Can a ‘bad bank’ solve the growing NPA crisis?

Finance Minister Nirmala Sitharaman in her Budget speech revived the idea of a ‘bad bank’ by stating that the Centre proposes to set up an asset reconstruction company to acquire bad loans from banks.

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.
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. However, generating profits is usually not the primary purpose of a bad bank — the objective is to ease the burden on banks, holding a large pile of stressed assets, and to get them to lend more actively.

According to the latest figures released by the RBI, the total size of bad loans in the balance sheets of Indian banks at a gross level was just around ₹9 lakh crore as of March 31, 2020, down significantly from over ₹10 lakh crore two years ago.
While the size of total bad loans held by banks has decreased over the last few years, analysts point out that it is mostly the result of larger write-offs rather than due to improved recovery of bad loans or a slowdown in the accumulation of fresh bad loans.
The size of bad loan write-offs by banks has steadily increased since the RBI launched its asset quality review procedure in 2015, from around ₹70,000 crore in 2015-16 to nearly ₹2.4 lakh crore in 2019-20, while the size of fresh bad loans accumulated by banks increased last year to over ₹2 lakh crore from about ₹1.3 lakh crore in the previous year.
Further, due to the lockdown imposed last year, the proportion of banks’ gross non-performing assets is expected to rise sharply from 7.5% of gross advances in September 2020 to at least 13.5% of gross advances in September 2021.

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. The idea of a bad bank has been tried out in countries such as the United States, Germany, Japan and others in the past.
The troubled asset relief program, also known as TARP, implemented by the U.S. Treasury in the aftermath of the 2008 financial crisis, was modelled around the idea of a bad bank. It is estimated that the Treasury through its operations earned nominal profits.

Former RBI governor Raghuram Rajan has been one of the critics, arguing that a bad bank backed by the government will merely shift bad assets from the hands of public sector banks, which are owned by the government, to the hands of a bad bank, which is again owned by the government.
There is little reason to believe that a mere transfer of assets from one pocket of the government to another will lead to a successful resolution of these bad debts, when the set of incentives facing these entities is essentially the same.
Other analysts believe that unlike a bad bank set up by the private sector, a bad bank backed by the government is likely to pay too much for stressed assets. While this may be good news for public sector banks, which have been reluctant to incur losses by selling off their bad loans at cheap prices, it is bad news for taxpayers, who will once again have to foot the bill for bailing out troubled banks.

A key reason behind the bad loan crisis in public sector banks is the nature of their ownership. Unlike private banks, which are owned by individuals who have strong financial incentives to manage them well, public sector banks are managed by bureaucrats who may often not have the same commitment to ensuring these lenders’ profitability.
To that extent, bailing out banks through a bad bank does not really address the root problem of the bad loan crisis.
Further, there is a huge risk of moral hazard. Commercial banks that are bailed out by a bad bank are likely to have little reason to mend their ways. After all, the safety net provided by a bad bank gives these banks more reason to lend recklessly, and thus, further exacerbate the bad loan crisis.

Some experts believe that by taking bad loans off the books of troubled banks, a bad bank can help free capital of over ₹5 lakh crore that is locked in by banks as provisions against these bad loans. This will give banks the freedom to use the freed-up capital to extend more loans to their customers.
This gives the impression that banks have unused funds lying in their balance sheets that they could use if only they could get rid of their bad loans. It is, however, important not to mistake banks’ reserve requirements for their capital position.
This is because what may be stopping banks from lending more aggressively may not be the lack of sufficient reserves, which banks need to maintain against their loans.
Instead, it may simply be the precarious capital position that many public sector banks find themselves in at the moment. In fact, many public sector banks may be considered to be technically insolvent as an accurate recognition of the true scale of their bad loans would show their liabilities as far exceeding their assets.
So, a bad bank, in reality, could help improve bank lending not by shoring up bank reserves, but by improving banks’ capital buffers.
To the extent that a new bad bank set up by the government can improve banks’ capital buffers by freeing up capital, it could help banks feel more confident to start lending again.

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