When banks lend money, not all borrowers repay on time or at all. Over the years, especially during economic slowdowns, a pile-up of such unpaid loans
begins to choke the banking system. This is where the idea of a "bad bank" enters the conversation. In simple words, a bad bank is a specialised institution created to take over bad loans - also known as non-performing assets (NPAs) - from regular banks. By shifting these stressed assets off their books, banks get breathing space to focus on fresh lending, customer service, and economic recovery. Bad banks usually come into play during periods of financial stress, when the scale of bad loans threatens the stability and reputation of the banking system. While many policymakers see them as a clean-up tool. To address this moral hazard, the Reserve Bank of India (RBI) has made it clear that fraudulent loans cannot be transferred to bad banks, reducing the scope for misuse.
How do bad banks actually work?
Globally and in India, bad banks can be structured in different ways. Broadly, there are four key models as follows:
- On-balance sheet guarantees
- Internal restructuring units
- Special Purpose Entities (SPEs)
- Bad bank spinoff
On-balance sheet guarantees
In this model, banks keep the stressed assets on their books but protect themselves against losses using guarantees. This approach offers limited relief and does not fully isolate risk.
Internal restructuring units
Banks create a separate, ring-fenced division to manage bad assets. While ownership remains the same, operational separation helps bring focus and accountability.
Special Purpose Entities (SPEs)
Here, bad loans are transferred to a distinct legal entity created specifically to hold and resolve stressed assets. This allows sharper recovery strategies.
Bad bank spinoff
This is the most radical model, where an entirely new and independent bank is created to house bad assets. It completely isolates risky loans from the parent bank’s balance sheet.
In India’s case, the emphasis has been on using asset reconstruction companies (ARCs) as bad banks, supported by policy and capital backing.
Need for bad banks?
The core purpose of introducing bad banks is a one-time clean-up of bank balance sheets. Over the years, Indian banks, especially public sector banks have struggled to resolve large corporate NPAs through existing mechanisms.
The urgency became clear when the RBI’s stress tests in January 2021 projected that the gross NPA ratio could rise to 14.8 per cent by September 2021, compared with 7.5 per cent in September 2020. This was even before the full economic impact of the Covid-19 pandemic played out.
Recognising this risk, the Union Budget for FY22 announced measures to strengthen the asset reconstruction framework. Instead of repeatedly selling bad loans in a fragmented manner, banks were encouraged to transfer stressed assets to a centralised ARC structure, allowing more professional and time-bound resolution.
Former RBI Governor Shaktikanta Das also highlighted that bad banks could help unlock capital stuck in unproductive loans, making the overall financial system more efficient.
How the government is backing India’s bad bank
The Union Cabinet -- chaired by Prime Minister Narendra Modi -- approved a Central Government guarantee of Rs 30600 crore to back Security Receipts (SRs) issued by the National Asset Reconstruction Company Limited (NARCL) for acquiring stressed loan assets, according to the Ministry of Finance.
Under this, the SRs issued by NARCL carry a sovereign guarantee from the Government of India for a period of five years. The guarantee can be invoked to bridge any shortfall between the face value of the security receipts and the actual recovery realised through resolution or liquidation of stressed assets.
In return, NARCL is required to pay an annual guarantee fee to the government.
The scale of the clean-up underscores the seriousness of the exercise.
Since its launch, NARCL has acquired 22 large stressed accounts with a total exposure of Rs 95,711 crore as of December 2024. In parallel, 28 stressed accounts resolved with an exposure of Rs 1.28 lakh crore.
What are benefits of bad banks?
The most immediate benefit of a bad bank is restoring normal banking operations. When bad loans pile up, banks become risk-averse, slowing credit to businesses and households. Offloading NPAs allows banks to lend again.
Another major advantage is improving the effectiveness of existing ARCs. Earlier, many ARCs struggled due to continuous inflows of stressed assets without sufficient capital or clarity on resolution timelines. The bad bank framework seeks to address this by:
- Setting clear NPA resolution targets
- Defining the finite lifespan of the bad bank
- Strengthening governance, transparency, and disclosure norms
- Ensuring stronger enforcement of property and insolvency laws
Together, these measures aim to make recovery faster and more credible.
(Disclaimer: The above article is meant for informational purposes only, and should not be considered as any investment advice. ET NOW DIGITAL suggests its readers/audience to consult their financial advisors before making any money related decisions.)
