Justification for a Bad Bank
- Lend incrementally: Banks profit from the fact that a sizable fraction of deposits stays idle in bank accounts. This deposit may be applied to borrowing. In a similar vein, not all advances made by banks are instantly deducted from the accounts. As a result, a portion of these loans might be utilized to expand credit. As a result, banks can give more loans to those in need the more money they have.
- Specialization: Since this would be its main responsibility, a bad bank would be very skilled at maximizing the recovery from a bad loan.
Banks, on the other hand, are not in the recovery business, therefore they have limited ability to settle the loans. - Releasing resources: Banks must reserve a portion of their operating income to pay for any potential dubious advances. The bank’s poor loans may be transferred to a bad bank, relieving it of the provisioning obligations. This implies that the same money can be used for lending because the banks are not compelled to set aside money for poor loans.
- Economic Sluggishness: There may be a rise in stressed assets as a result of India’s economic slump, according to reports. This could lead to a scenario where the NPAs reach an unmanageable limit when coupled with the COVID-induced lockout.
- Enhanced Sentiment: If India is serious about achieving its declared aim of a $5 trillion economy, industry needs to recover from the crisis it is currently suffering. This calls for an upbeat economic outlook. A bad bank might give the sector this boost by clearing the banks’ books.
- Less need for bank recapitalization: To meet the banks’ capital adequacy ratio, recapitalization is necessary. It is anticipated that this money can be used in other ways, such as for public welfare and infrastructure development, with the establishment of a bad bank.
Bad Bank
A company that deals in risky and illiquid assets are known as a bad bank. These assets are owned by banks, financial institutions, or a group of banks. It was set up to assist banks to remove troublesome debts from their balance sheets. It enables them to focus on their main tasks, which include receiving deposits and extending credit. Depositors typically do not lose money from this arrangement, but stockholders and bondholders typically do. The process can result in the insolvency of banks, which can then be liquidated, nationalized, or recapitalized.
India’s bad bank would be known as National Asset Reconstruction Ltd. (NARCL). This NARC will function as a firm that reconstructs assets. It will purchase defaulted loans from banks, relieving them of their Non Performing assets (NPA) obligations. After that, NARC will try to sell the stressed loans to companies that buy distressed debt. India Debt Resolution Company Ltd. (IDRCL) will make an effort to advertise and sell them. After the stressed asset is sold, the involved bank will receive partial payment. The government guarantee will be used if the bad bank in India is unable to sell the stressed loan for a profit or at all. It’s significant to note that the government has made a guarantee available for this purpose in the amount of Rs 36,000 crores. If a bad bank is able to sell a loan for more than it paid for it when it bought it from a commercial bank, it will turn a profit from its activities. The main goal of a bad bank is typically not to make money; instead, it is to relieve banks of the burden of holding a significant amount of stressed assets and encourage them to lend more aggressively.