BAD IS GOOD

Any weak or wilting parts of a plant should always be chopped off and trimmed by a gardener. He acts in this manner since those impede the plant's growth. Eliminating them is necessary for the plant to reach its maximum potential in terms of growth and development.

The idea of "bad banks" emerged as a result of multiple bank failures and an increase in non-performing assets (NPAs) in the banking sector. These banks are seen as a kind of guardian angel that looks out for their branches and removes withered leaves before the top institution has to intervene.

In short, a bad bank is a bank that buys stressed assets and other non-liquid holdings from other banks and financial institutions. This allows the bad bank to handle the recovery of those assets while the other banks can better concentrate on their regular operations. Usually, bad banks buy assets that are less than their book value. It makes an effort to recover as much of the loan's value as it can. It takes those loans and repackages them, then offers them to buyers. There is an advantage for the banks when they sell their undesired assets to a bad bank, even though they lose money on book value in the process. It shifts the burden of debt recovery and sells the asset that would not otherwise be liquid. In essence, it assists the banks in reducing short losses and focusing on their lending activities.

Despite their common usage, stressed/toxic assets and non-performing assets are not the same thing. Loans that have missed 90 days' worth of principal or interest payments are referred to as non-performing assets, or NPAs. On the other hand, all loans that are non-performing, have undergone restructuring, or have been written off by the bank are considered stressed assets of the bank. All of the bank's stressed assets are taken over by bad banks, who then attempt to sell them.

HISTORY:

The United States of America saw the emergence of bad banks in 1988. The Grant Street National Bank was established by Mellon Bank, which needed to be recapitalized due to its losses (GSNB). That bank's mission was to assume control of Mellon Bank's toxic assets, sell them off, and ultimately go out of business. At a discounted value of $640 million, GSNB sold off bad loans totaling $1.4 billion. Mellon Bank began turning a profit shortly after GSNB was established. The idea of "bad banks" gained traction when governments witnessed Mellon Bank's success. In order to sell stressed assets that were deemed bankrupt, the US government established the Resolution Trust Corporation, an asset management firm, in 1989.

While each nation has its own nomenclature for its failing banks, the goal of each is the same: to separate toxic assets from performing ones and then handle the bad ones with specialized knowledge. Japan established it as the Credit Co-operative Purchasing firm (CCPC) in 1992, however the United States referred to it as an asset management firm. The bad bank strategy has been successfully adopted even in Europe; in 1992, Sweden became the first country to establish two of those. The majority of bad banks are located in nations like Spain, Germany, Ireland, etc. Following the 2008 global financial crisis, which severely damaged banking institutions all over the world, the majority of bad banks in nations like Spain, Germany, Ireland, and so forth emerged.

STRUCTURE:

As previously said, a bad bank's main objective is to handle banks' toxic assets. However, the methods used vary depending on the requirements of various organizations. A bad bank does not always need to be established as a distinct legal organization. It could also be established inside the bank as a distinct business unit. While it is preferable to remove stressed assets from the bank's balance sheet, doing so is more complicated than leaving the assets on the balance sheet. These define the four fundamental categories of bad bank schemes: internal restructuring unit schemes, off-balance sheet special purpose entities, on-balance sheet guarantees, and bad bank spin-offs.

ON BALANCE SHEET GUARANTEE:

The problematic loans are still listed on the bank's balance sheet in the event of a guarantee arrangement. A guarantee is provided by the government or another entity that the stressed assets' book value will not drop below a specific amount. Put simply, if a borrower defaults, the institution pays the loss. This approach is the least preferred since there is only a little amount of risk transferred and the bad loans remain on the bank's balance sheet. The only benefit is that there isn't a significant upfront capital required.

INTERNAL RESTRUCTURING UNIT SCHEME:

According to this concept, the bank establishes an internal unit whose only responsibility is to manage those stressed assets. Establishing an internal bad bank serves as a warning to the market and is especially advantageous if the bank's performing assets' financial statements are released independently. Given that the stressed assets are being managed by the same administrators who first generated them, the effectiveness of this paradigm is in doubt, particularly in India.

