Bad Bank


A bank set up to buy the bad loans of a bank with significant nonperforming assets at market price. By transferring the bad assets of an institution to the bad bank, the banks clear their balance sheet of toxic assets but would be forced to take write downs. Shareholders and bondholders stand to lose money from this solution (but not depositors). Banks that become insolvent as a result of the process can be recapitalized, nationalized or liquidated.

The bank divides its assets into two categories. Into the bad pile go the illiquid and risky securities that are the bane of the banking system, along with other troubled assets such as nonperforming loans. For good measure, the bank can toss in non-strategic assets from businesses it wants to exit, or assets it simply no longer wants to own as it seeks to lessen risk and deleverage the balance sheet. What are left are the good assets that represent the ongoing business of the core bank.

By segregating the two, the bank keeps the bad assets from contaminating the good. So long as the two are mixed, investors and counterparties are uncertain about the bank’s financial health and performance, impairing its ability to borrow, lend, trade, and raise capital. The bad-bank concept has been used with great success in the past and has today become a valuable solution for banks seeking shelter from the financial crisis.

But while the idea is simple, the practice is quite complicated. There are many organizational, structural, and financial trade-offs to consider. The effect of these choices on the bank’s liquidity, balance sheet, and profits can be difficult to predict, especially in the current crisis. Capital and funding markets are still fragile in many regions, and many asset classes have been severely affected.
Consequently, institutions have developed several variations on the bad-bank theme to handle their particular sets of troubled assets and their available financial resources. These banks have made their choices, for better or worse, and are now working through a range of operational problems. Others, however, are still stuck at square one and are understandably perplexed by the range of possibilities and how the choice of a bad-bank model might affect their future. An analysis of bad banks set up in the crisis suggests that there are five sets of choices banks must make—choices about the assets to be transferred, the structure, the business case, the portfolio strategy, and the operating model. Each of these choices must be made while considering the impact on funding, capital relief, cost, feasibility, profits, and timing—a daunting array.

Success depends on getting these choices right, and on a number of other factors. Chief among these is government support, to help banks understand and manage the many regulatory, accounting, and tax issues, and in some cases to provide financial backing. Again, each country’s case is different, depending on the health of its banks, but broadly speaking, governments must smooth the way for the creation of bad banks and clearly establish the extent to which the state will assume the risk of the bad assets. In some countries, governments are considering a national bad bank to house the unwanted assets of all domestic banks. Many governments have not gone that far, but most are concluding that their support is justified to ensure the future stability of the financial system.

The bad-bank concept has attracted so much support lately that it is now widely viewed as the most likely savior in the rescue of the banking system. While that may be expecting too much, it is fair to say that an understanding of the bad bank is essential for the modern banker.
Governments often encourage the creation of bad banks in order to stabilize a faltering financial sector. Sweden, Finland and Ireland have all used bad banks to help end financial crises. Even though the bad loans don't go away, getting the bad loans off a bank's balance sheet can give the bank additional time to repair itself.

A well-known example of a bad bank was Grant Street National Bank, which was created in 1988 to house the bad assets of Mellon Bank. The financial crisis of 2008 revived interest in the bad bank solution, as managers at some of the world's largest institutions contemplated segregating their nonperforming assets into bad banks.

Creating a bad bank is a way to segregate nonperforming assets from a bank's core business. In theory, once the bad assets are removed from the balance sheet, the bank will be able to start lending again. The idea is that over time, the bank will earn enough interest from new, good loans to cover the losses from the bad loans it made before the financial crisis.

Tuesday, 02nd Feb 2016, 07:59:48 AM

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