Bad bank in simple
terms is an asset reconstruction company. Let's discuss it with an example,
assume a bank 'X' lends Rs.100 to a man 'Y'. The man pays back Rs.30 to the bank but he is unable to pay the balance amount, Rs.70. Then the bank can
restructure the loan by either reducing the interest rate or increase the
tenure of the loan. If the man is still not able to pay back the loan then the
bank will write off the loan. It will be in the books of the bank as "Bad
loans / Non-Performing Assets (NPA) / Stressed assets".
Here comes the role of the Bad Bank. The bad bank buys the NPA worth Rs.70 for a lesser price, Rs.40 (for example). The bad bank pays 15% of the value in cash and the remaining as Security Receipts. The bad bank then tries to recover the amount from the man 'Y' or it tries to sell the assets at a higher price than it bought from the bad bank, Rs.50 (for example). Then Rs.50 - Rs.40 = Rs.10 is the profit of the bad bank. The bank 'X' still faces loss but it's reduced a lot (loss reduced from Rs.70 to Rs.30).
The bad bank works in a three-layered structure in India,
- Asset Reconstruction Company (ARC)
- Asset Management Company (AMC)
- Alternate Investment Fund (AIF)
The Asset Reconstruction Company (ARC) buys the NPA from the bank and issues security receipts. The Asset Management Company (AMC) creates a market for the security receipts so that the banks will be able to sell the receipts. The Alternate Investment Fund (AIF) will convince the investors in the secondary market to buy the receipts.
The concept of the bad bank was first proposed in the U.S. in 1980, then finally the Grant Street National Bank (a bad bank) was created by Mellon bank in 1988. It helped the banks to reduce the NPA and it was very successful.
The Bad bank will help the banks to focus on their main activity of lending. This also helps the banks to maintain a good balance sheet. Some people feel that it's just a mere transfer of NPAs.
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