A Bad Bank while ominous-sounding, is not a bank acting in bad faith. It is a structure meant to isolate high risk and illiquid assets of banks and/or financial institutions, to clear their balance sheets while still taking some write downs.
The concept gained popularity during the 2008 financial crisis when they were being considered among a number of solutions, especially championed by Ben Bernanke.
McKinsey outlined four basic models for bad banks in 2009. These included:
- An on-balance-sheet guarantee (often a government guarantee), which the bank uses to protect part of its portfolio against losses
- A special-purpose entity (SPE), wherein the bank transfers its bad assets to another organization (again, typically backed by the government)
- A more transparent internal restructuring, in which the bank creates a separate unit to hold the bad assets (a solution not able to fully isolate the bank from risk)
- A bad bank spinoff, wherein the bank creates a new, independent bank to hold the bad assets, fully isolating the original entity from the specific risk
The most common criticism levelled against the concept of ‘bad banks’ include how the idea is a ‘moral hazard’, in so much that it would encourage banks to take undue risks while lending knowing that there was a ready solution to any non-performing assets (NPA) accumulated through such practice.
Another is the fact that with a Bad Bank system in place, bondholders are typically allowed to sue immediately for bankruptcy (which is what encourages investors to become stakeholders in the institution). The swiftness of this enforcement mechanism, does not give a company the chance to develop its productivity- there is no potential pressure on the company to get better and it is a subsidy for corporate bankruptcy at the cost of business.
Bad Banks must be implemented carefully, while balancing the interests of financial institutions and business while not leaving taxpayers holding the tab for essentially a ‘corporate bailout’ in the guise of a bad bank.
The concept is gaining traction in India again, in light of the looming NPA shadow over the banking sector.
Examples of Bad Bank Structures
Grant Street National Bank. This institution was created in 1988 to house the bad assets of Mellon Bank.
In 2009 the Republic of Ireland formed a bad bank, the National Asset Management Agency in response to the nation’s own financial crisis.
Danaharta in Malaysia was set up in 1998 as one of three agencies to help clear up Malaysia’s debt crisis.
Sweden has long been touted as an example of positive implementation of bad banks, during their national 1992 banking crisis.
The Malaysia Success Story
Danaharta operated by offering to buy any bad loan over 5 million ringgit ($1.3 million) at a price it determined and pay the bank 80 percent of anything it recovered above that. If banks declined, they were required to write the loan’s value down to Danaharta’s offer price anyway. Danaharta bought 19.8 billion ringgit ($5.2 billion) in bad debt for 46 cents on the dollar. Importantly, the Act establishing Danaharta enabled the agency to take over management of debtors or foreclose without going to court. Mohamed Azman Yahya, the banker in charge of the agency, attributes the success of the agency to this. The agencies were closed seven years after their formation, having accomplished their goals at that time.
The Mehta Panel
In July 2018, a high-level panel presided by Mr. Sunil Mehta, the Non-Executive Chairman of Punjab National Bank, submitted a report proposing ‘Project Sashakt’ . The panel had been originally formed to find solutions for restructuring stressed assets and creating more value for public sector banks (PSBs). The report suggested a five-point multi-pronged approach to deal with non-performing assets.
- an SME resolution approach,
- bank-led resolution approach
- AMC/AIF led resolution approach
- NCLT/IBC approach
- asset-trading platform
One of the proposals of the panel was to set up an independent Asset Management Company (AMC) to deal with loans of larger than Rs. 500 Cr. In addition they suggested an alternative investment fund (AIF) to be set up which would raise funds from institutional investors where banks could potentially also invest in and become stakeholders. It is interesting to note that the then interim finance minister Mr. Piyush Goyal noted that the report did not propose setting up a bad bank.
The Current IBA Proposal
On May 13, 2020, Indian Banks Association (IBA) after much speculation, submitted a report to the ministry of finance and the Reserve Bank of India, proposing setting up a ‘Bad Bank’ to deal with NPA worth around Rs.75, 000 Cr.
The IBA plan proposes setting up of three entities — an asset reconstruction company (ARC), an asset management company (AMC), and an alternative investment fund (AIF) to acquire bad loans from banks with an aim to turn around those assets. It is in part based on the Mehta Panel report which suggested setting up of the AMC and AIF to deal with large value NPAs.
There is no doubt that the proposal will raise a lively debate on the efficacy of the structure.
Moral Hazard is a term in economics describing how behavior changes when people are insured against losses, the term ‘insurance’ being used in a wider sense here. https://www.cbsnews.com/news/explainer-moral-hazard/