFL, etc.

Advantages of Bad banks:

  • Clear-off balance sheets of financial institutions: The bad bank would help banks and Financial Institutions clear-off their balance sheets by transferring the bad loans and focus on its core business lending activities.
  • Smooth debt resolution: Large debtors have many creditors. Hence a bad bank could solve the coordination problem, since debts would be centralised in one agency.
  • Speedier settlements: Bad banks can also affect speedier settlements with borrowers by cutting out individual banks.
  • Professional enforcement of settlements: It can drive a better bargain with borrowers and take more stringent enforcement action against them.
  • Revenue resources: It can raise money from institutional investors rather than looking only to the Government.

Concerns associated with Bad banks:

  • Requirement of capital: The bad bank will require significant capital to purchase stressed loan accounts from public sector banks.
  • No guaranteed private participation: The chances of private participation are low unless investors are allowed a major say in the governance of the new entity.
  • Larger issues of misgovernance in banks: Bad banks will not address more serious corporate governance issues plaguing public sector banks that led to the NPA problem.
  • New wine in old bottles: Unless effective reform measures are taken, setting up a new institution would be very time-consuming and non-effective. Is it viable in the Indian context, where most NPAs constitute viable projects pending due to structural bottlenecks in decision-making?
  • Ownership and scope for corruption: Challenges on its ownership structure as well as the pricing of bad loans taken over from banks. This also includes questions like who would hold the majority of stake in Bad banks- private or public?

Way out:

  • Bad banks could be envisaged through PPP route in accordance of appropriate arrangement between private and public authorities
  • Parliament should establish a statutory body- Loan Restructuring Agency (LRA) by an act of Parliament. Its mandate should be to guide banks in smooth transferring loans to bad banks.
  • Bad banks should be installed only for weaker banks instead of ‘one size fits for all’ policy.

Model Mains Question:

  1. What are the reasons behind the perennial problem of rising NPAs in the banking sector in India? In this context, discuss the viability of setting up Bad Banks.