Explained: What’s a bad bank and why it’s taking so long to set it up

In her budget speech on February 1, 2021, Finance Minister Nirmala Sitharaman had announced the government’s decision to form a ‘bad bank’ to clean up the balance sheets of commercial banks saddled with high non-performing assets. Then, in September last year, Sitharaman announced a dual structure for the bad bank.

However, with the next budget speech less than a month away, the proposed bad bank hasn’t yet started functioning. And it looks like the proposal may be off the table, at least for now.

The Reserve Bank of India (RBI) informed lenders last fortnight that the formation of such a ‘bad bank’ could get delayed as it is not in favour of permitting the establishment of a dual structure, in which one entity acquires non-performing loans, and the other reaches a resolution, The Economic Times has reported.

First things first. What exactly is a bad bank?

A bad bank is basically an asset management company that isolates non-performing assets—or bad loans—held by a bank or a group of banks. Such an entity helps banks that have accumulated huge NPAs segregate them from their good loans and help investors assess the bank’s financial health better, so that it can keep raising capital.

Such an entity may also be set up by a bank or financial institution as part of a strategy to deal with a difficult financial situation, or by a government or some other official institution as part of an official response to financial problems across a number of institutions in the financial sector. 

So, what is stopping the RBI from allowing such a bank to be set up?

The RBI is reluctant to allow such an entity as there is no legal provision for setting one up, according to the ET report.

What exactly was the proposal in the works?

As per the proposal submitted to the RBI, the National Asset Reconstruction Company Ltd (NARCL) was supposed to acquire NPAs from banks while India Debt Resolution Company Ltd (IDRCL) would provide resolution of these assets. The RBI has now conveyed that under the Securitisation and Resolution of Financial Assets and Enforcement of Securities Act (Sarfaesi), acquisition and resolution activities have to be housed under the same structure. The RBI draws its power to regulate and issue ARCs licences from the Sarfaesi Act.

What are the banks proposing now?

As per the ET report, after the RBI expressed its reservations, sponsors of NARCL—the state-owned banks—have now proposed a structure where there is a principal-agent relation between NARCL and IDRCL.

As per the new arrangement, NARCL will enter into a contract with IDRCL to outsource resolutions of NPA. However, the resolutions offered by IDRCL will not be binding on NARCL, the report said.

Why are the lenders in such a hurry to sort this issue out?

Lenders are in a hurry to sort out the issue soon since the government wants them to announce at least a token transaction before the Union Budget is presented on February 1.

What did the last budget actually propose?

The budget proposed a dual structure in a bid to keep the resolution of NPAs outside the ambit of the investigative agencies, which have often questioned the commercial judgements of lenders. On account of this rationale, private banks hold a majority stake in IDRCL, which will dispose the NPAs, while public-sector banks held a majority in NARCL, the acquirer.

But the news report says that since NARCL will have authority to approve or reject resolution plans suggested by IDRCL, it will negate the purpose for which a dual structure was created—to keep loan resolution outside the purview of investigative agencies.

What could happen under the fresh arrangement being proposed?

Under the new arrangement, NARCL will set a reserve price—a floor price—for acquiring each asset from lenders. Subsequently, IDRCL will be mandated to provide a resolution above the floor price. NARCL will have a final say on the proposal made by IDRCL, according to the ET report.

As per the earlier proposal, IDRCL had the final authority on the resolution of the asset, while NARCL was only an acquisition vehicle. This model is no longer workable, the report said. 

How big is the mountain of non-performing loans that the NARCL plans to acquire?

The NARCL plans to acquire bad loans of the order of Rs 2 lakh crore under the conventional 15:85 structure wherein 15% of the transaction value would be paid upfront and the remaining in the form of security receipts to be redeemed based on the recoveries made by NARCL, according to the ET report. In September, the Union Cabinet cleared a proposal to provide a government guarantee of Rs 30,600 crore to security receipts issued by NARCL.