Tuesday, November 30, 2021
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Explained | What is a bad bank and why you should care about it

MUMBAI: Union Finance Minister Nirmala Sitharaman on Thursday announced that the Cabinet has approved Rs 30,600 crore in security receipts to be issued by the National Asset Reconstruction Company (NARC) towards resolution of bad loans.

The move is another step in the direction of making the NARC operational. The government said banks have identified bad loans worth Rs 2 lakh crore, which will be shifted to the NARC for resolution, and nearly Rs 90,000 crore of bad debt would be resolved in the first phase.

The NARC is now awaiting a licence of operation from the Reserve Bank of India after having filed an application with the central bank. The government indicated that the licence is under process and could be issued soon.

What is NARC?

NARC is basically a bad bank created by the government in the mould of an asset reconstruction company-cum-asset management company. The NARC will pick up bad loans above a certain threshold from banks and would aim to sell them to prospective buyers of distressed debt. The NARC will also be responsible for valuing the bad loans to determine at what price they would be sold.

Is it a good idea?

The idea of a bad bank in whatever mould has been a hotly debated one in India. Its supporters have argued its benefits in freeing capital on the balance sheet of PSBs, which can then kickstart the credit cycle in the economy. Its detractors have argued that it only takes care of the here and now, but does not fundamentally change the underlying problem of lax credit standards and appraisal by banks.

Many have argued that governance reforms at state-owned lenders, which account for two-thirds of the loans in the banking system, would provide a long-term solution to the bad loan crisis that plagues India every few years.

How will banks benefit from NARC?

For banks, mainly state-owned banks, the NARC is a heaven-sent. It will allow banks to transfer the bad loans from their balance sheets to NARC. The reduction of bad loans on balance sheets will allow banks to free up capital that was locked up to cover for the bad loans. Eventually, a successful resolution of the bad loan will also allow banks to reverse a substantial chunk of the provisions made by them depending on the amount recovered, which will boost their earnings.

How will NARC benefit the economy?

The majority of the bad loan pile in India is stuck with the state-owned lenders. The pandemic has made the crisis worse, although relatively less than what was expected, but RBI is projecting Indian banking sector GNPAs to rise in 2021-22.

Public sector banks account for the majority of loans generated in the Indian economy and because their capital has been stuck in providing for the large amount of bad loans, their ability to lend has been constrained.

Credit growth in India has been largely dormant in the past three years due to low appetite in the corporate sector and households deleveraging their balance sheet following the IL&FS crisis and the pandemic.

“Since the banks will remove these NPAs from their balance sheets, they can focus on lending activities that can help trigger a fresh round of credit off take that the economy badly needs,” said VK Vijayakumar, chief investment strategist at Geojit Financial Services.

How will it benefit households?

With capital freed up and stress on the balance sheet eased, banks may be more willing to ease credit standards and borrowing costs for borrowers. While the interest rate that a borrower pays today is linked to her collateral, credit score and income stream, in times of economic distress, banks automatically tighten credit standards or charge higher interest rates to discourage bad actors from borrowing. This form of adverse selection imposes a cost on the good borrower, who would have otherwise paid lower interest rate on loan due to his high creditworthiness.

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