Letters: Managing a bad bank

With reference to the report, "Govt considers 'bad bank' proposal despite doubts" (February 20), the idea is worth a try. A "bad bank" will basically buy the bad loans of a bank with significant non-performing assets (NPA) at the market price. By transferring bad assets of an institution to a "bad bank", banks will try to clear their balance sheets of toxic assets but will have to take write-downs. Shareholders and bond-holders, but not depositors, would likely lose money from such a move.

The history of banking worldwide contains several instances of bad banks. One oft-cited example is Grant Street National Bank, which was set up in 1988 to house the bad assets of The Bank of New York Mellon. The US sub-prime mortgage collapse of 2008 revived interest in bad banks as a solution, as managers at some of the largest banking institutions considered segregating their NPAs into bad banks.

In 2009, a report by McKinsey & Company identified four basic models for bad banks: 1) In an on-balance-sheet guarantee, the bank uses some mechanism (typically a government guarantee) to protect part of its portfolio against losses. While simple to implement, this situation is difficult for investors to assess; 2) In an internal restructuring, the bank creates a separate unit to hold the bad assets. This solution is more transparent, but doesn't isolate the bank from risk; 3) In a Special Purpose Entity, the bank transfers its bad assets to another organisation, typically one backed by the government. Such a solution requires substantial government participation.

The Reserve Bank of India (RBI) and the finance ministry have to pick the model that best suits their needs.

Several experts are of the view that the first year of a bad bank determines its success. The challenge is how to deal with a large number of non-performing loans in a variety of sectors in different geographical locations and several types of industries. If the bad bank does not quickly get a grip on the loans, a lot of value would be lost and the capital requirements of the bad bank would change drastically.

A well-defined process on how different loans should be handled has to be established. This process has to be followed and managed well, else the bad bank will find itself in chaos. Let us hope the RBI takes a quick decision on this issue.

J S Broca New Delhi

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