What are Bad Banks?

A bad bank is a special bank which is set up by the government for the sole purpose of buying bad loans and holdings of other banks that are not liquid. Banks and institutions having a significant level or number of non-performing assets can sell it to the bad banks at market price. By transferring, the other banks and institutions are able to clear up their balance sheet. 

Bad banks typically cater to a group of institutions instead of a single one. They specialise in 'Debt Securitisation'.

What is Debt Securitisation?

Debt securitisation is a process practiced in the field of finance, in which different types of contractual debts at lending institutions, such as mortgage and credit card debt, are packaged as assets for investors to buy into. The principle is that the investors benefit from whatever receivables come in from these debt instruments, which would otherwise directly go to the lender.

The process helps the originator (lending institution, in case of debt securities) remove these debt assets from their balance sheets. This frees them up to underwrite fresh loans without the burden of managing existing loans. This is essentially what a Bad Bank helps lenders with.

Understanding Bad Banks

Bad banks are special in the sense as to when they are set up. These are typically floated during times of crisis, and generally when banks and other financial institutions are having financial and reputation problems. Bondholders and shareholders lose money through this solution, but that is not the case for depositors. Banks becoming insolvent due to the process can be nationalized, recapitalized, or liquidated altogether. In case they don’t face insolvency, a bank bank’s manager can try maximizing the value of the new, high-risk assets.

There are some experts who criticize the very setup of bad banks. According to them, since states take over non-performing assets, it encourages banks to take more unrequired risks.

Bad Bank Announcement Explained

In the recent Budget 2021 speech, the Finance Minister Nirmala Sitharaman said “The high level of provisioning by public sector banks of their stressed assets calls for measures to clean up the bank books. An Asset Reconstruction Company Limited and Asset Management Company would be set up to consolidate and take over the existing stressed debt and then manage and dispose of the assets to Alternate Investment Funds and other potential investors for eventual value realization.” 

This Asset Reconstruction Company Limited and Asset Management Company is a more formal way of saying “Bad Bank.” It shall be managing the bad debt of Public sector Banks like Punjab National Bank, the State Bank of India, and others.

This announcement by the Finance Minister is of considerable significance because it shall provide more stability to the financial sector. These banks mentioned above are worse off, especially after the pandemic and lockdowns of last year. There is a mess of stressed assets and debts which is affecting the service of these public sector banks. The Bad Bank is therefore introduced to clean their books. The introduced bad banks shall consolidate and take over the affected PSBs stressed assets. The ARC and AMC shall then manage and dispose of these assets to potential investors like Alternate Investment Funds for value realization. 

It shall thus hold bad debts for the mentioned PSBs, and then less off these to investors at a discounted price. Doing so shall clean up the banks’ balance sheet while making future capital requirements less problematic.

The industry has taken this news positively as it shall take care of the banks’ bad debts. 

Why is a Bad Bank Necessary Now?

The current number of bad loans is a significant worry for PSBs. As of September of last year, the total gross NPAs of the Indian Banking system was 7.5% of the total banking industry’s loan book. The RBI says that this will reach 13.5% by March or September 2021. Estimates say that non-performing assets to the value of Rs. 899,803 shall be given over to the bad bank.