Bad Bank: What is in it for depositors?

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The Union Cabinet finally approved the creation of NARCL – which essentially is a bad bank. Many may be wondering about what the bad bank is, especially depositors who have their money in bank deposits. More so because Indian households largely have their movable assets in the form of financial savings or gold – although equity is also catching up fast.

Some Background

To understand what the NARCL or the Bad Bank is requires us to better understand the chronology of events that have necessitated the creation of such an institution. India’s economy started to accelerate from 2003 onwards – aided by slew of reforms and a lower level of interest rates. However, the 2008 crisis had a severe impact on the economic growth prospects – more so globally than in India. Between 2003 and 2008, global growth was robust, and this obviously had a positive impact on India. Since then, global growth was largely muted, more so from early 2010s onwards after the Euro zone crisis.

Because of robust growth, many companies overinvested in capacities in the run up to 2008, and further easing of lending combined with weaker prudential regulations resulted in credit being extended even to unviable projects. Some loans that were granted were given only because of political capital of promoters rather than their ability to repay the loans. When growth faltered, defaults happened creating stress in the banking system. However, typically, most banks in India simply never recognized them as Non-Performing Assets and therefore, the loans kept on piling on with the expectation of money being repaid eventually, even if it meant restructuring or booking a loss on the balance-sheet of the bank.

At this point, for depositors, it is also important to understand how the system works. Popular belief is that banks lend out depositors’ money. This essentially implies that if a bank has Rs 100 of deposits, it gives out a Rs 100 of loans. This is not true as banks essentially create credit through their deposits, and thus, they tend to lend out more money than their deposits. Therefore, even if banks take a loss on a few of these loans, the depositors money remain safe, but it is the shareholder of the bank who has to pay for the losses.

In 2013, when Raghuram Rajan became the RBI governor, he sought to attempt to fix the system – and with the new government in 2014, the process of cleaning up was initiated. The objective was to recover the money lent out by banks and bring about a systemic change by imposing a cost on those who default. The Insolvency and Bankruptcy Code was introduced – which did improve recoveries and resulted in many big promoters losing their companies. However, the sheer quantum of bad loans stuck in the system overwhelmed the functioning of the IBC. This is why in 2016 the idea of making a bad-bank was being discussed – and finally in 2021 a similar entity has been created.

What is a bad bank and how does it work?

So, a bad bank essentially is a new company which is an asset reconstruction company. Asset reconstruction companies essentially purchase assets at a discount and then try to make a profit by selling them for a higher amount of money. Think of it as a typical reseller of cars who would purchase an old car, modify it and make it new with some new parts etc with the hope of selling it for a higher price later. So the way this will work is that the banks will identify their NPAs of up to Rs 2 lakh crores and sell them to the bad bank, which will then attempt to recover the value from these assets either through liquidation, or restructuring or mergers etc. Therefore, banks will receive some money for these assets upfront while the bad bank will continue to recover money from these assets in the hope of making some profits. Since 51% of the bad bank will be owned by PSBs, they too will benefit from the profits made by the bad bank. This will also ensure that one institutional ARC is focused towards restructuring of debt while others can

So why now?

One of the reasons why it makes sense to introduce the bad bank now is because of the experience of the last few years whereby banks have been too focused on dealing with recoveries rather than them working on lending. This has had implications for growth and there are also concerns of further stress on the banking system post the pandemic. Therefore, an institutional mechanism to deal with corporate sector stress will systematically strengthen the overall financial system and prevent for such a piling on of NPAs in future.

What does it mean for my deposits – & for the economy?

The implications of bad bank are more for banks and their shareholders rather than depositors – although a systemically healthy bank is in the interest of depositors. But, in the context of India, its institutions have always managed to preserve the interests of Indian shareholders over the last few decades. For the shareholders, they can expect a lot of stuck capital of the banks getting unlocked as they get an upfront payment post transfer of NPAs. This will also result in better focus on lending which will ad to overall growth of the bank and their balance sheets. As far as depositors are concerned, the biggest implication now will be that banks will have more bandwidth to deal with their credit requirements – be it for a new home or for a new car.

On a lighter note, in an earlier post I had suggested that this is the best time to purchase residential real estate – so maybe now would be a good time to speak to your relationship manager regarding the same.