SPECIAL PURPOSE ENTITY:

This model creates a Special Purpose Entity (SPE) to which all stressed assets are transferred. Usually, these assets are sold to various investors after being securitized. Although asset offloading is a costly and intricate procedure, it is far more effective than on-the-balance-sheet methods. For homogeneous assets, this model performs best.

BAD BANKING SPINN-OFF:

This strategy, which is the most popular and efficient, entails creating a distinct legal organization with a banking license that, in most circumstances, manages the undesirable assets of many banks. Although it guarantees maximal risk transfer, considering the work required to comply with regulatory standards, it is seen as a "last resort." Since money may not be easily accessible for such fully developed bad banks, the government typically plays a role in their operations.

FUNDING:

The two main expenses of a poor bank are acquisition and operating expenditures. A bad bank's acquisition of assets typically takes the form of debt security or equity, so working capital is only required to the amount necessary to cover operating expenses. The government or other public organizations may supply this funding, or the banks themselves may contribute money.

DISPOSAL OF ASSET:

The disposal of the assets that problematic banks have acquired from other banks is the main issue of disagreement in the entire discussion of bad banks. When it comes to hazardous assets, there are certain important judgments that must be made. These investments could depreciate much more if they are retained until maturity. Negotiations to restructure or reschedule debts would therefore need to be undertaken by the management of failed banks before they could be sold off. Certain assets must be managed actively, such as an unfinished infrastructure project that may need to be finished in order to raise its worth; other assets must be handled passively and eventually recovered. Only when these assets are disposed of effectively can the shareholders of failing banks profit.

CONSTRUCTIVE IMPACT:

A bank that has no non-performing assets (NPAs) is highly regarded by depositors, investors, borrowers, and credit rating agencies. Bad banks are therefore a crucial entity since any bank with a rising percentage of non-performing assets (NPAs) will wish to improve its balance sheet. Furthermore, once the bad loans are moved to these bad banks, it's simpler for the management of the bank to concentrate on its primary duties, which promotes the bank's expansion and growth. Since the toxic assets are now being managed by professionals with the necessary skills, the assets can be recovered quickly, which would have otherwise increased the bank's losses.

DOWNSIDES:

The process of establishing bad banks is intricate.A single bad choice over asset transfers, bank funding, or asset disposal might result in enormous losses.3 The process of establishing bad banks is intricate.A single bad choice over asset transfers, bank funding, or asset disposal might result in enormous losses. As a result, most nations lack a robust legal system, which is vital. The recruitment of specialised staff is necessary for the management of failed banks, which results in extremely high operational costs. Asset management and transfer are also expensive endeavours. Ulrich and Ilgmann discuss the fire in their paper, "Bad banks: A proposal based on German financial history." This transfer lowers the assets' total market worth, which in turn causes other institutions to sell them and drive down prices, creating a kind of vicious cycle. Bad banks aid banks in cleaning up their balance sheets, but they also have the potential to encourage risky lending practices at certain banks.

THE FRAGILE INDIAN BNAKING SYSTEM AND BAD BANKS:

Not only did the COVID-19 pandemic affect India's population's physical health, but it also had a negative impact on the country's economy. With the imposition of a strict and long lockdown across the country, even the biggest of firms had to face shutdown, and joblessness became rampant. Even those who had jobs had to deal with steep pay reductions. However, the expenses of living and doing business hardly changed. This produced the ideal environment for debt default. Both individuals and organizations that took out large and small loans were unable to repay their debts. The Indian banking sector had not been doing well, even on the plus side. Long before the epidemic struck, it has been infirm for the past few years. Multiple mergers were required to help the weaker banks, as non-performing assets (NPAs) were already a hindrance. Additionally, withdrawal caps have to be seen by the public—not just once, but several times. NPAs were rife in the loan market, which had been severely damaged by the epidemic and related moratoriums. The Reserve Bank of India stated in its January 2021 Financial Stability Report that by September of that year, the gross non-performing assets (NPA) ratio could increase from 7.5% to 13.5%. Such predictions caused tremors in the Indian banking system, which was already in precarious shape. The last thing the Indian economy needed was a bank failure, or worse, a bank run.

