Business of Banking:

A bank raises money through deposits and lends it to borrowers. It makes money through the difference in the interest rates it charges from borrowers and what it pays to the depositors. This is based on the premise that not all depositors will demand their money back at the same time.

Regulators require Banks to maintain certain level of capital:

Regulators want Banks to keep a certain amount of capital in proportion to the money they lend. The idea is that if there are loan losses it has to first be absorbed by the owner of the bank first. (If some Borrowers default, then the owner of the Bank will take the hit first. The capital invested will get eroded). This is to safeguard the depositors and ensure stability of the banking system.

Higher Non Performing Loans → Lower capacity to lend:

When a bank faces an increasing amount of Non-Performing Assets (Loans which have gone bad), it will see its capital getting eroded.Thus in such a case without raising more capital, a bank will not be able to lend.

If the banking system is facing increased NPAs (Non-Performing assets) , banks will find it difficult to lend.

This will result in lower credit in the system → Lower investment and spending → Lower Economic growth.

Increase in NPAs due to Covid:

As of March 2020, the ratio of non-Performing loans to total loans is around 8.5%, According to RBIs Financial Stability Report, due to Covid led slowdown the ratio may increase to around 12.5% – 14.7% by March 2021. 

This might lead to a slowdown in credit which will affect economic growth.

Thus, it is very important to solve the issue 

Enter Bad Bank: 

Bad Bank is an entity which will buy the bad loans or NPAs from the banks. It then tries to turnaround, restructure the stressed entities and their loans and recover the amount. 

The idea is that a bad bank will help banks get rid of toxic assets and increase their ability to do fresh lending. The banks usually sell their NPAs to Bad banks at market prices and thus they will have to take a haircut. 

Asset Reconstruction Companies (ARCs):

Asset Reconstruction Companies (or ARCs) are also similar entities. But in India ARCs are severely capital starved and can’t buy the level of bad loans from banks to make a large difference.

Main Challenges with the idea of Bad Banks:

Valuation of stressed loans.  

The banks have to take a haircut on loans transferred to Bad Banks.(Haircut -> reduction in the value of the loan). This would result in losses for the Banks and their capital will erode. They would require more infusion of capital. But the problem is that the majority of the NPAs are with Public Sector Banks where the Government is the majority owner and is not in a position to infuse large amounts of capital. 

Who will fund the Bad Bank:

Also, the Bad Bank would require capital to be able to buy out the loans. But where is the money? 

A bad bank will have to be funded with public money. But government finances are stretched and not in a position to finance a well funded bad bank capable of absorbing majority of Non Performing loans. 

It’s important for the Government to arrange large amount of capital for Public Sector Banks or decide to lower its ownership stake below 51% to solve the issue.

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