A bad bank serves as a central entity that acquires non-performing assets (NPAs) or bad loans from various banks within the financial sector, often at a discounted rate. Subsequently, it takes steps to recover and resolve these distressed assets. This concept bears similarity to Asset Reconstruction Companies (ARCs), which assume the responsibility of managing and recovering these loans.
Arguments For Bad Banks
Providing Lending Leverage to Banks:
- Bad banks offer several advantages, including enhanced lending leverage for banks, primarily due to three key factors:
- Capital is released from inadequately provisioned bad assets.
- Capital is freed up from security receipts, thanks to a sovereign guarantee.
- Cash receipts are returned to banks, which can be leveraged for lending, while also eliminating provisions from the balance sheet.
- Notably, the United States implemented the Troubled Asset Relief Program (TARP) in response to the 2008 financial crisis. TARP played a pivotal role in revitalizing the U.S. economy following the subprime crisis.
Revival of Credit Flow Post-Covid:
- Some experts contend that a bad bank has the potential to unlock over Rs. 5 lakh crore in capital that banks currently have tied up as provisions against bad loans. This could facilitate the revival of credit flow in the post-Covid economic scenario.
Arguments Against Bad Banks
Failure to Address Structural Issues:
- Critics argue that the establishment of a bad bank does not fundamentally address the structural problems within the banking sector. It is seen as a mere relocation of the problem rather than a comprehensive solution.
Tight Fiscal Position:
- One significant challenge is the difficulty in mobilizing the required funds for setting up and operating a bad bank, particularly in a scenario where fiscal resources are constrained.
Unclear Loan Selection Process:
- The absence of a clear procedure to determine the price and selection criteria for loans to be transferred to the bad bank raises concerns about transparency and fairness.
- Renowned economist and former Reserve Bank Governor, Raghuram Rajan, raises the issue of moral hazard associated with bad banks. The fear is that such entities could inadvertently incentivize banks to continue reckless lending practices, exacerbating the NPA problem.
In conclusion, while the concept of a bad bank holds promise, its success is contingent upon addressing the underlying structural issues within the banking sector.
Reforms aimed at improving the governance and efficiency of public sector banks are imperative. A bad bank can serve as a valuable tool, but it should be part of a broader strategy to enhance the resilience and stability of the financial system.