The creation of designated financial institutions to purchase and resolve nonperforming loans (NPLs) from banks is referred to as the “bad bank” model of troubled asset resolution. It has been viewed by policy makers as a viable method to resolve distressed banking assets (e.g., Geithner, 2009). Such a model has been used to resolve financial crises since the 1980s in China, France, Germany, Spain, Sweden, and the United States. Most recently, in February 2021, the Indian government proposed a bad bank structure in its Budget 2021.1
However, despite the buy-in of various policy makers, systematic study of the efficiency of the bad bank model has been scarce due to the lack of transaction-level data. In a recent research study, we use China as a setting to analyze the empirical performance of bad banks in resolving NPLs.
Binding Financial Regulation, Opaque Transactions, and Distorted Incentives
Starting in 2012, the Chinese government has allowed local asset management companies (AMCs) as designated financial institutions to acquire NPLs from banks, explicitly stating that local AMCs should conduct transactions “in accordance with the principle of market economy.”
The Chinese Banking and Insurance Regulatory Commission enforces regulatory minimums on the loan loss allowances relative to NPLs and the loan loss allowances relative to total loans; both requirements appear binding in the data as banks cluster just above their respective thresholds. Selling NPLs to AMCs allows banks to remove NPLs and generates more slack in satisfying the regulatory ratios.
As distressed debt resolution specialists, local AMCs are tasked with assuming the credit risks of the NPLs from banks and resolving NPLs outside the banking sector. We analyze detailed transaction-level data from a leading local AMC and document five revealing facts:
Collectively, these results are more consistent with NPL transactions concealing rather than resolving troubled bank assets. Three parties are involved in the concealment process: (1) banks, which want to remove NPLs from their balance sheets to comply with the quantity-based loan quality regulation; (2) AMCs, which are compensated for acting as pass-through entities; and (3) third-party bank affiliates, which are the ultimate owners of the NPLs and borrowers of the bank.
Source : blogs.worldbank.org