April 26, 2023

Bad banks: Things to know

Summary: Bad banks have evolved in the last five decades. They have gained prominence due to crises, such as the 2008 financial crisis and US TARP. They operate globally with some advantages and disadvantages of note. Challenges include pricing conflicts, finding buyers, and potential duplicative support for banks in distress.

A bad bank is a financial institution whose function is to acquire non-performing assets (NPAs) from other banks and financial institutions. Acquiring the NPAs of other banks provides a safety net to them by removing bad loans from their balance sheets and enabling them to lend without constraints. The bad bank can then repackage the bad loans it acquired and resell them to investors. Should the bad bank sell the loan at a higher price than its acquisition cost, it will turn a profit on its operations.

According to McKinsey, a bad bank could have any of the following four structures:

The bank could use an on-balance sheet guarantee (often provided by the government) to safeguard a part of its lending portfolio against potential losses.
The bank could use a special-purpose entity (SPE) to which the bank would transfer its bad assets. Such an SPE typically receives government support.
Another restructuring mode involves the creation of a business unit formed to hold the bad assets. This structure exposes the bank to some risks.
Sometimes, a bad bank involves the creation of a new, independent financial institution to which the bad assets are transferred. This structure shields the original bank from the specific risk emanating from the bad assets.

How have bad banks evolved?

Bad banks have been in existence since the 1980s, starting with the creation of the Grant Street National Bank, which assumed the bad assets of Mellon Bank. More recently, bad banks have come into prominence due to the financial crisis of 2008 and the Great Recession, which led to the US government’s Troubled Assets Relief Program (TARP). Besides the US, bad banks have been functioning in several other countries such as Sweden, Germany, and France to address the problem of bad assets on banks’ balance sheets.

In India, the government formed the National Asset Reconstruction Company Limited (NARCL) in July 2021 to address the growing problem of bad assets in public sector banks in the country.

What are the advantages of using bad banks?

Consolidation: A bad bank can aggregate all NPAs under a single entity, giving scale and breadth to the bad asset reconstruction effort.
- Freeing up capital: Once NPAs are transferred to the bad bank, the originating bank can use the provisions made against these bad assets to lend to more credit-worthy customers. According to estimates, as much as INR 5 lakh crore, currently held as provisions against NPAs in India, will be freed up if these bad assets are transferred to a reconstruction entity or bad bank.
- Capital buffers can improve: Government backing of bad banks generates confidence in lending in originating banks.

What are some of the disadvantages associated with bad banks?

Inter-government transfer: Transferring loans from a public-sector bank to a government-backed bad bank merely shifts the onus from one pocket of the government to another. This implies that the incentives available to both entities are essentially the same, and the taxpayer could end up paying for any losses that may arise.
- Lack of incentives: PSU employees typically lack the profit-generating incentives that are common to privately-owned companies. Hence, government intervention in these financial institutions could result in no real solution to solving the bad debt problem.
- Moral hazard: Bailout of a commercial bank by the government could disincentivise the entity to exercise caution in its lending policies in the future.

How challenging is the environment for bad banks?

While bad banks offer certain benefits, the ecosystem they function in is fraught with challenges and difficulties.

Price discovery

The NARCL was projected to acquire about INR 2 lakh crore in NPAs at its inception. However, it has acquired only about INR 21,350 crore until July 17, 2023. The financial institution is facing issues in acquiring bad loans from banks due to differences over pricing and future liabilities, according to Reuters. The NARCL is also facing difficulties in transferring bad loans due to differences between the words used in the loan purchase agreements, particularly relating to fraudulent accounts.

Finding buyers

Sometimes finding buyers for a portfolio of risky assets can be challenging, particularly if there is no precedence or market mechanism in place.

Bank recapitalisation

A financial crisis usually results in some form of government intervention. Since the Great Recession of 2008, when the concept of “too big to fail” was floated, governments have often recapitalised banks to help them deal with loan losses. Creating a bad bank for NPAs would imply a duplicate form of government support to originating financial institutions in terms of dealing with bad assets.

In conclusion

While bad banks are a good idea overall, there are issues relating to structural problems within the banking system that still need to be addressed. These include higher lending standards and adequate capitalisation. Besides, until PSU employees embrace greater professionalism, gaps in lending standards and consequently higher NPAs are sure to remain. Therefore, structural reforms of the banking sector need to be instituted.

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