FM’s Solution To India’s Bad Loan Problem

The Finance Minister spoke about setting up a new ARC and AMC to clean up banks’ balance sheets. So, what does it mean?

Just In

In her 2021 Budget Speech, Finance minister Nirmala Sitharaman announced plans to establish a new asset reconstruction company (ARC) and asset management company (AMC). This is part of the government’s strategy to clean up the balance sheets of banks. There is a simple term to call these entities (i.e) a Bad Bank. The set-up ARC will take over bad loans.

What Is A Bad Bank?

A bad bank is a bank which will buy out all toxic loans from banks. This will help the other banks get on with their business while the bad bank will focus on recovering the loans or releasing cash from selling the underlying assets.

Advantages Of Having A Bad Bank

Asset Monetisation: Once banks have transferred all of their bad loans to the bad bank (which is basically like Marie Kondo-ing their balance sheet), banks can prevent the assets from mixing together.

Once the bad loans are out of the picture, one can see the actual financial health of the bank, which will help the lender in raising capital, borrow and lend money to other companies.

Were They Any Bad Banks Before This One?

YES! The bad bank model was first proposed in the 1980s. U.S-based Mellon Bank set up a bad bank in 1988 to hold its toxic assets by spinning off its own capital and five of its own board members into the Grant Street National bank.

So, Grand Street National Bank is the bad bank here, and it did not take deposits from the public like normal banks do, and it wasn’t a member of the Federal Reserve System. Once the bank served its purpose of resolving or liquidating bad debt to recover as much money as it can, it was eventually liquidated a few years down the line. Following in the footsteps of the US, Sweden, Finland, France, Germany, Indonesia and many other countries also deployed the same idea.

Challenges With A Bad Bank

It is very complicated to bring this to life. A McKinsey & Company report, says that a banking institution has to keep in mind its choices of assets to be transferred into the risky category, business case, portfolio strategy, and the operating model. The report added that each of these choices must be made while considering the impact on funding, capital relief, cost, feasibility, profits, and timing.

Zooming Out

The rising non-performing assets (NPAs) are a problem, and we can’t ignore it any longer. At the end of September 2020, the total gross NPAs of the banking system was 7.5% of the overall industry loan book. As per RBI’s forecast, this number is anticipated to jump up to 13.5% by March-September this year. Hence, the government’s solution to handle these bad loans have come at the right time. We need to wait and see how this entity helps the banking industry in the future.

Head to moneyguru’s Insight section to stay updated on all major financial news updates of the day