The Origin of the Bad Bank Concept
The concept of a bad bank was first introduced by the Mellon Bank, headquartered in Pittsburgh, in 1988. A bad bank is set up as a separate entity that buys the Non-Performing Assets from other banks, thereby freeing up their books for new lending. Its primary focus is on asset recovery.
There are instances when a bank may accumulate a large portfolio of debts or other financial instruments that are at risk of partial or full default. In such cases, a large volume of non-performing assets can make it challenging for the bank to raise capital, for instance, through bond sales.
Under these circumstances, the bank may prefer to segregate its “good” assets from its “bad” assets, which can be achieved through the creation of a bad bank.
How Does a ‘Bad Bank’ Function?
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Banks can segregate their assets into good assets and toxic or bad assets.
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Good assets are those where loans are repaid as per schedule, while defaulted ones are classified as toxic assets or bad assets.
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Toxic assets can be transferred from the banks' books to the Bad Bank, which is solely dedicated to aiding the recovery of these risky assets.
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Consequently, the banks can clean up and reduce their exposure to risky assets.
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The Bad Bank will acquire all the toxic assets of banks at a price that is below the book value of these loans.
Why Do We Need a Bad Bank?
Large NPA’s are often perceived as an indicator of a bank's financial weakness or ill-health. If the NPA’s are high, the bank loses its ability to borrow, lend, or conduct business.
Structure of a Bad Bank – IBA Proposal
The proposed 'Bad Bank' will have a 2-tiered structure.
Tier 1:
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An Asset Reconstruction Company (ARC), backed by the Government, will buy bad loans from banks and issue Security Receipts to the banks.
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As per RBI guidelines, ARC will hold 15% of the Security Receipts.
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Banks will receive 15% of the cash and will hold 85% of Security Receipts. Hence, it is referred to as the 15:85 structure.
Tier 2:
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There will be an Asset Management Company (AMC).
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The AMC will be operated by public and private entities, including banks.
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It will employ turnaround professionals.
Past Discussions on Bad Banks
The concept of a Bad Bank is not new. It recently made headlines due to the challenges posed by
COVID-19.
Earlier, the idea of a Bad Bank was a subject of debate among banking and finance circles when former Interim Finance Minister Piyush Goyal proposed the idea. A committee led by Sunil Mehta was formed to assess the feasibility of a National Asset Reconstruction Company. The 2017 Economic Survey also suggested the creation of a Public Sector Asset Rehabilitation Agency (PARA). Former
RBI
governor Raghuram Rajan also initiated a debate on Bad Banks in 2015 as a potential solution to the problems of Non-Performing Assets.
Test Your Knowledge on the Topic
Consider the following statements:
1. A Bad Bank is set up as a separate entity that purchases Non-Performing Assets from other banks to free up their books for fresh lending.
2. This concept has been successfully implemented in European countries following the 2007 financial crisis.
Which of the statements is/are true?
A) Only 1
B) Only 2
C) Both 1 and 2
D) Neither 1 nor 2
Answer: C
A bad bank is a bank that _________
A) Purchases the loans of other lenders to clear their balance sheets
B) Cannot recover their losses by any means available
C) Have been taken over entirely by another entity
D) Has a bad
Cash Reserve Ratio
Answer: A
Candidates can find the general pattern of the UPSC Exams by visiting the
UPSC Syllabus 2021
page.
