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Analysis on Bad Bank

Dipen Thakkar 
on 10 March 2017

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Bad bank, when we hear this word the very first thought that comes to our mind is that it would be a bank which has done something wrong either with the country or with its depositors or its share holders. But in actual Bad Bank is an economic concept used by many countries to acquire the illiquid or NPA loans held by Banks and other financial institutions jointly or separately.

Thus an Entity called a Bad Bank is construed which acquire/ Purchase all the bad loans of the banks and NBFCs at Market rate decided mutually by them.

Banks and NBFCs thus off loads their Balance sheets by transferring bad Loans and write off the loss if any due to the same thus it would badly affect the profit & loss account of the banks thus it might have adverse impact on the stock price of the banks in short term but it will have positive impact on the balance sheet hence same will be rewarding in long term to the shareholders.

Using Bad Bank as a remedy for financial or banking crises is not new one. Mellon Bank, was the first Bank who used this concept in 1988 to address the own Commercial Real Estate Portfolio crises.

Bad Bank Concept has been used by many countries in the time of financial crises in past and it had been of great success for them, to quote some of that instances from Past, Bad bank concept was suggested as part of the Emergency Economic Stabilization Act of 2008 address the subprime mortgage crisis in the US. In the Republic of Ireland, a bad bank, the National Asset Management Agency was established in 2009 in response to the country. Bad Banking idea has also been applied by Germany, France & Sweden during their own financial or banking crises.

Bad Bank can also be a Self dividing concept for individual Bank which in turn will focus on 3 things mainly, First to cure the Balance sheet of the Bank second to boost confidence of investors and depositors and third to assign the clear responsibilities to the management in respect of both Good Bank (Existing Entity) & Bad Bank. Models that are generally used by the Governments and Financial institutions are , Internal restructuring i.e. Transferring Bad Loans to another separate unit of the Bank, Special Purpose Vehicle (SPV) i.e. To create whole new entity this might be backed by government and or other financial institutions jointly which is used by all the partner institutions to off load their balance sheets, Spin off of new Bad Bank Company in form of subsidiary or Joint Venture, On Balance sheet guarantee can also be obtained either from government or some other institutions against the loss of the loan. Selection of one of this models depend on how the bank or institution wants to address the bad loan issue either by keeping it on its own balance sheet or by off loading the same. Moreover before implementing any of the above models certain things like Costing, Capital issues, Regulatory norms compliances and accounting and taxation problems to be checked thoroughly. Government Support is one of the main key factor required for the success of the said Bad Bank idea.

Models that are generally used by the Governments and Financial institutions are , Internal restructuring i.e. Transferring Bad Loans to another separate unit of the Bank, Special Purpose Vehicle (SPV) i.e. To create whole new entity this might be backed by government and or other financial institutions jointly which is used by all the partner institutions to off load their balance sheets, Spin off of new Bad Bank Company in form of subsidiary or Joint Venture, On Balance sheet guarantee can also be obtained either from government or some other institutions against the loss of the loan. Selection of one of this models depend on how the bank or institution wants to address the bad loan issue either by keeping it on its own balance sheet or by off loading the same. Moreover before implementing any of the above models certain things like Costing, Capital issues, Regulatory norms compliances and accounting and taxation problems to be checked thoroughly. Government Support is one of the main key factor required for the success of the said Bad Bank idea.

Benefits of implementation of Bad Bank Concept:

In addition to curing of the Banks' /Holding Financial Companies' Balance sheets against the worsening Loan Portfolios Bad Bank concept if implemented can be beneficial in following ways,

> Specially Skilled Management will look after Bad Portfolio where as Top Management of existing organization can focus on Good Bank's Core Businesses

> Specially Focused and Efficient Management with clear vision for betterment of the Portfolio of toxic assets can maximize the Value of those toxic assets.

> It can also help in addressing the Financial Crises in the Economy.

> Regain the Trust of the investors by giving better results in core business in the future.

Negative Impact from implementation of Bad Bank Concept:

It is said that nothing comes a free. Thus all the above mentioned benefits comes with one or combination of more than one of the following price tags.

There are chances that banks and NBFCs may start taking undue risks while lending with the perception that if anything goes wrong Bad Bank will save us i.e. Bad Bank might be a kind of Insurance against the toxic assets for them.

Some people also see the Bad Bank concept as a subsidy against the Corporate Bankruptcy.

Creditors and bond holders of the company will not give company a chance to wake up in the time of slow down before proceeding for bankruptcy which will results in selling of the company to Bad Bank.

Another and Biggest problem in the Bad Bank is the Price at which Banks and Financial institutions will transfer the Bad loans to the Bad Banks.

Bad Bank Journey:

Bad Bank journey starts with the Establishment of a separate organization (we are here talking about the SPV model specifically)

Then after All the banks transfer their toxic assets at the mutually agreed price to the Bad banks thus all the loans in the balance sheets of the transferring or selling company is either converted in the investment in the Bad Bank or is converted in to cash depending on their mutual agreement.

Then after with the specially skilled work force Bank starts resolving accounts one by one with every possible strategy. If this is not done in a quick manner it may increase the requirement of the Capital for the bank which can also lead to failure of the Project organization called Bad Bank.

Thus at the end of the journey of the Bank which typically last for around 5-7 years which is reasonable time period of any Banking or financial crises Bad Bank which was owning all the Toxic assets of the economy becomes the Bank with assets.

