Bad Bank UPSC Notes (Prelims and Mains)

What exactly is a bad bank?

A bad bank is a corporate entity in which problematic assets held by banks are segregated into a separate firm. It is formed to acquire non-performing assets (NPAs) from a bank at a price specified by the bad bank.

What is a non-performing asset (NPA)?

A non-performing asset (NPA) is a loan made by a bank that has not accrued interest for more than 90 days. In other words, when a bank fails to collect principal and interest on a loan for a period of more than three months, the debt is classified as a non-performing asset (NPA).

How do non-performing assets affect the banking sector?

Banks gain money by charging interest on loans made to borrowers. The bank uses this revenue to pay interest to depositors. The difference between interest earned and interest paid is the bank’s profit. This is why the bank’s interest rate is always higher than the interest paid to depositors.

As an example, suppose a bank charges 10% interest on loans to borrowers — both businesses and retail customers. Additionally, it pays a 6% interest on on deposits. The remaining 5% will be used to operate the banking operations, and the remainder will be profit for the bank.

Indeed, the bank uses the deposits it receives to make loans. Additionally, if the borrower defaults on the loan, the bank will have difficulty returning the deposit to its consumers.

Thus, it is critical for banks to recover their loans, including interest, on time in order to continue operating, repaying depositors, and earning a profit.

How much non-performing assets do banks have?

As of March 2021, the banking system’s total bad debts were at Rs 8.35 lakh crore.

The Reserve Bank’s financial stability report indicates that the gross non-performing assets (GNPA) and net non-performing assets (NNPA) percentages remained constant in the second half of 2020-21, standing at 7.5% and 2.4%, respectively, in March 2021.

When a bank incurs a loss due to unpaid loans, it can offset the loss by increasing the interest rate on subsequent loans or by paying lower interest to depositors. A small percentage of delinquent loans have no effect on a bank’s day-to-day operations.

The issue arises, however, when bad debts become too large to be recouped by interest rate adjustments.

To address this, banks must restructure their processes and structures in order to permanently overcome these issues. In September 2021, Assocham and Crisil released a joint study emphasising the need for Indian banks, particularly public sector banks, to upgrade their risk management policies.

Thus, we can summarise by saying that bad debts are all loans that the bank was unable to collect. And, in response to rising bad debts, the Indian government is establishing a Bad Bank that will acquire all such uncollectible loans from banks and sell them to prospective buyers via India Debt Resolution Company Ltd.

Commercial banks collect deposits and make loans in every country. Deposits are a bank’s “responsibility” since they represent the money the bank has taken from a common man and must repay when the depositor requests it. Additionally, it is required to pay interest on those deposits in the interim.

By contrast, the loans that banks make are their “assets” because they generate interest and are money that the borrower must return to the bank.

The entire business model is predicated on the assumption that a bank would earn more money by extending loans to borrowers than it will lose by repaying depositors.

Consider a scenario in which a bank discovers that a sizable loan is not being repaid because the borrower’s business has failed and the borrower is unable to repay either the interest or the principle.

Every bank can withstand a few of these blows. However, happens if such “bad loans” (or loans that will not be repaid) increase dramatically? In this circumstance, the bank may fail.

Now consider a scenario in which multiple banks in an economy are simultaneously confronted with significant levels of problematic loans. This will jeopardise the economy’s overall stability.

When the number of poor loans increases — they are commonly expressed as a percentage of total advances (loans) — two things happen. One, the bank in question becomes less lucrative as a result of having to utilise some of its revenues from other loans to offset the loss on the poor loans. Two, it grows more adverse to danger. In other words, its officials are hesitant to issue loans to company endeavours that appear even marginally risky out of concern about aggravating an already high percentage of non-performing assets (or NPAs).

How will the band bank benefit businesses and consumers?

If a bank has a high level of non-performing assets (NPAs), a significant portion of its income will be used to reduce losses. As a result, banks with significant non-performing assets are likely to become risk adverse and less eager to lend money to borrowers. It would become more difficult for firms and households to obtain loans from banks, eroding the economy’s overall resilience.

Additionally, in India, a sizable amount of non-performing assets is held by government-owned public sector banks. Historically, the government had to inject new funds into PSBs to improve their financial health. The government injecting more resources into PSBs means that other programmes will receive less funding.

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