Question-2: What is a Bad Bank ? How does the piling up of non performing assets affect the functioning of a bank?
Answer: A bad bank is a financial entity set up to buy non performing assets (NPAs), or bad loans, from banks.
The aim of setting up a bad bank is to help ease the burden on banks by taking bad loans off their balance sheets and get them to lend again to customers without constraints.
Working of bad banks
- After the purchase of a bad loan from a bank, the bad bank may later try to restructure and sell the NPA to investors who might be interested in purchasing it.
- A bad bank makes a profit in its operations if it manages to sell the loan at a price higher than what it paid to acquire the loan from a commercial bank.
- A supposed advantage in setting up a bad bank is that it can help consolidate all bad loans of banks under a single exclusive entity.
How NPAs affect functioning of a bank
- Large capital of commercial banks is locked in form of bad assets. Without disposing the bad assets, the bank cannot extend new loans and in turn its expansion is curtailed.
- Many commercial banks have low profits due to bad loans, which has affected its value. Once bad assets are disposed off, the value of banks will be realized again.
Thus, a bad bank, in reality, could help improve bank lending not by shoring up bank reserves but by improving banks’ capital buffers.
Tags: GS 3 (Economy)
By – Prashant Tiwari