Major reasons due to which any government would apply the said concept are, Stability of Economy, Improving liquidity, Restore Investor confidence, and to strengthen the Industries against the crises.

Bad Bank in the context of India:

As we all know due to increasing burden of toxic assets (around 11.5% of the loan portfolio of the country) in the banking industry RBI has started Balance Sheet "Swachchata Abhiyan" which has affected the PSBs to larger extent.

In India First question that comes with the Bad Bank concept is who will establish or start it?

Because Private company if will start the same then it will be more or less like ARC which will be having limited capability and will not be able to clean the toxic assets of the Economy.

If Bad Bank is being established by the Government then Government will be purchasing the Bad assets from the banks and then recovery, whatever happens from the same, will accrue to the government and rest unresolved accounts if waived by the government will be similar to the Loan waiver schemes of the government.

Prospective model and working of the Bad Bank in the Context of the India can be as follows;

Establishment & Structuring:

Same is NAMA of Ireland Indian can form special Entity which can be set up with the special Act dictating the establishment structuring and working of the same.

Indian Government in partnership with Institutional Investors like insurance companies and Mutual Funds can form a special entity called Asset Management Company of India (AMCI).

Structure of the AMCI shall be such that approx. 49% of the share of the same shall be kept open for the investors and remaining shall be held by Indian Government to control the working and other managerial decisions in the Organization.

Capital Contribution made by the investors and Government will be used by the AMCI for purchase of Loan Books from Various Banks and Financials organizations.

Organization will be for Profit organization so that investors and government can get sufficient return over their investment in the same.

Joint Venture with the Private Investors and Government will fetch best talent of the country for the special Project of the Country.

Working & Returns:

AMCI as defined above will work as mentioned in the article above for the cleaning the balance sheets of the Banks and other financial institutions.

In most cases Loan books of the financial organizations will be purchased at reasonable discounted value to the book value so that even AMCI can benefit from the same and can give return to investors in appropriate and best possible manner.

Financial organizations from whom the loans are being purchased will be given in return Government bonds. Hence after some time Financial organizations can sell the Bonds in the open market and can also make profit for the same.

In case of secured debts AMCI will carry on the revaluation of the securities offered and will accept the same at considering the same at reasonable LTV( Loan to Value) ratio. Moreover AMCI and government shall also take some steps so that moral hazard situation does not occur in the economy for the same some of the below mentioned measures can be applied like, penalize the institute for bad crediting by acquiring loans at reasonable discounts, impose some restrictions on the institutions with high bad loans etc. moreover to punish the borrower whose loan is sold to the AMCI mechanism shall be set like the said borrower cannot get further funding from any financial institutions of the country unless he is given No Due certificate from the AMCI.

AMCI will earn interest from the loan purchased by him along with some interest which will be the major source of income for it. AMCI will pay the annual dividend to the investors from the same. Moreover Banks and institutions from whom the loans are bought will be paid interest on the bonds if the same has not been sold by them. AMCI can also earn income from sell of securities offered against the loans for the speedy administration of the same separate sets of rules might be required.

The private investors in the AMCI would be entitled to the following economic returns: the equity investors will receive an annual dividend linked to the performance of the AMCI; On winding up of the AMCI, the equity investors including government will get their proportionate share of return along with their original equity investment. Annual dividend of the AMCI can be capped at some bps (Basis Points = 100th point of 1 percent) above the benchmark yield of the Government Bond considering the risk of investment taken by the investors.

Whether AMCI will purchase the Bad Loans only from PSUs or from both the private and public sector units is a question yet. Moreover till how much time AMCI will be accepting the applications for purchase of bad loans is also a question. All this practical questions will be answered once the AMCI become operational.

Valuation of Bad Asset:

Same as other assets bad asset can also be valued using the DCF model in which all the probable cash flows that can be generated from the particular asset will be discounted using the appropriate rate of discount.

Now to decide the appropriate rate of discount and probability of receipt of the cash flow we can get the company rated based on the management of the company, depth of its pockets, level of stress in the company's assets and many other related things which are affecting the company from making it due clear on timely basis.

The ratings will be given by Two rating agency to avoid any kind of mistake and confusion on their part and based on that government/RBI will fixed up the model which will give the company a final rating which will be used by the Bad Bank to decide the Rate of discount that can be used by it to discount the cash flow it work on the concept of, Higher the rating Lower the Discounting rate.

Thus Above mentioned concept will take care of both the things, Probability of receipt of the cash flow as well as risk underlying the asset and as the same will be universal method of discounting it will be accepted both by the Banks as well as by Bad Bank or PAMC.

One more thing that government or RBI must ensure that while deciding the discounting rate it must make sure that bad bank also get some return out of it to make the concept of the BAD Bank Viable.

Winding Up:

After the project or mission for which the AMCI has been formed is achieved it shall be wind up by paying the investors their money back along with the profit if any.

Ending Part:

Why the bad bank is required to be established in India? Because India's banking industry is facing very much difficulties from the toxic assets in their balance sheets more over public sector banks where government's and public's money is invested majorly are most affected due to the same and they are not having much specialization to fight against the toxic asset, moreover there is also a lack of ARCs with such a huge potential and ability along with the huge capital investment which can fight against the rising toxic assets of banking industries hence to overcome the same and give Indian banking industry a new fresh start establishment of Bad Bank is recommended.

All the above mentioned data and facts are based on the various information available in the news and internet. Moreover the name and structuring along with the working pattern for the Bad Bank of India is proposed one and is not having any governmental backing.


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