In today's newsletter, we provide an explainer on bad banks and....

Yeah, that's about it.

The Story

India has had a problem with bad loans for a while now. People borrow and they don’t pay back. And it’s crippling banking institutions in this country.

But if rumours are to be believed, preliminary discussions are already underway to solve the crisis by resorting to a radical solution that’s quickly gaining traction — Bad Banks

But before we get to bad banks, a note on bad loans.

For starters, bad loans aren’t just bad. They’re pure toxic. And once unpaid loans start piling up, the whole bank starts looking suspect. New investors won’t want to pour money into these institutions anymore. Other more robust banks won’t want to lend to them anymore.

And even when they manage to borrow money from outside investors they’ll have to do it at such exorbitant interest rates that it’ll most likely suck them dry (financially).

Obviously, this also means, the losses will mount and they won’t be able to extend new loans like they used to. And this, in turn, will hurt other businesses who are looking to borrow from these people at reasonable interest rates. It will be a travesty.

So what do you do?

Well, one thing you can do is move all the toxic loans someplace else. That way, the bank will be left with the pristine stuff — the good loans (loans that are likely to be repaid in full) and they can focus on getting their act together instead of worrying about the problem loans.

Also, when outside investors look at the bank the next time around, they will see that there’s a real money-making opportunity here. No Toxic Stuff!!!

Maybe they will also infuse some cash and buy a small stake (ownership) in the bank. And as the bank receives more money, they can shore up their reserves and they won’t have to be afraid about extending new loans —  since they can always fall back on the reserves if some of these loans don’t get paid.

It’s a great plan.

So let’s start moving the bad stuff elsewhere.

But where?

…..

Also, how does this actually solve the problem considering the banks just shifted the burden elsewhere?

I mean, are we talking about selling the bad loans to someone else?

Well, yes, but with a few caveats.

Okay, here’s the thing. These bad loans are definitely toxic. There’s no doubt about it. But that doesn’t mean they aren’t worth anything. In fact, some of them are worth a fair sum.

Consider for instance the banking industry’s tryst with the power industry

A few years ago, banks loaned a ton of money to the power industry in India. Unfortunately, most of these companies could never turn a profit and they defaulted on their repayment obligations. This meant banks had to contend with boatloads of unpaid loans and they had no idea what to do. The only thing they could do was sell the collateral backing the loan i.e. the power stations.

Unfortunately, selling this stuff isn’t easy, especially considering it’s not something banks do on a daily basis. But there are institutions that will buy it off of you for a discount if they think they could spin it off and sell it to another investor and make some money in the process.

These companies called — Asset Reconstruction Companies (ARC) quickly gained prominence. Unfortunately, they wanted this stuff at such steep discounts that bankers balked at their price quotes.

And so, if you can’t sell it to ARCs, who do you sell it to?

Well, you sell it to a bad bank. And unlike private companies that are looking to buy these assets at throwaway prices, the bad bank will likely be owned by a group that includes the government, private investors, and the banks themselves. And this distinction is very important.

Because unlike stand-alone private institutions, the Government of India isn’t necessarily looking to turn a profit here. Instead, it’s looking to clean up the banking system and fix this problem once and for all.

And banks won’t have much to complain either since they will also share a part of the spoils if the toxic assets are sold at a higher valuation sometime in the future.

But here’s the thing. Recovering unpaid loans and selling distressed assets (like that power station) is still an extremely tedious affair. And simply moving it to a “bad bank” won’t solve the country’s problems.

Also, the bad bank structure we presented earlier is just one alternative. You could have a bad bank with just the government onboard or a combination of public and private entities. So figuring out the logistical challenges and setting up an efficient bad bank is no easy feat either.

Meaning when all is said and done, these bad banks will probably give us some breathing room. But if you are expecting it to fundamentally alter the course of the country’s banking industry. Yeah…

DON’T!!!

Until next time…

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With inputs from Naman Jain