Bad Banks And How They Function.

Introduction

The name 'bad bank' seems like an abnormal financial institution name, but why is it so? Can a bank be bad? 
The name bad bank correlates to the fact that such kind of bank is cleaning up the 'bad things' from our financial ecosystem. Non-Performing Assets (NPAs) are an example of 'bad things' happening in our banking ecosystem. NPAs simply mean loans that are defaulted on over time and have become a financial liability of the bank.

Loan default is a problem that banks have been witnessing since its inception. Even though there are tougher checks in place for the borrowers, the future can't be predicted based on the present. And it is difficult to predict if someone will default in their loan repayment accurately. Therefore, with the rise in (NPAs), the bad banks' concept was conceived.

Let's check the bad bank meaning and how they function.
 

What Is A Bad Bank?

A bank or other organization, known as a "bad bank," buys hazardous and illiquid assets from other banks and financial organizations, which have become a liability. By assuming a bank's poor loans, bad banks assist in cleaning up the bank's balance sheets. Banks may now concentrate on their primary activities, which include lending and accepting deposits. That is a bad bank definition.

Banks shift problematic assets to the bad bank in addition to clearing up their balance books. This aids the bank in raising its credit ratings & regaining the confidence of the general public and investors. Additionally, it aids in preventing losses and conserving earnings.

The Finance Ministry of India recently announced its desire to create a bad bank. However, the bigger issue will be finding potential purchasers for those stressed assets to resolve the dilemma. The (NARCL) is a bad bank established to acquire non-performing assets (NPAs) from domestic banks totaling INR 2 lakh crore. If you are still looking to find out 'what do you mean by bad bank,' keep reading.
 

How Do Bad Banks Work In India?

A bad bank's primary objective is stabilizing the banking sector, facilitating credit flow, and reestablishing investor confidence. These frequently purchase risky or problematic assets, such as loans that have lost value due to current market conditions or defaulted assets. A bad bank could also purchase financially viable assets to support banks in their efforts to restructure. For instance, most bad banks were established both before & after the financial crisis of 2008 to stabilize the banking sector. Moreover, to stop several significant banking firms from failing due to a decline in asset values.

The objectives and financial institutions' desire to retain assets off their balance sheet heavily influence the sort of bad bank and its structure. The four categories of bad bank structures are as follows:

● Bad Bank Spinoff: This is probably the most popular kind of bad bank. In this case, all of the bank's troubled assets will be acquired by the bad bank, a distinct legal entity.

● Regarding a balance sheet guarantee: With this arrangement, banks are assured that the government will support them, protecting a portion of their portfolio losses.

● Internal Restructuring: In this kind of organization, a bank will create a distinct internal division to house its troubled assets. This structure is common when the amount of problematic assets in the bank's balance exceeds 20%.

● Special Purpose Entity: In this structure, a bank transfers all undesirable assets to a bad bank. The government typically supports such a bad bank.

Examples of Bad Bank Structures

The following are examples of bad banks in the Indian financial ecosystem.

● National Asset Reconstruction Company Limited (NARCL): Its main objective was to dispose of commercial banks' stressed assets. 

● India Debt Resolution Company Ltd (IDRCL): Their objective is to sell off the bank's stressed assets in the market. 

NARCL-IDRCL Structure:

● Existing ARCs have already been useful in resolving stressed assets, particularly for loans with lower loan values.
● The IBC and other relevant resolution tools are helpful.
● However, additional options and alternatives are required due to the high stock of legacy NPAs, which is why the NARCL-IRDCL structure was proposed in the Union Budget 2021.

How NARCL-IDRCL Works and the Guarantees Offered:

Following the parameters outlined in the "Debt Management Agreement" signed between these two corporations, IDRCL  and NARCL will have an exclusive agreement. The resolution will be owned and approved by NARCL as the Principal under this arrangement, which will be on a "Principal-Agent" basis.

● The NARCL would first buy troubled bank loans.

● The remaining 85% of the agreed-upon amount will be paid in the form of "Security Receipts," with 15% of that total paid in cash.

The government approved a 5-year assurance of a maximum of Rs 30,600 crore for NARCL to use as non-cash compensation for the transfer of NPAs in the form of security receipts. This will alleviate the worries of the banks and RBI over incremental provisioning.

A five-year government guarantee increases security receipts' liquidity, tradability, and worth. The guarantee, a contingent liability, doesn't require the federal government to spend any money immediately.

Conclusion

Bad banks were conceptualized to release the NPA burden faced by financial institutions in India. They work to clean off the banking institutions' bad liabilities and help clean up the bank's balance sheets. This article delves more into the functioning and structure of bad banks.