Bad bank conveys the impression that it will function as a Bank but has bad assets to start with. Technically, a Bad Bank is an asset reconstruction company (ARC) or an asset management company that takes over the bad loans of commercial Banks, manages them, and finally recovers the money over a period of time. The Bad bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans.
The takeover of bad loans is normally below the book value of the loan and the Bad bank tries to recover as much as possible subsequently. Banks drive the nation's economy; however many times the borrowers find it difficult to service their loans. It requires the lenders to set aside the capital to cover the losses. When the Bad bank comes into the picture to help them free up to start lending.
Significance of Bad Bank
Bad Bank will seek to provide financial stability in the banking sector. It will hold problem loans for public sector banks which can then be sold on to investors at a reduced price.
The Bad Bank does not involve itself in lending and taking deposits, but it helps to make commercial banks clear their balance sheets and resolve bad loans.
The process of taking over bad loans is generally below the book value of the loan
Bad Bank tries to recover as much as possible from those bad loans
Mellon Bank based in the USA was the first one in this field. It is referred to as the first Bad Bank in 1988.
A Bad Bank aids a bank to segregate its good assets from the bad ones which make it easier to raise capital through equity or debt.
Toxic assets separation helps in generating some confidence among potential investors so that they can then clearly examine the financial health of the lender.
Sour loans when transferred to a Bad Bank can help lenders prioritize their financing business and the specialized institution deals with maximizing loan recovery.
Requirement of Bad Bank
The high level of provisioning by public sector banks of their stressed assets calls for measures to clean up the bank books. An Asset Reconstruction Company Limited and Asset Management Company would be set up to consolidate and take over the existing stressed debt and then manage and dispose of the assets to Alternate Investment Funds and other potential investors for eventual value realization.
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