Union Budget 2021 | FM Sitharaman announces 'bad bank’ to clean up banks’ balance sheets

Finance minister Nirmala Sitharaman on February 1 announced plans to set up a new asset reconstruction company (ARC) and asset management company (AMC) as part of a strategy to clean up banks’ balance sheets.

Announcing its version of the bad bank, the government will set up an Asset Reconstruction and Management Company to take over bad loans.

A bad bank will act as an aggregator of all stressed assets in the system. It is set up to buy the bad loans and other illiquid holdings of another financial institution. Once toxic assets are transferred to this entity, attempts for an early resolution by experts begins while originating banks can focus on their business.

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Banks can transfer non-performing assets (NPAs), or loans that have turned bad, to a bad bank at a discount. The price discovery can happen at a later stage.

In 2018, the government announced a plan for public sector banks (PSBs) called 'Project Sashakt', which had a five-point plan for bad loan resolution.

The bad bank modelled on this project is guided by the principles of an asset management company (AMC) resolution approach, under which an independent AMC would be set up to focus on asset turnaround, job creation and protection.

The functions of this new company will likely be aligned with the Insolvency and Bankruptcy Code (IBC) process and IBC laws.

The existing stock of bad loans is a big worry for banks. At the end of September last year, the total gross NPAs of the banking system was 7.5 percent of the overall industry loan book.

This is expected to shoot up to 13.5 percent by March-September this year, according to the Reserve Bank of India’s (RBI) projection.

In a worst-case scenario, the bad loans are likely to rise up to 15 percent of the total loans. This will be a big shock to banks as they will require significantly higher capital to cover the impact of bad loans. Moving the existing stock to a separate entity at the earliest could be an escape route.