The economy was starting to revive as corporate operations resumed and the labor market grew once more. But it would take time, and the path was steep. Time that the financial system was unable to provide. Thus, there was an immediate as well as severe necessity for bad banks.

Banks have made efforts to regain stability and mitigate the harm. Techniques like interest waivers, loan restructuring, and rebate incentives have been used to recover as much money as possible while preserving some liquidity. These could hardly, however, take the place of a bad bank.

During the prolonged period of forbearance following the global financial crisis, the Indian banks reorganized a large number of assets, including the unviable ones, which resulted in the window dressing of their accounts. The NPAs began to mount up in 2015, when the forbearance period came to an end. The government has implemented a number of measures to address the issue of growing non-performing assets (NPAs), including the Insolvency and Bankruptcy Code (IBC), the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act), and the Asset Quality Review (AQR) to clean up the banks.

In the 2021 budget, the government ultimately suggested creating an Asset Management Company (AMC) and Asset Reconstruction Company (ARC) to oversee and assume control of the stressed debt that currently exists, as well as manage and sell the assets to Alternate Investment Funds and other possible buyers in order to eventually realize their value.

The first aid that the damaged system need is an ARC. While it might not be able to fully heal its beneficiaries on its own, clearing balance sheets and supplying fast liquidity gives them the strength to carry on with their task. “Bad banks can address this issue (of NPAs) in a transparent manner and get the credit cycle back in action,” stated Uday Kotak, Managing Director of Kotak Mahindra Bank.

EFFICACY IN INDIA:

The audacity of the move was something that both proponents and opponents of the notion of an ARC or a bad bank for India could agree upon. Dr. Raghuram Rajan, who is regarded as India's most respected and acclaimed banking expert, has been a critic of bad banks. He states, "I just saw this as shifting loans from one government pocket to another and did not see how it would improve matters," in his book "I do what I do." Indeed, the unwillingness to act would only be transferred to the failing bank if it were a public institution. Many financial professionals around the nation share this opinion. Some even go so far as to refer to it as a pointless exercise in "window dressing." There is also a perception that a public sector ARC will overpay for non-liquid assets and bad loans, in contrast to an ARC run by the private sector. Additionally, it won't have the personnel with the necessary experience to bargain with the private sector. Ultimately, the nation's taxpayers will be the ones who ultimately pay for the banks' errors. Therefore, ownership of the failing bank is a problem that requires careful consideration. In India, public sector ownership is turning out to be a significant source of criticism. There are 29 private ARCs in India, but a shortage of funding has prevented them from aggressively taking on problematic loans. Proponents of bad banks maintain their position, emphasizing the seriousness of the non-performing asset (NPA) problem and emphasizing that a bad bank would be the most effective means of restoring liquidity and payback cycles. Duvvuri Subbarao, a former governor of the RBI, described a failing bank as "not just necessary but unavoidable."

CONCLUSION:

After careful consideration and analysis, it is evident that bad banks are a transitory solution rather than a permanent one. They are corrective rather than preventive in nature. They give banks the immediate support they require, but they don't address the long-term, structural inefficiencies those banks face. The action is undoubtedly beneficial, but many more reforms are required for the failing banking institutions in many nations to get them back on track.

Thus, the anticipated duration of such an organization is another important topic. Should governments wish to maintain it as a long-term safety net for banks, or should it only be a temporary solution? In the future, we wouldn't want to celebrate the success of failing banks since that would mean that stressed assets would always be present in the system.

In addition to addressing the current problem of toxic assets, it is critical to keep an eye on the bank lending procedures to make sure that loans are not extended hastily, that zombie lending is not occurring, and that no unviable projects are being restructured. At that point, the banking plant will blossom and its leaves won't drop.