Why in News: The Indian Banks’ Association has pitched the idea of creating a ‘bad bank’ to help lighten the load of stressed assets on the books of Indian lenders.

Bad Bank
• Technically, a bad bank is an Asset Reconstruction Company (ARC).
• When the problem of non-performing loans (NPLs) becomes pervasive and too big for individual banks to handle, governments often propose the setting up of a bad bank to buy out all toxic loans from banks.
• This helps banks get on with business as usual, while the bad bank grapples with recovering the loans or realising cash from selling the underlying assets.

Benefits of setting up a bad bank
• The major benefit of forming a bad bank is asset monetisation.
• Asset Monetization refers to the process of turning a non-revenue-generating asset into cash.
• Bad assets would stay in the ‘risky’ category, while the good one stays in the other category, saving them from mixing together.
• The real benefit for a bank comes when its investors are sure of its financial health, which helps it in the long run in raising capital, borrow, and lend money to other companies.

Background
• Though the idea of bad bank was first pioneered in the US in 1988, the idea of forming a ‘bad bank’ in India was initially floated in January 2017 when the Economic Survey of India suggested setting up a Public Sector Asset Rehabilitation Agency (PARA), to buy out the largest NPLs from Indian banks.
• The RBI also came up with a suggestion to form two entities to clean up the bad loan problems ailing PSBs by PAMC (Private Asset Management Company) and NAMC (National Assets Management Company).
• A Private asset management company (PAMC) which would be suitable for sectors where the stress is such that assets are likely to have economic value in the short run, with moderate levels of debt forgiveness.
• A National asset management company (NAMC) for sectors where the problem is not just one of excess capacity but possibly also of economically unviable assets in the short- to medium-term.
• It said the NAMC would be formed with the government support, which would invest in bad assets with short-term stress but good chances of turnaround and economic benefit.
• In 2018, in proposing Project Sashakt, a five-point plan to revive Indian banks, the Sunil Mehta panel suggested that a new Asset Management Company (AMC) be set up to tackle bad loans of over ₹500 crore.
• The AMC will in turn set up alternative investment funds that will buy up stressed assets in different sectors, from asset reconstruction companies, then try to auction them off to raise cash.
• Although the government did not back the proposal, some suggestions such as an inter-creditor agreement were accepted.

• Banks led by State Bank of India (SBI) are pushing for a ‘bad bank’ in the form of an asset reconstruction company (ARC), preferably sponsored by the government, which can take over loans that have been largely provided for by them.

• Main Purpose of Bad Bank: To cleanse bank’s books of non-performing assets (NPAs) so that they are in a position to focus on the restructuring of loans for businesses that are hit by Covid-19.

The proposed structure
• The structure being proposed involves creating an asset management company or an asset reconstruction company which would be promoted collectively by the government, banks and private sector entities.
• It would be run by private sector employees.
• The AMC/ARC, in turn, would be funded by an alternative investment fund which would seek funding from investors domestically and internationally.

• The bad bank would aggregate stressed assets from across the banking system and lead resolution efforts.
• The bad bank will also rope in private lenders that have a large share of bad loans in some accounts.
• However, a final decision will be taken by the RBI and the government.

How would the bad banks pay to the lender banks?
The bad bank (ARC) need not fully pay the discounted price and instead issue the lenders security receipts, which will entitle them to a share of the recovery.
The bad bank would pay to the banks at least 15 percent of the net present value of the assets upfront in cash and the rest will be paid in the form of security receipts, which can be redeemed by banks in the future.