The term ‘Bad Bank’ is mischievously deceiving; literally, it would mean a bank that has turned bad, that is, run out of capital and is on the verge of liquidation. However, in practice, it is quite the opposite.

It is an institution (generally set up by the sovereign) to absorb the bad (non-performing) assets of various banks and financial institutions within a country. The Mellon Bank in the US (1988) is supposedly the first bad bank in modern history, that absorbed USD 1.4 bn of non-performing loans (mainly energy and real estate advances). Since then, the idea has been widely used (especially in western Europe) in the aftermath of various local / regional banking crisis.

The Insolvency and Bankruptcy code, 2016(IBC) acted as a precursor to the idea of having a bad bank. The code aimed at speedy resolution of stressed assets and set up an insolvency regulator to regulate the insolvency proceedings.

In September 2021, the honourable Finance Minister announced the setting up of a bad bank (National Asset Reconstruction Company Limited – NARCL). The idea had been in the reckoning for a quite a while now and it finally saw the light of the day. Various banks (including privately owned banks) will have an ownership interest in the newly formed entity.

The NARCL shall acquire and aggregate the non-performing assets (fully provided for) of various commercial banks. The consideration shall be discharged partly in cash (15%) and partly in form of security receipts (85%). This will provide the banks with additional liquidity (since the security receipts are tradable in the market) and growth capital.

The banks will be able to write back the provisions (already made) as and when the proceeds are received, thereby improving the bank’s profitability metrics. The difference between the face value and the realised value (from the resolution of these NPA’s) will be guaranteed by the Union Government (INR 30600 Cr) for a period of five years.

The sovereign guarantee gives greater credibility to the entire exercise and helps enhance the value of these assets. The guarantee fees (payable by NARCL to the Government) will increase by 0.25% each year, incentivising speedy disposal of assets. The finite time period of five years further incentivises the NARCL to seek quick resolution of these assets, beyond which the government guarantee cannot be invoked.

The Government also set up an India Debt Resolution Company Limited (IDRCL) which will manage the bad assets with the help of market professionals and turnaround experts.The NARCL would liaison with the IDRCL and ensure that the stressed assets are appropriately resolved (either liquidated or revived). Once these bad assets are taken out of the books of various banks, the banks will then be able to focus their efforts fully on disbursing fresh advances, thereby improving the credit flow in the economy.

Prima Facie, the idea appears to resolve the NPA mess that Bharat’s banking system has been grappling with since almost a decade. However, there are a few things to remain cautious of.

First is the moral hazard. The bad bank must be a one-off exercise aimed at resolving the legacy stressed assets of Bharat’s banking system. It must not be an incentive to lower credit underwriting standards (for incremental disbursements) by lenders in the hope that Bad Bank 2.0 (sometime in the future) would bail them out once again, just like Bad Bank 1.0.

Secondly, the time frame of five years must be strictly adhered to. Past experiences show that if an asset cannot be resolved in five years, it is very unlikely that in can be resolved thereafter. Lastly, the NARCL and IDRCL should work in cohesion with (and not in conflict to) the Insolvency and Bankruptcy Code.

The right first step has been taken. The governance and ownership structure are in place, the intent (of the government and the bankers) is clearly visible and the RBI’s permission is only a matter of time. Bharat shall now witness its first ever (and hopefully last) bad bank that has the potential to change the banking landscape forever.

Hopefully, the markets, professionals and bankers do what is in the best interest of Bharat’s banking sector and economy.

(Featured image source: medium)