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India’s first ever Bad Bank announced by Finance Minister – NARCL to acquire Rs 2,00,000crore NPAs

India’s first ever Bad Bank announced by Finance Minister – NARCL to acquire Rs 2,00,000crore NPAs

Relevance:

  • GS 3 || Economy || Banking & Financial Sector || Banking Reforms

Why in news?

Government released the fine print of the proposed entity that will acquire stressed assets from bank balance sheets to enable them to lend to productive sectors of the economy.

What is Bad bank?

  • A Bad Bank is an Asset Reconstruction Company (ARC) or Asset Management Company (AMC) that takes over commercial banks’ bad loans, manages them, and recovers funds over time.
  • It is not a lender or a deposit taker, but it assists banks in cleaning up their balance sheets.
  • Bad Bank will buy all of a bank’s bad assets for less than the loans’ book value.
  • The first bad bank was established in the United States in 1988, and nations such as Sweden, Germany, and France soon followed.
  • Rationale: A bad bank is a concept that aims to reduce nonperforming assets (NPAs) in the banking sector before reviving lending and credit growth.

It will be possible to construct bad banks:

  • The new bad bank is the NARCL-IDRCL structure.
  • Under the Companies Act, the National Asset Reconstruction Company Limited (NARCL) has already been formed.
  • It will buy stressed assets totaling Rs 2 lakh crore from a number of commercial banks in stages.
  • The stressed assets would then be sold in the market by another business, India Debt Resolution Company Ltd (IDRCL), which has also been established.

What is the NARCL-mechanism IDRCL’s of operation?

  • The NARCL will buy problematic loans from banks first.
  • It will pay 15% of the agreed price in cash and the rest 85% in “Security Receipts.”
  • The commercial banks will be paid back the remainder when the assets are sold with the help of IDRCL.
  • The government guarantee will be activated if the bad bank is unable to sell the bad loan or must sell it at a loss.
  • The difference between what the commercial bank was intended to get and what the bad bank was able to raise will be reimbursed out of the government’s Rs 30,600 crore.

Benefits of bad bank:

  • Regular Banks’ Revival: If there are no bidders for the assets, it makes logical to delegate responsibility for hazardous assets to domain experts until they can be sold. After moving its hazardous assets to the bad bank, the regular bank may concentrate on its long-term core business without having to worry about the toxic assets.
  • Stakeholders’ and agencies’ good books: Cleaning up the regular bank’s balance sheet by shifting toxic assets to the bad bank will improve the regular bank’s image in the eyes of credit rating agencies, investors, lenders, borrowers, and depositors.
  • Growth of Business:Transfer of Toxic Assets would enable the company to engage in profitable/growth-oriented commercial operations.
  • Bad asset centralization: The ownership of toxic assets and their collaterals is concentrated in the bad bank, allowing for better asset management.
  • Reduces the danger of failure: The good bank-good bank system reduces the risk of contagion. Because the regular bank’s toxic assets are removed from its balance sheet and transferred to a new business, the regular bank’s non-performing assets are less vulnerable to failure.
  • Improved Cost Discovery: A poor bank is best suited for price discovery, which is a key part of the negotiation. If the discovered cost is less than the book value and the bank wants to keep it on its books, it should make additional provisions.

Challenges associated with bad bank:

  • Not Addressing the Root Cause: Without governance reforms, public sector banks (which accounted for 86 percent of total NPAs) may continue to operate as they have in the past, resulting in the accumulation of bad debts.Furthermore, the bad bank concept is equivalent to transferring debts from one government pocket (public sector banks) to another (the bad bank).
  • Mobilizing Capital: Finding buyers for damaged assets in a pandemic-affected economy will be difficult, especially when governments are grappling with the issue of fiscal deficit reduction.
  • Recapitalization Addresses Provisioning Issues: Over the previous few years, the Union Government has injected about Rs 2.6 lakh crore into banks through recapitalization.Those who oppose the concept of bad banks argue that the government has recapitalized banks to compensate for write-offs, and hence a bad bank is unnecessary.
  • Moral Danger:Former RBI Governor Raghuram Rajan stated that a bad bank might create a moral hazard, allowing banks to pursue risky lending practices without any commitment to eliminate nonperforming assets (NPAs).
  • Market-related Issues: The price at which bad assets are transferred from commercial banks to the bad bank will not be established by the market, and there will be no price discovery.

Steps taken by government:

  • Economy’s credit flow: The RBI and the government made steps to remedy this issue, which was having a negative influence on the economy’s credit flow. The RBI’s strict regulations, reforms including The Insolvency and Bankruptcy Code (IBC -2016), and government initiatives to recapitalize banks helped reduce the gross nonperforming assets (NPA) ratio in the banking sector to 8.5 percent in March 2020.
  • However, many corporations are in a bad financial state as a result of the COVID crisis’ influence on economic activity, and the NPA ratio is ready to rise once more.
  • Furthermore, the exact magnitude of the growth in NPAs is uncertain due to government backing, a credit moratorium, and banks’ easing of NPA reporting requirements.
  • However, according to the RBI’s recent financial stability assessment, gross nonperforming assets (NPAs) might rise to 12.5 percent in March 2021, or 14.5 percent in the worst-case scenario.

Conclusion

The resolution of bad loans in five years will be a big challenge.The private ARCs have been struggling to resolve the issues as there has been a lack of interest among buyers.Many of the NPAs have very little value left for getting a good price.

Mains oriented question:

Discuss how the concept of a bad bank might help the Indian banking system deal with the NPA situation and restart lending.