A bank set up to buy the bad loans of a bank with significant nonperforming assets at market price. By transferring the bad assets of an institution to the bad bank, the banks clear their balance sheet of toxic assets but would be forced to take write downs. Shareholders and bondholders stand to lose money from this solution (but not depositors). Banks that become insolvent as a result of the process can be recapitalized, nationalized or liquidated.
Toxic assets are assets that become illiquid when the secondary market for buying and selling them disappears. Toxic assets cannot be sold because they are widely perceived as being a guaranteed way to lose money. The term toxic asset was coined in the financial crisis of 2008-09 to describe the drying up of the the market for mortgage-backed securities, collateralized debt obligations and credit default swaps. These assets became difficult to move, resulting in large collections of these deeply troubled assets sitting on the books of various financial institutions. As the decline in value continued, these assets threatened the solvency of the banks and institutions that were unable to unload them.
A well-known example of a bad bank was Grant Street National Bank, which was created in 1988 to house the bad assets of Mellon Bank. The financial crisis of 2008 revived interest in the bad bank solution, as managers at some of the world's largest institutions contemplated segregating their nonperforming assets into bad banks.
• The Financial Stability Report, produced by the RBI, had said that the gross non-performing advances ratio increased to 9.1 per cent from 7.8 per cent between March and September 2016, pushing the overall stressed advances ratio to 12.3 per cent from 11.5 per cent.
• India's NPA ratio is higher than any other major emerging market, barring Russia, the Economic Survey said. High NPAs have weighed down the Indian banking system's capacity to lend money to the corporate sector, resulting in a drag on the country's growth.
• According to theEconomic Survey, banks' credit to the corporate sector till November 2016 in FY17 was minus 8 per cent. A negative growth in corporate lending means the industry will not be able to invest in new projects to create jobs.
At present, there seems to be a consensus building up on the need of creating a government owned bad bank, though former Reserve Bank of India Governor Raghuram Rajan was not in favour of such an entity.
• "It is not clear (if) India needs a so-called "bad bank" to deal with non-performing loans, adding that it would be preferable to push banks to clean up balance sheets themselves" Mr Rajan had said. As the head of the central bank, Mr Rajan was more in favour of capitalising the banking system.
• "We have to remain open to all solutions at this point because I think the problem is quite large," RBI Deputy Governor Viral Acharya had said recently.
• "We think it is something, if designed properly, could help," he said.
• "The stress in our banking sector must be eradicated to allow the system to lend to small businesses and other growing sectors of economy. And the present health of our public sector banks do not allow them to do so. • "Therefore, a national bad bank is a good idea," said Kotak Mahindra Bank's chief, Uday Kotak.
• By considering the whole band bank and bad loan scenario, it can be said that solutions to the NPA problem will have to be designed keeping in mind the political economy of India.
• Regular communication about running efforts to bring fraudulent defaulters to justice can help in boosting confidence in the bad bank initiative.
• For making bad bank a viable solution, the government and the RBI will have to ascertain that it does not get labeled as a “bailout” of crony capitalists and corrupt bankers at the cost of taxpayers.
• For this purpose, we need a larger and multiple and oversight committee to speedily vet loan write-offs. It is advisable constitute a Loan Resolution Authority by an Act of Parliament.
• The government would be required to provide adequate capital to the banks to cover write-offs and also facilitate fresh loan growth. If all these measures would be met then it can be possible that India could get rid of the bad loan problem.