Why it is called a Bad Bank and how it works?

                                                                by Rajeev Pathak

          image courtesy: iStockphoto.com                                  

A Bad Bank is nothing but an Asset Reconstruction Company (ARC) that buys stressed assets of banks & other lending institutions for resolution in due course of time. It helps banks and financing institutions to clean their Balance Sheet and concentrate on fresh business then why it is called a Bad Bank? We will discuss it here in detail and learn How it works? 

Stress Assets includes NPAs (Non-Performing Assets), restructured assets, and also written-off accounts. There are some accounts in the Standard category showing early warning signals. These accounts are called Special Mentioned Accounts (SMAs). 

Categories of SMA Accounts:

When an account is overdue for payment of principal or interest or any other dues either fully or partly  for the below-mentioned number of days:

CATEGORY          NO. OF DAYS OVERDUE

SMA-0                   01-30 Days

SMA-1                   31-60 Days

SMA-2                   61-90 Days 

  Once an account remains overdue for payment of principal and/or interest either part or in full, it becomes  NPA.

NPAs are further classified into three major categories namely, Sub-Standard, Bad & Doubtful & Loss. This classification is made for each NPA account based on their age (since when the account turned NPA), Value of security / realizable security.  

Impact of an account turning into NPA

Banks have to cease charging interest from the date of NPA, and in addition to this, have to make provisions for such NPAs in their books every year. This eats the profits of the current year. That's why NPAs are called Double-Edged Weapons. 

When banks do not have enough profits for making provisions, they run into losses, and ultimately the owner-promotor or the Government in the case of Public Sector Banks (PSBs) have to bring in or infuse fresh capital to keep the business of lending running and also to cushion adequate capital adequacy. 

Whether all NPAs are sold to a Bad Bank:

No, banks do not sell all NPAs to an ARC or a Bad Bank. In the Substandard category, chances of recoveries are comparatively high and provisions are to be made at a lower rate. In the case of Loss assets, the value of the security is generally nil or nominal and provisions are to be made in full. So chances of recovery are very few.  In the case of Bad & Doubtful Assets, security may be there, but may not be liquid or easily realizable. That requires a lot of effort, litigation, and so on... 

In the case of SMA Accounts, though the accounts are currently Standard, sometimes banks or financial institutions feel that the going may be tough in the future or for some other reasons, a bank seeks exit from the account. On the other hand, there may be another bank or promotor, or entrepreneur who wants to take exposure to it and believe that the account may do a turnaround if supported financially or with a change of management.   

Why banks do not recover themselves: 

Banks do make efforts to recover the amount in all NPAs. But the fact remains that thousands of recovery cases are under litigation in various courts for years.  

Many a time banks initiate action under SARFAESI Act to sell the collateral properties, but the borrower brings a stay order from the court, or in some cases, district authorities stop the process in the name of law and order.   As a result, NPAs are piled up in the books of banks, and bankers remain occupied to attend legal proceedings and hardly get any time to do new business. 

How ARCs will be able to recover:

This will depend on case to case whether an ARC is able to recover, if yes, how much. The idea is that ARC or a Bad Bank will have a devoted team of officers and professionals to deal with the recovery procedure, giving an opportunity to bankers to focus on new business. 

How this system works:

After learning Why it is called a Bad Bank, now we will discuss How it works. As per the guidelines of the Reserve Bank Of India (RBI), Banks identify NPA accounts keeping all factors in view including the amount of provision held and chances of recovery, such accounts are put on sale in a bunch. ARCs generally will buy such assets at 45-50% of the book value.   Banks will be paid about 15% amount in cash upfront, for the remaining amount, ARC issues Security Receipt (SRs). These receipts will be exchanged in lieu of cash when ARC finds a suitable buyer for the asset as a measure of resolution.

Indian Scenario:

In our country, there are 28 Asset Reconstruction Companies (ARCs) registered as of 31.01.2021 with RBI. Oldest and 1st amongst them are Asset Reconstruction Company (India) Limited (ARCIL) which is promoted by major public and private sector banks. Now the question is why this talk of a new Bank for the purpose. 

Experience shows that banks were not very keen to sell stressed assets to private ARCs for two reasons: one, ARCs sought a very high percentage of hair cut and offering 25-30% of book value with 5% in cash and remaining in the form of SRs, and secondly, bank officers were always afraid of accountability in taking such decisions where banks have to make sacrifices in terms of recoverable amount. 

In her budget speech on 1st February 2021, the Indian Finance Minister made an announcement regarding the establishment of a Bad Bank in the public sector. The proposed Bad Bank idea is based on the line of PARA (Public Sector Assets Rehabilitation Agency). It is believed to be more effective due to its backing by Government. 

As this proposed Bad Bank is expected to resolve Bad Debts of banks, it is termed as a Bad Bank, but my view is that it may prove to be a Good Bank.

As per a report published in Economic Times, banks have already identified stressed assets of Rs. 2 lakh crore to be sold to proposed Bad Bank and expect 45-50,000 crores with 15% cash upfront. 

The report further says that 11 banks / financial institutions including State Bank Of India, Punjab National Bank, Bank Of Baroda, Bank Of India, Canara Bank, Union Bank Of India, ICICI Bank, Axis Bank, IDBI Bank, Power Finance Corporation, and REC are in the process of contributing to the capital of proposed Bad Bank with an equal shareholding of 9% each.  

Hope this new initiative will go a long way in resolving the chronic problem of banks' NPAs and improve banks' health. Still, the more important is to cultivate the culture of credit discipline and it is not possible without the support of borrowers. Hope we have been able to give justice to the topic, 'Why it is called a Bad Bank and How it works,' in this capsule post.

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