What is Asset Reconstruction Company or Bad Bank that was proposed in the Union Budget 2021?

The Weekly Insights | Issue 8

What’s the Deal?

To clean up non-performing assets (NPAs) in the banking sector, on 1st February, Finance Minister Nirmala Sitharaman, proposed setting up of an Asset Reconstruction Company (ARC) (Bad Bank) and Asset Management Company (AMC).

ARC is also called Bad Bank as it houses Bad Loans or NPAs

NPAs, which may see a surge once regulatory forbearance to deal with the impact of Covid-19 is withdrawn, will be dealt by these new entities.

Trajectory of NPAs

As observed in the above table NPAs were on a downward trajectory since Mar-18 but are now expected to almost double to 14.8% in a worst-case scenario by Sept-21 from 7.5% in Sept-20 due to Covid-19 setbacks.

Banks fear capital erosion as NPAs are expected to see a steep surge. Banks might also see a deterioration in their capital adequacy ratio.

Here comes in Asset Reconstruction Company Limited and Asset Management Company…

“An Asset Reconstruction Company Limited and Asset Management Company would be set up to consolidate and take over existing stressed debt and then manage and dispose off to Alternate Investment Funds and other potential investors for eventual value realization,” Said Finance Minister.

How will it Benefit the Banks and ARC both?

ARC will absorb all the bad assets of the banks at a lower price than the book value of these loans and manage them in an attempt to finally recover the money over a period of time.

Here, banks make at least some money which otherwise would have been considered as bad debts and ARCs will make a cut i.e., the difference between the asset absorption price and final selling price of the asset.

Who will set up ARC?

It will be set up by private sector and state-owned banks and there will be no equity contribution from the government. Under ARC there will be an Asset Management Company that will manage and sell bad assets.

ARC will first look to resolve stressed assets of INR 2–2.5 lakh crore of 70 large accounts.

Closing Note…

Those in favour of bad banks argue that it will allow banks to focus on their core activity of lending and leave resolution to the experts. It will also help clean the balance sheet of the banks and make them financially healthy. Those against the idea of bad banks, like the former RBI governor Raghuram Rajan, argue that it will enable banks to continue with their reckless behaviour and create a moral hazard.

What’s the Deal?

ARC is also called Bad Bank as it houses Bad Loans or NPAs

NPAs, which may see a surge once regulatory forbearance to deal with the impact of Covid-19 is withdrawn, will be dealt by these new entities.

Trajectory of NPAs

Gross NPA ratios of SCBs

Mar-17

9.30%

Mar-18

11.50%

Mar-19

9.10%

Mar-20

8.20%

Sep-20

7.50%

Sept-21 Projected

14.1%-14.8%

As observed in the above table NPAs were on a downward trajectory since Mar-18 but are now expected to almost double to 14.8% in a worst-case scenario by Sept-21 from 7.5% in Sept-20 due to Covid-19 setbacks.

Banks fear capital erosion as NPAs are expected to see a steep surge. Banks might also see a deterioration in their capital adequacy ratio.

Here comes in Asset Reconstruction Company Limited and Asset Management Company…

“An Asset Reconstruction Company Limited and Asset Management Company would be set up to consolidate and take over existing stressed debt and then manage and dispose off to Alternate Investment Funds and other potential investors for eventual value realization,” Said Finance Minister.

How will it Benefit the Banks and ARC both?

ARC will absorb all the bad assets of the banks at a lower price than the book value of these loans and manage them in an attempt to finally recover the money over a period of time.

Here, banks make at least some money which otherwise would have been considered as bad debts and ARCs will make a cut i.e., the difference between the asset absorption price and final selling price of the asset.

Who will set up ARC?

It will be set up by private sector and state-owned banks and there will be no equity contribution from the government. Under ARC there will be an Asset Management Company that will manage and sell bad assets.

ARC will first look to resolve stressed assets of INR 2–2.5 lakh crore of 70 large accounts.

Closing Note…

Those in favour of bad banks argue that it will allow banks to focus on its core activity of lending and leave resolution to the experts. It will also help clean the balance sheet of the banks and make them financially healthy. Those against the idea of bad banks, like the former RBI governor Raghuram Rajan, argue that it will enable banks to continue with their reckless behaviour and create a moral hazard.

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