What is a bad bank and how can it fix India’s bad loans problem?

The concept of a “bad bank” has recently come to the fore again, following a decision from India’s Ministry of Finance to establishing a committee to assess the feasibility of such a vehicle as a way to solve India’s bad loan problem.

No, it’s not a bank that is evil.

A bad bank is a corporate entity that takes up all the non-performing assets of a financial institution or a group of financial institutions at a price that is below their book value. In doing so, the sellers of these bad loans are then able to clear their balance sheets and retain all the good assets after taking a write-down on the unhealthy assets.

A prominent example of a bad bank in recent history is Portugal’s Novo Banco. Novo Banco was established by the Portuguese government in August 2014, as part of a rescue of the failing Banco Espirito Santo (BES), which was the second-largest private bank in Portugal at the time. BES was split into a “good bank”, comprising all its healthy assets, and a bad bank (Novo Banco), which took up all of the risky and unrecoverable loans.

Restructuring assets

A bad bank frees other banks from recovering their bad loans themselves. It exclusively focuses on the restructuring and liquidation of unhealthy assets, allowing the “good bank” to concentrate on its main operations like lending.

The idea of a bad bank, or 'Public Asset Rehabilitation Agency' (PARA), was mooted in last year’s Economic Survey. While a bad bank is technically different from an asset reconstruction company (ARC), the two are, for the purpose of this undertaking, interchangeable in the eyes of the Indian government.

The Finance Ministry wants to create a separate company to absorb a significant portion of the bad loans from India’s state-owned banks. This will enable these banks to reduce their risk and raise capital. However, the move will come at a significant cost to the Indian government as it will have to capitalise the bad bank.