What is this Bad Bank idea expressed in the budget all about and how would it work?

One of the big ideas finally put forth in the Union Budget document was that of the Bad Bank. It is a much demanded but less understood idea. Senior bankers have been asking for a bad bank for quite some time which will act like a super-ARC to take over bad debts of the banks. Of course, the budget called it an ARC-AMC, which is effectively a bad bank.

This is how a bad bank will actually be structured. A bad bank will be a kind of nodal bank that will take over the stressed assets of the banks in the system and at the same time free up the balance sheets of banks. As of now it is not clear if it will only be PSU banks or will include private banks, but to begin with it could only be PSU banks with most stress.

This will allow the banks to lighten their balance sheets and focus on expanding their loan books. As a result, it will help enhance their ROI as the business becomes lighter in terms of assets. The way it works is that banks sell part of their stressed assets to these bad banks. Mostly, these bad banks are allowed to pick and choose parcels of loans based on their assessment of quality.

Bad bank will purchase the stressed loans from the bank. Subsequently, these bad banks will either hive of these assets to other willing buyers or even issue high risk debt. This will be high risk debt so it will entail higher returns to make it attractive. Now, the loans being stressed will be purchased by the bad bank at a discount to the loan value.

How will the discount be decided? It will be based on the quality of the underlying asset but quite often also on the bargaining power of the bank. Needless to say, the bad bank will try to drive hard bargains by maximizing the haircut on the loan values so as to increase their own ROI. The returns for bad banks depend on how cheap they buy quality loans.

An important point to remember out here is that the bad bank will not pay the entire discounted sum to the bank upfront. The typical model is that bad banks tend to pay out 15-20% of the agreed sum upfront. The balance money will be contingent to a term sheet with the mutually agreed time lines and milestones in the future, so as to factor in IRR too.