The term “bad bank” is not about a bank gone bad. In fact, the work that is done by this bank is equally good. Someone might say, they do an even tougher job than orthodox banks.
So, the concept of bad banks is going to help commercial banks clean up their balance sheet. It will increase the bank’s lending potential, thereby more profits. For an investor, banks making higher profits, in the future, is like music to the ears.
Recently our Indian finance minister has announced the incorporation of NARCL (National Asset Reconstruction Co. Ltd). Another entity called IDRCL (India Debt Resolution Co Ltd.) has also been set up. Both NARCL and IDRCL together will function as a bad bank.
Bad Bank will function to clean up the balance sheet of the banks. Banks with healthy balance sheets will lend more and hence make more profits. Good news for investors.
So, this was a trigger for me to know more about the bad banks.
How Bad Bank Will Function in India
A Bad bank consists of two main components, NARCL and IDRCL. Together, the two entities function as a bad bank. Before we know the roles of NARCL and IDRCL, we must have more details about the banking itself.
In a healthy economy, bad banks are not required. But when going gets tough, and NPA’s of banks begins to rise above the nominal levels, bad banks are needed.
How Banks Function?
Banks take deposits from people and issue loans to the needy.
- Deposits are kept in the bank for a period. On the deposits, the banks have to pay interest to the depositors. After the tenure is over, the bank must also payback the deposit amount.
- Loans are issue by banks to people. During the loan tenure, people must repay the loan EMI’s to the bank. The loan EMIs include the interest and principal.
The interest charged on loans is always more than the interest paid on deposits. This is what is called the net interest margin (NIM) of a bank. The higher is the NIM, the greater profits a bank will make.
How NPA’s effect Bank’s Profits
The business model of banks is based on this theory that interest income from loans will be higher than the interest paid on deposits.
But NPA’s are those loans that are not earning any interest. Moreover, for NPAs, the loan principal paid to the borrower, is also at a risk.
As NPS’s are not yielding interest income, the overall profitability of the bank goes down.
Once a loan converts into an NPA, there is a legal process that needs to follow to recover the dues. Before the bank can confiscate the hypothecate asset of the borrower, a legal cost must be borne by the banks. It further reduces the profits.
Need of Bad Banks
It is normal for banks to encounter few NPA from their pool of performing loans. It is an unavoidable happening. Generally, banks keep a provision for such NPA. It is a manageable situation.
You can see the level of Gross NPA between FY’09 to FY’14. It was kind of stable between 2.25% to 3.8%. But post FY’14, the GNPA of banks is rising steeply.
In FY’18 it has peaked at 11.18%. After that, there is some cooling down happening. This is because the Banks are taking the hit and writing off some of their NPAs. The provisions kept by the banks are not enough to take care of when NPA numbers cross 7%-8%.
In FY’2020-21, COVID-19 happened. People and companies were given a moratorium. It is feared that in the post COVID era (FY’22), the NPA situation may balloon out of proportion.
This is fear, and the GOI is taking a preemptive step by creating a bad bank. As of today, it is estimated that GNPA in Mar’22 will be about 9.8%. But the reality may be much worse.
When banks are reeling under the load of NPA, it starts to reflect not only in their profits but also in the economy. Such banks become lending averse. They become too cautious, hence many genuine borrowers might not get loans. Hence the consumer spending falls, bringing the GDP growth rate down.
How Bad Bank (NARCL + IDRCL) will Work?
NARCL will first purchase a bad loan (NPA) from a bank at a mutually agreed price. This is an important step.
Mutualy Agreed Price
Suppose the book value of an asset (attached to a loan) is say Rs.500 crore. But NARCL may not want to acquire the loan and its asset at the book value. So they will explain their limitation to the bank. At this point, both NARCL and the bank must reach an agreement.
Why Banks will agree to a lower price than the book value? Because for banks, anyways the asset is not generating any income (NPA). Moreover, to liquidate the hypothecated asset attached to the loan, they would have to fight a long legal battle.
So, the bank may find it suitable to transfer all rights of the asset and the loan to the bad bank, and in turn, pocket some cash.
Once the price has been agreed upon, the next step is the cash transfer.
First Cash Trasfer
15% of the agreed price will be paid to the bank in cash. To enable this cash transfer, the government has agreed to fund Rs.30,600 to the bad bank. This amount has already been declared by the government as a guarantee to the critics of the bad bank concept.
There is another utility of the government guaranteed fund. We will see it in the next section.
Role of IDRCL and Security Receipts (SR’s)
At this stage, both NARCL and IDRCL will jointly try to sell the bad loan, as a package with the hypothecated asset, in the market. The sale proceeds will then be used to pay the balance 85% cash.
In case the bad bank could sell the asset only at a loss, how the bank will get its full balance of 85%? It will be paid to them from the government guaranteed fund of Rs.30,600 core.
Bad banks are only the firefighters. They are not going to prevent banks from generating more NPA. At present, the majority NPAs are the result of oversight and corruption within the bank. Hence, banks must be held accountable for their NPAs.
When Bad bank will come into force, there is a chance that banks may become even more complacent in issuing loans. Why? Because they know that if something goes wrong (NPA), it will be transferred to the bad bank. It will not reflect in their balance sheet. In the worst case, for PSB’s, the GOI will recapitalize and infuse cash for the bank.
The concept of a bad bank looks good in the present scenario. But it does not tell how the PNB’s, Yes Bank’s, DHFL’s, IIF&L’s will not prop up in the future.
So as an investor, I’m keeping my fingers crossed. The hullabaloo created over bad banks looks good on paper. RBI and Finance Ministry has to play their part in making the banks (specially PSB’s) work as per rules.
[Note: Multiple Asset Reconstruction Companies (ARCs) are already operating in India. They function like a Bad Bank. So, why a new entity is required? All ARCs that are currently operations are privately managed. NARCL and IDRCL will a government entities. Moreover, they are funded by the government. Hence, may report better results than present ARCs.]
Have a happy investing.