What is a Bad Bank?
A Bad Bank is a specialized financial entity created to take over and manage the troubled or non-performing assets (NPAs) of a financial institution. It can be established as a separate entity or structured within the existing bank by segregating toxic assets. The primary aim is to isolate bad loans from the balance sheet of the parent institution, enabling the latter to focus on core operations. A Bad Bank assumes responsibility for the resolution, restructuring, and recovery of problematic assets over a fixed period. It does not accept deposits or lend money but solely serves to rehabilitate financial institutions burdened by bad debts.
Contrary to popular belief, a Bad Bank cannot be established at the whim of a bank's board of directors. It is not a magic solution for poor decision-making or corrupt practices within financial institutions. Rather, it is a targeted mechanism that becomes necessary when NPA levels become unmanageable or systemic risk arises-such as during a financial crisis or when multiple banks collectively decide to offload their toxic assets.
In developed economies, the establishment of a Bad Bank or Asset Management Company (AMC) typically requires regulatory approval, although not necessarily from the central bank. In contrast, countries like Nepal and India require explicit approval from the central bank, along with adherence to capital and structural requirements.
The first Bad Bank, Grant Street National Bank, was formed in 1988 as a subsidiary of Mellon Bank without requiring Federal Reserve approval. It pioneered a model of internal restructuring that helped Mellon Bank recover credibility and attract investors. While such autonomy was possible then, today's systemic risks-ranging from crypto currency volatility to custodial fraud-may require more oversight.
Alternative Approaches to Bad Loans
Not all countries adopt the classic Bad Bank model. Approaches to handling NPAs vary, ranging from direct government intervention to public-private partnerships or customized debt restructuring schemes. The choice depends on the nature of the economy, structure of the banking system, and specific policy objectives.
The success of loan restructuring also hinges on whether the loans are secured or unsecured. In many developed economies, creditworthiness-not collateral-determines loan issuance. Thus, effective management of a Bad Bank requires expertise and innovative recovery tools. It is crucial to identify the real causes behind the rise in bad loans before designing resolution strategies.
AMCs use a range of tools: they can reduce interest rates, extend repayment periods, convert debt to equity, advise on operational improvements, or bundle and sell NPLs to investors. A longer repayment window or further rate reductions can ease the financial burden on debtors, but these measures must be implemented transparently and strategically.
Funding the Bad Bank
Bad Banks can be funded through various means-capital from the central bank, equity investment by the parent bank, bond issuance, or private/institutional investors. Some models blend public and private capital or draw support from a consortium of banks. However, a crucial point remains: every Bad Bank must be uniquely tailored to its domestic context. Copy-pasting a successful foreign model to a country like Nepal is risky and often counterproductive.
Many in Nepal tend to reference international success stories to justify policy decisions that eventually advantage a handful of crooked individuals. This tendency must be challenged if Nepal truly wishes to reform its banking sector.
Lessons from History
Frank Cahouet, the banking visionary behind Mellon Bank's recovery, was instrumental in establishing the first successful Bad Bank. The entity lasted seven years, cleared Mellon Bank's NPAs, and reintegrated staff into the parent company. Interestingly, Cahouet did not use the Bad Bank model when assisting Crocker National Bank in California, despite similar problems-highlighting that context matters.
Following Mellon Bank's success, countries like Sweden (Securum), Ireland (NAMA), Japan, South Korea, and China replicated or adapted the model. While it proved effective in parts of East Asia and Europe, the model fared poorly in the Middle East, Africa, and Latin America – often due to weak governance, informal economies and fiscal constraints.
The Nepali Context
Nepal's banking sector has evolved significantly since the establishment of Nepal Bank in 1937. It came into existence about twenty years earlier to the Central Bank. The post-1990 liberalization era saw an explosion in banking and financial institutions, bringing with it rapid economic growth and modernization. However, this growth masked deep-rooted structural flaws.
By 2012, Nepal had 32 commercial banks, 88 development banks, and 77 finance companies-an unsustainable number for an economy with a GDP of less than $20 billion at that time. Today, these numbers have been reduced, but the damage persists. The proliferation created fertile ground for corruption, mismanagement, and regulatory failure.
Many individuals with strong political and bureaucratic ties entered the banking sector and engaged in practices that undermined ethics, legality, and financial prudence. Some were borrowers, promoters, and even regulators-blurring lines of responsibility and integrity. Rampant collusion, inflated collateral values, hidden charges, and loan misrepresentation became widespread.
Despite efforts like Basel III implementation and increased capital requirements, the root issues-NPLs, non-banking assets, and predatory lending-remain unaddressed. There are allegations that Nepal's actual NPL rate is far above the official 4–6%. At the same time, the country's credit to GDP ratio remain elevated, hovering between 95-105%, raising concerns about the quality and sustainability of credit growth.
Practices such as Evergreening of Loans – particularly to large borrowers, parking impaired assets in subsidiaries, exchanging bad debts among institutions, inflated collateral valuations and declaring dividends and bonuses based on accrued (but unrealized) profits are some of the methods BFIs use to temporarily mask financial distress and mislead the public.
The Risks of a Bad Bank in Nepal
The possibility of a Bad Bank-or AMC-with an estimated NPR 10 billion in capital, jointly funded by the government and financial institutions, is seen by many with skepticism. While the policy intention is sound, the timing, transparency, and execution mechanisms are questionable.
Insiders know Nepal's financial health is poor. Economic stimulation is largely remittance driven. Window dressed balance sheets are masking deeper issues. And land sales which once bailed out bad loans are no longer viable in a saturated real estate market.
In this context, there are serious concerns that a Bad Bank in Nepal could become:
- A haven for fraudsters and defaulters to offload NPLs without consequences
- A mechanism manipulated by political and business elites for personal gain
- A dumping ground for politically-connected toxic loans
- A channel for legitimizing illicit or laundered assets
- A tool for insider trading through undervaluation or overvaluation of assets
- A hotbed of cronyism in key appointments
- A magnet for regulatory capture by vested interests
Given that Nepal is already on the FATF Grey List for anti-money laundering deficiencies, a poorly designed Bad Bank could further erode credibility and push the country into the Black List. The IMF is already demanding external audits in some banks, and failure to meet these benchmarks could reduce access to concessional funding, aid, and donor confidence.
What Should Be Done Instead?
Nepal needs bold, credible, and transparent reforms-not cosmetic solutions. A more effective approach would involve:
- Creating an autonomous, politically insulated agency to determine the actual volume and nature of NPLs
- Making NPL lists, borrowers, and collateral public to ensure transparency and public oversight
- Establishing a legal framework with fast track courts and fixed term operations
- Hiring qualified and honest professionals, not political appointees or retired bureaucrats
- Requiring forensic audits and independent assessments
- Allowing failing banks to collapse, while protecting small depositors
- Punishing defaulters and preventing moral hazard by denying bailouts to reckless BFIs
- Severing the nexus between borrowers, bankers, and regulators
BFIs in Nepal must open itself to impartial and honest external auditing with or without IMF pressure. Time is running out. Mergers have only postponed the inevitable. If deep reforms aren't undertaken soon, the banking sector may experience a full-blown crisis far worse than the cooperative fraud scandals that have already scarred the country.
Conclusion
A Bad Bank is not inherently bad-but in a country like Nepal, riddled with institutionalized corruption, politicization, and regulatory weaknesses; it could do more harm than good. The idea, while noble on paper, risks becoming another elite project that burdens the masses. Reform must begin at the root, with transparency, accountability, and the political will to punish financial wrongdoing-not with another state-sponsored mechanism that may aggravate it.
