Decoding India’s New Bad Bank Framework

Bad banks are established to take on the bad loans of underperforming banks, enabling them to come out of the financial rut. In papers, the theory works seamlessly. The original bank gets to start afresh with a clean slate. It has a neat balance sheet, and can raise more funds as investor confidence is regained. The bad bank, on the other hand, has a sole focus – recovering the bad loans it has acquired at discounted rates to the maximum extent possible, for a fee.

The concept of bad banks as a recovery mechanism has many detractors. Significant points of contention include:

• If the bad bank is a government entity, what the bad bank does – or intends to do – would practically amount to accounting entries and shifting assets from one government entity (PSBs) to another (government owned ARC), with the NPA issue still persisting. This would be similar to “divestment” of PSUs which are bought by another government entity, LIC!
• A bad bank system could over time encourage banks to continue to lend recklessly and without self-restraint
• There is no well-established price discovery mechanism for the rate at which loans are purchased

However, the fact remains that the pandemic-induced recession has been threatening to elevate system level NPAs to double digit percentages. It’s in this backdrop that the Indian Banking Association suggested the idea of the bad bank to the Government of India. Today, the two-tiered bad bank structure, as it stands proposed by India’s Finance Minister Nirmala Sitharaman, involves the National Asset Reconstruction Company Limited (NARCL) and India Debt Management Company (IDMCL), which are asset reconstruction and management companies, respectively.

In many ways, India’s newly established roadmap on bad banks is a welcome move, as it addressed the contentious issues discussed above:

• The ₹30,600 crore government guarantee for security receipts issued by NARCL will be instrumental in improving recoverability. Eventually, this will be a pivotal factor in ensuring banks’ balance sheets are in good shape
• Most critically, with NARCL posing as a bidder, individual ARCs will be obliged to bid for loans at competitive rates, faster, curbing extremely low buyouts and circumventing delays
• The fact that the ownership of NARCL is a joint PSB-private partnership elevates optimism and leaves expectations of recovery high
• Involvement of IDMCL is expected to expedite and add value to the entire process of asset resolution

Of course, the entire game plan is contingent on efficiency of its two cornerstones – the NARCL and IDMCL – and their ability to expedite and effect closure. A bad bank with participation from existing banks in terms of ownership as well as specialized project appraisal and recovery skills can be the shot in the arm that India’s ailing banking system desperately needs. The potential payoffs are huge. A higher recovery rate by the bad bank would translate to higher profits to the owners – ultimately, the banks themselves.