explained | What is the need of ‘Bad Bank’?

the story So Far: Union Cabinet on Wednesday ₹30,600 crore backstop facility for guaranteeing securities approved To be issued by the National Asset Reconstruction Company Limited (NARCL), the so-called ‘Bad Bank’, is being set up to help the aggregate. Non-Performing Assets (NPAs) of Consolidated Lenders or bad debt.

What is a ‘Bad Bank’ and specifically NARCL?

A ‘bad bank’ is a financial entity set up to secure and resolve NPAs from banks. The bank, which sold stressed assets to a bad bank, is now relieved of the burden of bad loans and can instead focus on growing its business by giving fresh loans to borrowers in need of credit. A clean balance sheet also makes it relatively easy for the lender to raise fresh capital when needed. NARCL, which is being set up by lenders and will be 51% owned by public sector banks, proposes to take over fully provisioned stressed assets worth around Rs 90,000 crore in the first phase. The minimum size of each NPA to be acquired will be ₹500 crore as the focus is on resolving big-ticket bad loans. The long-term target for NARCL is to help resolve NPAs of ₹2 lakh crore, with the remaining properties expected to be transferred in the second phase with less provisions.

How will NARCL work?

The ‘bad bank’ will acquire the property by making an offer to the lead bank of the group of lenders of NPAs. Finance Minister Nirmala Sitharaman said that NARCL will pay 15% cash to banks based on valuation and the rest will be given as security receipt. In return, these receipts will be guaranteed by the government’s ₹30,600 crore backstop facility. To assist NARCL, public and private banks will jointly set up an India Debt Resolution Company Limited (IDRCL) which will manage the acquired assets and strive to improve their value for a final settlement. And on completion of the resolution, the remaining 85% of the value, which is kept in the form of security receipt, will be given to the banks.

Why is the center providing a backstop?

Given the large volume and individual size of these NPAs, a backstop resolution from the government helps in lending credibility to the process and provides a contingency buffer. The guarantee, which will be valid for five years, will be enforced to cover the shortfall (if any) between the face value of the security receipts and the actual realization at the time of either resolution or liquidation. The central government guarantee will also increase the liquidity of these receipts, which are tradable. Furthermore, given that there will be a pool of assets, it is likely that in many cases the realization of the value will exceed the acquisition cost, eliminating the need to dilute the guarantee.

What’s next for the banking industry?

The government expects that setting up of twin entities, NARCL and IDRCL, with adequate capital and its guarantee, will encourage prompt action on resolving stressed assets, which will help in better value realisation. As holders of these stressed assets and security receipts, banks stand to reap the benefits accrued from a successful resolution process. To discourage delay in resolution, the government has also proposed that NARCL pay the guarantee fee to the Centre, which will increase with the passage of time. However, critics of the bad bank concept argue that the government’s role in guaranteeing some part of the NPAs may lead to laxity on the part of bankers in assessing the risk and thus creating new dodgy loans. Separately, the January 2020 Bank for International Settlements Working Paper on ‘Bad Bank Resolution and Bank Lending’ indeed found that “bad bank separations are effective in cleaning up balance sheets and boosting bank credit, if they allow recapitalization of assets.” combined with separation”. The study, based on data covering 135 banks from 15 European banking systems over the period 2000-16, found that neither recapitalization nor asset segregation used in isolation “to boost credit and reduce future losses”. will suffice” NPAs.