When the borrowers of a bank start defaulting on their payments recurrently, the loans are categorised as ‘bad debts’. And when these bad debts spike beyond manageable limits, a separate bank might have to be created to look after them collectively. That new bank is called a bad bank. Let us decode what it means
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To tackle the growing problem of mounting bad debts in the banking sector, Union Finance Minister Nirmala Sitharaman recently announced the creation of Bad Bank. This will be tasked with acquiring bad debts from several banks worth ₹two lakh crore.
After the bad debts are acquired, the stressed assets will be sold in the market by India Debt Resolution Company Ltd (IDRCL). The government has already given its go-ahead for ₹30,600 crore that can be used as guarantee. Let us understand what it means.
A bad bank is a corporate entity that alienates illiquid and risky assets held by banks and financial institutions or a group of banks. It is created to help banks clean their balance sheets by transferring their bad loans so that the banks can focus on their core business of taking deposits and lending money.
The first bad bank in the world was created in 1988 by US-based Mellon Bank to hold its stressed assets. Following this success, it became a phenomenon of sorts and the model was followed in several countries such as the US, Finland, Sweden, Indonesia and Belgium.
Now, India’s Finance Minister Nirmala Sitharaman has formally expressed its intent to start a bad bank but the bigger challenge would be to sell those stressed assets to prospective buyers to resolve the crisis.
The problem of NPAs has been burgeoning for quite some time in India, and it continues to be a bugbear. A joint report released by Assocham and Crisil in September 2021 said that the gross NPAs of commercial banks are likely to cross ₹10 trillion by March next year.
The report further attributed the rise to smaller accounts held by MSMEs and retail borrowers since the corporates have already cleared a substantial chunk of their loans.
A non-performing asset (NPA) is a loan given by a bank that has stopped adding interest to the bank’s kitty for a period more than 90 days. In other words, when a bank stops receiving payment of principal and interest towards a particular loan for more than three months, that loan is treated as an NPA.
How do NPAs impact the banking sector?
The banks earn their income through interest they receive on the loans given to the borrowers. With that income, the bank pays interest to depositors. The balance between the interest income and income paid is the profit earned by the bank. This is the reason the interest charged by the bank is always more than the interest given to depositors.
So, let us suppose a bank charges 10 percent interest on loans given to borrowers -- companies as well as retail customers. And it pays an interest of 6 percent on deposits. The balance 5 percent will be used to run the banking operations, and the remainder will be the bank's profit.
As a matter of fact, the deposits received by the bank are used to give loans. And when the loan is not repaid by the borrower, the bank would also find it difficult to return the deposits to its customers.
So, it is imperative for the banks to recover their loans, along with interest, on time to be able to run its functions, repay its depositors and also earn some profit in the process.
When the bank loses money via unpaid loans, it can compensate for it by either charging a higher interest on subsequent loans, or by offering lower interest to its depositors. A small fraction of loans, if unpaid, do not disrupt the day-to-day functioning of a bank.
The problem, however, occurs when the bad debts become too huge to be recouped by the interest rate tweaks.
To fix this, the banks need to overhaul their systems and structures so that these problems are permanently resolved. A joint report by Assocham and Crisil in September 2021 underscored that the Indian banks, especially public sector banks, need to strengthen their risk management practices
So, we can summarise by saying that bad debts include all the loans which the bank failed to recover. And because of mounting bad debts, the government of India is set to start a Bad Bank that will take all such irrecoverable loans from the banks’ books and sell them to prospective buyers through India Debt Resolution Company Ltd.
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