How a Bad Bank Can Reduce NPAs? Learn its Meaning, Working, and Need

Loan defaults have been a long-standing issue for banks, where borrowers fail to repay their loans. Despite banks tightening their checks on borrowers' creditworthiness, the problem of NPAs (non-performing assets) continues to rise. For the unaware, NPAs refer to loans that are either overdue or at risk of never being repaid. This has created financial stress in the banking sector.
 

To solve this problem, the Indian government established a "bad bank” in October 2021. A bad bank takes over these NPAs and allows regular banks to focus on their core operations. Also, by transferring bad loans, banks can clean up their balance sheets and focus on fresh lending.
 

In this article, let’s understand how a bad bank works and how successful it has been since its launch in 2021. Also, we will see why India Inc. really needs a bad bank.

• Non-performing assets (NPAs) occur when borrowers fail to repay loans.
  

• In October 2021, the government created a bad bank that can purchase these NPAs from banks.

• This bad bank is known as The National Asset Reconstruction Ltd. (NARC) and sells the acquired NPAs to asset reconstruction companies (ARCs).

• The establishment of NARC has increased competition among private ARCs. As a result, banks are not getting better pricing when selling NPAs.

Banks earn money from the interest on loans, which are considered assets. However, when a borrower can not repay, that loan becomes a non-performing asset (NPA), which means it no longer earns money for the bank. Banks in India have several such loan accounts where borrowers have turned defaulters. They are simply unable to repay these loans after their term ends. With millions of borrowers and multiple banks across India, the number of NPAs has increased significantly.
 

In 2021, government banks in India had NPAs worth around Rs. 6.17 lakh crore. To maintain the stability of banks, governments even injected fresh capital into banks. However, this effort has not solved the problem because defaults and scams continue to rise.
 

This created the need for a bad bank that can make recoveries and clean up these bad loans. By setting up a bad bank, the government aims to:
 

• Reduce the burden on banks

• Let banks focus on new lending

• Avoid the growing amount of unpaid loans

Please note that a "bad bank" is an institution that takes over bad loans, or NPAs, from regular banks. In India, this bad bank is called the National Asset Reconstruction Ltd. (NARC), which buys bad loans from banks and frees them from the burden of these NPAs.
 

Once NARC has these bad loans, it tries to sell them to buyers who deal in distressed debt loans from bankrupt companies or those close to bankruptcy. This allows banks to focus on fresh business rather than managing bad loans. Additionally, the government has set up another company, India Debt Resolution Company Ltd (IDRCL). This entity sells these bad loans in the market.
 

Now, it is worth mentioning that when a bad loan is successfully sold, the bank that originally held it will receive money. If NARC and IDRCL can not sell a bad loan or sell it at a loss, a government guarantee will be used to cover the bank's losses. This guarantee ensures that banks are protected in either situation.

Since its launch in October 2021, NARCL has not met its target of acquiring Rs. 50,000 crore in bad loans. In two years, it has only bought Rs. 21,350 crore worth of debt. One of the reasons for this slow progress is how NARCL acquires bad loans. It pays only 15% of the loan value upfront in cash. The remaining 85% is paid through security receipts (SRs), which are backed by a government guarantee. In simple terms, this implies that NARCL pays far less for bad loans than their actual value.
 

As a result, banks remain hesitant to sell their NPAs to NARCL because they don’t find this method attractive. Moreover, the SRs take a long time to recover their value. Nowadays, with fewer NPAs in the market and improved risk management by banks, they prefer to hold onto their bad loans rather than sell them at such a high discount. Apart from this. NARCL has faced challenges related to fraudulent accounts sold by banks and their frequent leadership changes.
 

However, despite these problems, there’s a silver lining. NARCL’s presence has made the NPA market more competitive. Now, private asset reconstruction companies are changing their pricing and offering better prices to banks for their NPAs. This competition has benefitted banks, as they can sell their bad loans for a higher price.