Context: Recently, Finance Minister of India has announced the formation of India’s first-ever “Bad Bank”.
Key Points

• The National Asset Reconstruction Company Limited (NARCL)- India Debt Resolution Company Ltd (IDRCL) structure is the new bad bank.
• The government has okayed the use of Rs 30,600 crore to be used as a guarantee.

The National Asset Reconstruction Company Limited

• It will acquire stressed assets worth about Rs 2 lakh crore from various commercial banks in different phases.

India Debt Resolution Company Ltd (IDRCL)

• It will sell the stressed assets in the market.

What is a Bad Bank?

• It is a bank set up to buy the bad loans and other illiquid holdings of another financial institution.
• The entity holding significant nonperforming assets will sell these holdings to the bad bank at market price.
• By transferring such assets to the bad bank, the original institution may clear its balance sheet.
• If the proportion of bad loans (calculated as a percentage of the total advances) rise, then it leads to:
• The concerned bank becomes less profitable because it must use some of its profits from other loans to make up for the loss on the bad loans.
• It becomes more risk-averse.
• In India, the level of NPAs rose alarmingly since 2016. This was a result of the RBI requiring banks to clearly recognise the bad loans on their books.

The requirement of bad bank

• It was argued that the government needs to create a bad bank, an entity where all the bad loans from all the banks can be placed.
• It will reduce “stressed assets” of the commercial banks allowing them to focus on resuming normal banking operations, especially lending.
• While commercial banks resume lending, the bad bank would sell these “assets” in the market.

Working of NARCL-IDRCL

• The NARCL will first purchase bad loans from banks. It will pay 15% of the agreed price in cash and the remaining 85% will be in the form of “Security Receipts”.
• When the assets are sold, with the help of IDRCL, the commercial banks will be paid back the rest.
• If the bad bank is unable to sell the bad loan, then the government guarantee will be invoked.
• Thus, it will be paid from the Rs 30,600 crore that has been provided by the government.

Benefits of a Bad Bank
Providing Lending Leverage to Banks

• The benefits include recovered value, and significant lending leverage because of:
• Capital being freed up from less than fully provisioned bad assets.
• Capital freed up from security receipts because of a sovereign guarantee.
• Cash receipts that come back to the banks and can be leveraged for lending, also freeing up provisions from the balance sheet.

Revival of Credit Flow

• A bad bank can help free capital of over Rs 5 lakh crore that is locked in by banks as provisions against the bad loans.