The Hindu Explains | Can a ‘bad bank’ solve the growing NPA crisis?

The story so far: Finance Minister Nirmala Sitharaman in her Budget speech on Monday revived the idea of a ‘bad bank’ by stating that the Centre proposes to set up an asset reconstruction company to acquire bad loans from banks. While the problem of bad loans has been a perennial one in the Indian banking sector, the COVID-19 pandemic-triggered lockdown last year and the moratorium subsequently extended to borrowers by the Reserve Bank of India (RBI) have worsened the crisis. With banks expected to report even more bad loans this year, the idea of a ‘bad bank’ has gained particular significance.

What is a ‘bad bank’?

A bad bank is a financial entity set up to buy non-performing assets (NPAs), or bad loans, from banks. The aim of setting up a bad bank is to help ease the burden on banks by taking bad loans off their balance sheets and get them to lend again to customers without constraints. After the purchase of a bad loan from a bank, the bad bank may later try to restructure and sell the NPA to investors who might be interested in purchasing it.

Also read | India needs multiple bad banks to clean balance sheets of lenders, get credit growth back: CII

A bad bank makes a profit in its operations if it manages to sell the loan at a price higher than what it paid to acquire the loan from a commercial bank. However, generating profits is usually not the primary purpose of a bad bank — the objective is to ease the burden on banks, holding a large pile of stressed assets, and to get them to lend more actively.

What is the extent of the crisis faced by banks?

According to the latest figures released by the RBI, the total size of bad loans in the balance sheets of Indian banks at a gross level was just around ₹9 lakh crore as of March 31, 2020, down significantly from over ₹10 lakh crore two years ago.

While the size of total bad loans held by banks has decreased over the last few years, analysts point out that it is mostly the result of larger write-offs rather than due to improved recovery of bad loans or a slowdown in the accumulation of fresh bad loans.

Also read | Banks’ NPAs decline to ₹8.08 lakh crore in September 2020: Government

The size of bad loan write-offs by banks has steadily increased since the RBI launched its asset quality review procedure in 2015, from around ₹70,000 crore in 2015-16 to nearly ₹2.4 lakh crore in 2019-20, while the size of fresh bad loans accumulated by banks increased last year to over ₹2 lakh crore from about ₹1.3 lakh crore in the previous year. So, the Indian banking sector’s woes seem to be far from over.

Further, due to the lockdown imposed last year, the proportion of banks’ gross non-performing assets is expected to rise sharply from 7.5% of gross advances in September 2020 to at least 13.5% of gross advances in September 2021.

What are the pros and cons of setting up a bad bank?

A supposed advantage in setting up a bad bank, it is argued, is that it can help consolidate all bad loans of banks under a single exclusive entity. The idea of a bad bank has been tried out in countries such as the United States, Germany, Japan and others in the past.

The Hindu Explains | Why is the RBI worried when volume of bad loans declined in the September quarter?

The troubled asset relief program, also known as TARP, implemented by the U.S. Treasury in the aftermath of the 2008 financial crisis, was modelled around the idea of a bad bank. Under the program, the U.S. Treasury bought troubled assets, such as mortgage-backed securities, from U.S. banks at the peak of the crisis, and later resold them when market conditions improved. According to reports, it is estimated that the Treasury through its operations earned nominal profits.

Many critics, however, have pointed to several problems with the idea of a bad bank to deal with bad loans. Former RBI governor Raghuram Rajan…