A BAD BANK

There are private banks, public banks, co-operative banks and blood banks but on Sept 16th when the Indian Finance minister announced the formation of a BAD BANK the stock markets rose to their lifetime high. Sitting in the thought bar this week it’s what is good with a BAD BANK.

WHAT IS A BANK

A bank is a financial institution licensed to receive deposits and give out loans to anyone who qualifies to take a loan. In most countries such a bank is controlled by the central bank of the country in India, what we call the RBI (Reserve Bank of India). If a bank has deposits worth 100 it can’t lend out all the 100 BUT only 78 because RBI has something called the?Statutory Liquidity Ratio?or SLR is a minimum percentage of deposits that a commercial bank has to maintain in the form of liquid cash, gold or other securities ( 18%) of the total deposits and?Cash Reserve Ratio (CRR) is the share of a bank's total deposit that is mandated by the Reserve Bank of India (RBI) to be maintained with the RBI as reserves in the form of liquid cash ( 4%)

WHAT NORMALLY HAPPENS

Let us take an example of Bank X that has a deposit of 100 so as per RBI rules it can lend 78 and to maximise profits Banks usually lend up to the maximum allowed. Interest received by the bank from the borrowers is paid as interest to the depositors and life goes on smoothly until some borrowers don’t repay the loan and interest. If a borrower does not repay the bank for 90 days the bank classifies them as NPA (Non-Performing Assets) thereby reducing the income of the bank and subsequently its earning capacity. In our above example let us assume that 10% of the lent amount is classified as NPA and this 10 % is like a dead weight hanging on to the bank's neck which the bank would like to get rid off.

ENTER BAD BANK

Following through with one of her key announcements in the Budget, Finance Minister Nirmala Sitharaman??announced?the formation of India’s first-ever Bad Bank .The National Asset Reconstruction Company Limited?(NARCL) has already been incorporated under the Companies Act. It will acquire stressed assets?( NPAs) worth about Rs 2 lakh crore from various commercial banks. Another entity The India Debt Resolution Company Ltd (IDRCL), which has also been set up will then try to sell the stressed assets in the market. The NARCL-IDRCL structure is the new bad bank. To make it work, the government has Okayed the use of Rs 30,600 crore to be used as a guarantee.

HOW WILL THIS HELP BANK X

In our example of Bank X, 10% of 78 that is 7.8 of its bad loans can be transferred to the NARCL (Bad Bank) for an immediate return of 15% of the 7.8 amounting to (1.1) b and NARCL will look into the NPA try to restructure/sell/merge/and try to salvage the maximum. So our Bank X gets cash worth 1.1 and its books get clean to the tune of 7.8 infusing new lending power making it more agile and profitable. IF NARCL and IDRCL can do a good job of salvaging the NPA, banks get healthier and everyone is happy.

HAS ANYONE TRIED IT

Mellon Bank USA (1988) was the first bank to use the bad bank strategy which created a bad bank entity to hold $1.4 billion of bad loans, The financial crisis of 2007–2010 resulted in bad banks being set up in several countries. For example, a bad bank was suggested as part of the Emergency Economic Stabilization Act of 2008 to help address the subprime mortgage crisis in the US. In the Republic of Ireland, a bad bank, the National Asset Management Agency was established in 2009, in response to the financial crisis in that country. France, Indonesia, Belgium and many other countries have tried the bad bank concept. The most notable of them was in Malaysia ( financial crisis of SE Asia 1998) ,?Danaharta was established by the Government of Malaysia to act as the national asset Management Company (or AMC). Its prime objectives are to re-energise the Malaysian financial sector by buying non-performing Assets (NPAs) from financial institutions and maximize their recovery.

It is obvious that the NPA is transferred from a good bank to a bad bank with the guarantee of the sovereign government fully paid by the taxpayer. On the positive note the regular banks can concentrate on their daily business of lending and collecting deposits ( which they are good at) while a set of people at the bad bank can look at slicing, merging and monetisation ( which they are good at ) of the NPA .