Explained: What Is A Bad Bank, How It Has Been Used Around The World

In a firm indication that a 'bad bank' is no longer a concept but will soon become a reality, nine banks and two non-bank lenders are said to have finalised plans to invest jointly ₹7000 crores. Reported by the Economic Times, this story follows another one stating that banks have already started identifying the loans that would be transferred to such an institution.

The impending launch of a 'bad bank' has gained momentum after Finance Minister Nirmala Sitharaman confirmed the formation of such a bank in this year's Union Budget. While the plans to make it a reality maybe of recent origin, the demand for such a bank in India is not new. It is seen to be one of the structural solutions to be taken by the banking system themselves - with a little push from the government - to resolve the decade old bad loans issue plaguing it. The approach has been used before abroad, and the concept of a 'bad bank' dates back to 1988.

Sitharaman's announcement of a 'bad bank' can also be viewed in context of the Reserve Bank of India's Financial Stability Report that was released in January. While the issue of bad loans is already an albatross that the banking system carries around its neck, the report expects it to get worse due to the COVID-19 pandemic.

It says that by the end of the first half of the next financial year (end of September 2021), under a severe-stress scenario, which the reports calls its worse case scenario, the banking system could see 14.8% of its assets as non-performing. Public-sector banks have it worse, as they will see 17.6% of their assets non-performing.

How much of a bank is the 'bad bank'?

While Sitharaman announced a 'bad bank', she has not used these exact words, as 'bad banks' are not traditional institutions of lending and borrowing. Rather, they are asset management or restructuring bodies that take on sour debt from banks, and attempts to sell, restructure or revive it.

"The high level of provisioning by public sector banks of their stressed assets calls for measures to clean up the bank books. An Asset Reconstruction Company Limited and Asset Management Company would beset up to consolidate and take over the existing stressed debt and then manage and dispose of the assets to Alternate Investment Funds and other potential investors for eventual value realization", the finance minister said in her speech.

The RBI has supported the idea from its quarters too. Late last month, Governor Shaktikanta Das elaborated on this topic and said, "What you call a bad bank is not really that; an ARC-type entity will be set up to take over bad loans from the books of public sector banks and it will try to resolve just like any other ARC [asset restructuring company]."

With such a move, banks will look to achieve healthier assets by segregating the good ones from the bad, and offloading the bad ones to these asset-restructuring companies. On the back of better assets, banks can look to the future and realise better credit prospects and stronger business. Meanwhile, the ARC can determine how best to turn the non-performing asset around.

However, there could be many approaches to how a bank could deal with toxic assets. A 2009 report by McKinsey outlines four such avenues.

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Where have bad banks been used before?

However, while bad banks may be an idea just coming to fruition in India, it has been used to clean up banking systems abroad.

The McKinsey report states that the first instance of a bad bank being used was by US-based Mellon Bank in 1988.

Since then, a bad bank (or any of its approaches) has been used by banks around the world.

In 1992, when Sweden faced a banking crisis, two AMCs were set up - one for one bank each. Securum and Retriva, as the AMCs were called, were set up to manage the bad assets for Nordabanken and Gotabanken respectively, which then represented 20% of all assets in the Swedish banking system. These companies set a floor price (or a minimum value) for these toxic assets to assure and maintain trading in them. The European Commission (February 2009) said that this approach - 10 to 15 years down the crisis - proved to be successful.

Dresdner Bank in Germany - which was acquired in 2009 - set up an internal asset restructuring unit from 2003 to 2005. The various approaches highlighted above by McKinsey were used by banks around the world to cope with the 2008 financial crisis, when Citibank, Lloyds and ING used governmental support to isolate good bits of its portfolio against losses. During the autumn of 2008, UBS of Switzerland offloaded its bad assets in a government fund. It repurchased the fund in 2013 for $3.7 billion, which was the profit for the Swiss central bank, when the assets in that fund turned profitable again.

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