2 min read.Updated: 18 Jan 2021, 12:45 PM ISTShreejay Sinha
Banks and other financial institutions are the key drivers of economic growth. However, many borrowers may find it difficult to service their loans, requiring lenders to set aside capital to cover those losses. A bad bank can free them up to start lending.
A bad bank is an institution that takes over dud loans and other illiquid assets of lenders, helping them restart with a clean slate. Such a mechanism helps a bank segregate its good assets from bad ones, making it easier for it to raise capital by issuing equity or debt or both. The segregation of toxic assets helps generate confidence among potential investors who can then examine the financial health of the lender with greater clarity. Further, by transferring sour loans to a bad bank, lenders can prioritize financing businesses, while letting a specialized institution focus on maximizing loan recovery.
Why is it being talked about now suddenly?
The Indian economy slipped into a technical recession, contracting during the first two quarters of this fiscal year. It is likely to shrink 7.5% this year. The pandemic-led lockdown, imposed to curb covid infections, has already crimped earnings of businesses and individuals, impairing their ability to repay loans and potentially fuelling a jump in non-performing assets of banks. Despite regulatory forbearance in the form of a loan moratorium, many borrowers may find it difficult to service their loans, requiring lenders to set aside capital to cover those losses. A bad bank can free them up to start lending.
Have there been any parallels around the globe?
Bad banks found resonance during the global financial crisis of 2007-09. Citigroup moved loans worth about $900 billion to its bad-bank unit Citi Holdings. Bad banks also helped Barclays and Bank of America overcome their stress. The Republic of Ireland formed a bad bank to tackle its financial mess.
Banks and other financial institutions are the key drivers of economic growth, as they are the formal channels of credit. As things stand, lenders, particularly the state-owned ones, are saddled with massive bad loans. This has made them risk-averse and eroded their capacity to lend to help spur economic recovery from the shock of the covid-19 pandemic that has roiled the world. Banks will find it tough and exorbitantly expensive to raise capital from the market if the asset-quality trajectory remains uncertain, delaying and even jeopardizing, economic growth.
Should the Centre set up a bad bank?
To the extent that a bad bank will take sour loans off the balance sheets of banks, it is a good idea. However, the Centre isn’t smitten by the idea as yet. After all, there exist several private asset reconstruction firms that buy bad loans at a discount. Also, the Bankruptcy Code, though not perfect, has helped in higher recoveries. There is also the question of a moral hazard that a government-funded bad bank can create by allowing reckless lending to continue. There is also the fear that it end up as another case of throwing good money after bad.