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What is a bad bank? Understanding the good, the bad, and the ugly of the concept

We all own things we aren't proud of. That yellow Tshirt you bought on a whim but now rarely wear, or that specialized grating tool that sits in your kitchen that you've never used. What if someone agrees to buy those back from you, at a discount! If you're like most people, you would probably be quite happy with the deal. You get rid of things you didn't want anyway, and in place get cash, which you can now use to buy newer things - hopefully, better things.

The Indian Banking Association is proposing something similar - the creation of a large 'Bad Bank' that can buy out all the stressed and non-performing assets of the banks, freeing up capital. Banks can then begin to lend, hopefully to better folks, and get the economy restarted again.

In today's post, we deep dive into the good, the bad, and the ugly of the proposed Bad Bank.

Let's start with the bad!

The first issue with the suggestion is probably clear based on the comparison we made. The emergence of an organization that comes in and absorbs bad losses does nothing to the risk management frameworks of these banks. Banks that have bad risk management frameworks and external pressures that make them make bad lending decisions will continue to do so even after the bad loans have been removed from their books, making the need of a bad bank a periodic rather than a one time exercise. The argument here is that banks who have piled on heaps of bad debt due to weak risk management practices deserve to have less business going forward, and its best to let them wilt slowly. The banks that have consistently managed risk well will continue to grow their share and grow well, as they should.

The other is the question of selling assets where a clear fraud has been detected. In such cases, does it make sense for the taxpayer to bear the burden of a mistake of a third party?

Let's move to the good

But enough of the bad, let's move on to the good - and there is quite a lot that is good here. If the proposed bad bank is set up by competent folks with prior experience in the Asset Reconstruction domain, they could decide on discounts to the book which are fair to both the target bank as well as the bad bank.

At a time where there is a crisis of confidence, both in terms of banks unwilling to lend, and customers increasingly afraid of parking their deposits with weaker private banks, the proposed bad bank will cure both issues in a single swoop.

And let's end with the ugly

The Indian Banking system is a mess probably too big for a single entity to fix. With the estimated NPAs at around 10 lakh crores, a bad bank that has any chance to fix the issue at hand will have to be extremely large in scale, executing an operation of the scale that has probably never been done before in the country. Doing this in a time-bound manner for all these assets is a challenge in itself as well.

The history of such organizations elsewhere in the world have not been too reassuring either. In two such exercises implemented in China & Spain, the organizations set for the task remained consistent loss-makers. So while the concept may have its allure, it will probably end up doing more harm than good.

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