What is the need for a ‘bad bank’?

The Union Cabinet has recently approved Rs 30,600 crore government guarantee for the National Asset Reconstruction Company (NARCL), thereby paving the way for operationalisation of bad bank.
It will acquire non-performing assets (NPAs) worth about Rs 2 lakh crore from various commercial banks in different phases. Another entity — India Debt Resolution Company Ltd (IDRCL), which has also been set up — will then try to sell the stressed assets in the market. The NARCL-IDRCL structure is the new bad bank.
The proposal has come as a welcome move for the banking sector which has been reeling under the weight of bad loans. One of the key ideas behind formation of bad banks is to de-stress the balance sheets of the banks.
- NPA is a loan* or advance for which the principal or interest payment remains overdue for a period of more than 90 days.

A bad bank is a corporate structure that acquires NPAs from banks and resolves them.
The bank, which sells the stressed assets to the bad bank, is now relieved of the burden of the bad loans and can focus instead on growing its business by advancing fresh loans to borrowers requiring credit. The cleaner balance sheet also makes it relatively easier for the lender to raise fresh capital, if required.
In Budget 2021-22, Finance Minister Nirmala Sitharaman had announced setting up of a bad bank as part of resolution of bad loans worth about Rs 2 lakh crore.

The NARCL will first purchase bad loans from banks. It will pay 15% of the agreed price in cash and the remaining 85% will be in the form of government-guaranteed security receipts. When the assets are sold, with the help of IDRCL, the commercial banks will be paid back the rest.
If the bad bank is unable to sell the bad loan, or has to sell it at a loss, then the government guarantee will be invoked and the difference between what the commercial bank was supposed to get and what the bad bank was able to raise will be paid from the Rs 30,600 crore that has been provided by the government.
The value of bad loans being carved out of bank books for transfer to the NARCL is around Rs 2 lakh crore. About Rs 90,000 crore in bad loans will be transferred in the first phase. The guarantee of Rs 30,600 crore will cover the entire pool of Rs 2 lakh crore.
The government guarantee will be valid for a period of five years.
To disincentivise delay in resolution, NARCL has to pay a guarantee fee which increases with the passage of time.

If a bank has high NPAs, a large part of its profits would be utilized to cut losses. As a result, any bank with high NPAs is likely to become more risk averse and would be less willing to lend money to borrowers. It would become more difficult for businesses and consumers to take loans from banks, thereby impacting the overall robustness of the economy.
Moreover, in India, a large portion of NPAs is with the government-owned public sector banks. In the past, the government had to infuse fresh capital to improve the financial health of PSBs. The government infusing fresh capital in PSBs means less money for other schemes.

As per World Bank data, the share of NPA to gross loans in India is significantly higher compared to developed western economies. It also exceeds most other emerging economies.
In India, the level of NPAs rose alarmingly since 2016. In a big way, this was a result of the RBI requiring banks to clearly recognise the bad loans on their books. The fact is several banks had witnessed deterioration of their loans portfolio since the global financial crisis of 2008-09.
As of March 2021, the total bad loans in the banking system amounted to Rs 8.35 lakh crore.

Critics of the bad bank concept, however, contend that the government’s role in guaranteeing some part of the NPAs could lead to laxity on the part of bankers in assessing risk and thus creating fresh bad loans.

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