Will a Bad Bank Save India's Banking Sector?
The Central government has come up with a vital measure to tackle the looming bad loans crisis in India’s banking sector. They have established a bad bank to take over bad debts worth Rs 2 lakh crore from public sector banks. There has been a lot of hype regarding the institution lately. In today’s article, we discuss the concept of a bad bank and how it could reduce the burden of India’s banking industry.
The Rising NPA Crisis in India
Banks are the backbone of any modern economy. They provide the necessary credit (loans) to empower citizens and develop core sectors of the country. As we know, lenders earn income through the interest they receive on loans. Thus, banks need to recover their loans (along with interest) on time to run their core business.
Unfortunately, India has been facing a severe crisis with respect to bad loans for a while now. Non-performing assets (NPAs) or bad loans have increased multifold across all prominent banks in India over the past decade in the aftermath of the global financial crisis (2007-’08). [NPAs are those assets on which interest has not been received for at least three months]. Simply put, individuals and businesses are unable to pay back their loans due to unfavourable economic conditions. The situation has deteriorated further amidst the Covid-19 pandemic.
Once unpaid loans start piling up, banks and other financial institutions would face losses. They won't be in a position to extend new loans. Outside investors will not be willing to infuse money into such institutions. Ultimately, small businesses will suffer as they cannot borrow essential capital at reasonable interest rates.
According to a report from the Reserve Bank of India (RBI), the total value of bad loans in the Indian banking system stood at Rs 8.35 lakh crore as of March 2021! And this figure excludes NPAs of private sector banks. The volumes of NPAs are not only large but also fragmented across various lenders. These stressed assets have been sitting on the financial books of state-owned banks. This essentially means that the Centre has been continuously using taxpayer money to re-capitalise and support them.
What is a Bad Bank? How Does it Work?
To tackle this serious issue, Finance Minister Nirmala announced the creation of the National Asset Reconstruction Company Ltd (NARCL) or a “bad bank” in her Budget speech for 2021-22. This entity will take the form of an asset reconstruction company (ARC). It will adopt bad debts of public sector banks (typically below their book values). This measure will help the Indian banking sector to get rid of a large sum of NPAs.
All poorly performing loans will be moved to the NARCL. Thus, commercial banks will be left with loans that are likely to be paid in full. As the balance sheets will be cleaned up, outside investors might be willing to infuse some cash into such banks. When a bank receives more capital, it can increase its reserves and extend new loans.
Important Facts on NARCL
- The NARCL aims to acquire total stressed assets worth up to Rs 2 lakh crore from the lenders’ balance sheets. The process will be completed in phases based on the framework and regulations of the RBI.
- The NARCL will be supported by the India Debt Resolution Company Ltd (IDRCL). This entity will manage the acquired assets (bad loans) and allow market professionals to add value to them. It will essentially recover the NPAs. The IDRCL is nothing but an asset management company (AMC).
- Upon resolution, the bad bank will pay up to 15% of the agreed value for cash loans to the banks. The remaining 85% would be government-guaranteed security receipts (SRs). On Sept 15, the Cabinet approved a government guarantee of up to Rs 30,600 crore to back SRs to be issued by NARCL.
- Public sector banks will hold a 51% stake in NARCL and a 49% stake in IDRCL. The remaining stake in both entities will be held by private-sector lenders. The State Bank of India, Union Bank of India, and Punjab National Bank have picked up over 12% stake each in NARCL. Indian Bank has acquired 13.27% in the proposed bad bank.
Bad banks are not a new concept. The first bad bank in the world was created way back in 1988 by US-based Mellon Bank to hold its stressed assets. Following its success, bad banks became a widely recognised model in several countries such as Finland, Sweden, Indonesia, and Belgium. However, such a measure has been unsuccessful in countries such as China, Mexico, and Italy due to improper planning and execution.
On Sept 4, the RBI granted a license to the Rs 6,000 crore NARCL. This move will kickstart the operations of the bad bank. The creation of the NARCL and IRDCL would help accelerate the resolution process of NPAs. Banks in our country will benefit from improvement in the value of NPAs through the IRDCL. However, a crucial challenge would be to sell the stressed assets to prospective buyers to resolve the crisis. Even if the stressed assets fail to be resold in the market (or if they are sold at a discount when compared to their fair market values), banks can invoke the government guarantee to make up for any shortfalls.
The removal of a large sum of toxic loans from the lenders’ balance sheets will allow them to expand their lending activities. It would also free up the funds that had been allocated for addressing losses associated with NPAs. More funds will be available to cater to the productive sectors of their lending businesses. The bad bank will also bring an improvement in the valuation of PSU banks and enhance their ability to raise capital.
Banks in our country will have to collectively move towards better resolution of NPAs. There is hope that NARCL will finally be able to alleviate the bad loan crisis in India. What are your views on the proposed bad bank? Let us know in the comments section of the marketfeed app.