December 10, 2023

Bad Bank

Syllabus- General Studies 3 (economy)


As India gets ready to operationalise a new bad bank, China is struggling with one of its biggest bad banks, the China Huarong Asset Management Co. Ltd. (Huarong). Recently, it skirted a potential bond default.

Bad bank

  • A bad bank is technically an asset reconstruction company that buys bad loans(NPAs) from the commercial banks at a discount and tries to recover the money from the defaulter by providing a systematic solution over a period of time.
  • The idea of a bad bank seeks to reduce the NPAs in the banking sector and then revive lending and credit growth.

Bad banks in China

  • In the aftermath of the Asian financial crisis, China set up dedicated bad banks for each of its big four state-owned commercial banks.
  • These bad banks were meant to acquire non-performing loans (NPLs) from those banks and resolve them within 10 years.
  • Evergreening of loans: Recent research at University of Singapore highlights that Chinese bad banks effectively help conceal NPLs.
    • The banks finance over 90 per cent of NPL transactions through direct loans to bad banks or indirect financing vehicles.
    • The bad banks resell over 70 per cent of the NPLs at inflated prices to third parties, who happen to be borrowers of the same banks.

The researchers conclude that in the presence of binding financial regulations (for example, on provisioning) and opaque market structures, the bad bank model could create perverse incentives to hide bad loans instead of resolving them.

Lessons for India

The Chinese experience holds four important lessons for India.

  1. First, a centralised bad bank like NARCL should ideally have a finite tenure.
    • Such an institution is typically a swift response to an abrupt economic shock (like Covid) when orderly disposal of bad loans via securitisation or direct sales may not be possible.
    • The banks could transfer their crisis-induced NPLs to the bad bank and focus on expanding lending activity.
    • The bad bank in turn can restructure and protect asset value.
  2. A bad bank must have a specific, narrow mandate with clearly defined goals. Transferring NPLs to a bad bank is not a solution in itself. There must be a clear resolution strategy.
  3. Much like China, Indian banks remain exposed to these bad loans even after they are transferred to asset reconstruction companies (ARCs). 
    • To address this problem, RBI has tightened bank provisioning while liberalising foreign portfolio investment norms.
    • Policymakers must ensure that the creation of the NARCL does not reverse this trend.
  4. The resolution of bad loans should happen through a market mechanism and not through a multitude of bad banks.
    • In India, the Narasimham Committee (1998) had envisaged a single ARC as a bad bank.
    • Yet, the SARFAESI Act, 2002 ended up creating multiple, privately owned ARCs.
    • While AIFs should be allowed to purchase bad loans directly from banks and enjoy enforcement rights under the SARFAESI Act, ARCs should be allowed to purchase stressed assets from mutual funds, insurance companies, bond investors and ECB lenders.
    • ARC trusts should be allowed to infuse fresh equity in distressed companies, within IBC or outside of it.

The Chinese experience should nudge Indian policymakers to limit the mandate and tenure of NARCL, while facilitating market-based mechanisms for bad loan resolution in a steady state.

Question- Setting up a Bad bank is not a panacea to resolve the NPA crisis of the Indian banking sector; what’s needed is a comprehensive resolution mechanism. Comment.



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