What is a Bad Bank

Bad Bank is not a wicked or a corrupt bank. Neither is it a failed bank. Let us find more about the concept and working of a Bad Bank.

What is a Bad Bank

A bad bank is termed so simply because it houses bad loans, or in financial parlance - non-performing assets (NPAs).

A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution. The entity holding significant nonperforming assets will sell these holdings to the bad bank at market price. By transferring such assets to the bad bank, the original institution may clear its balance sheet—although it will still be forced to take write-downs.

Need for a Bad Bank

A bank may accumulate a large portfolio of debts or other financial instruments which unexpectedly increase in risk, making it difficult for the bank to raise capital, for example through sales of bonds. 

In these circumstances, the bank may wish to segregate its "good" assets from its "bad" assets through the creation of a bad bank. 

By separating the non-performing loans from the banks, it is possible to start the process of focusing the banks back to lending. 

Trying to work out all the non-performing loans inside the bank only prolongs the healing process in the organisation and reduces its ability to lend more to the public and businesses.

The goal of the segregation is to allow investors to assess the bank's financial health with greater certainty. 

In addition to segregating or removing the bad assets from parent banks' balance sheets, a bad bank structure permits specialized management to deal with the problem of bad debts. The approach allows good banks to focus on their core business of lending while the bad bank can specialize in maximizing value from the high risk assets.

Why Bad Banks make sense

Repairing the balance sheet of the banks is only one important element to get the banks back to normal lending activities. The other major element is organisational processes.

The organisational requirements are very different in a bad bank than in a normal bank. A good bank is a 'process' organisation while a bad bank is a 'project' organisation. The skill set and the emphasis on type of skills are different in a restructuring and winding up situation than in a lending situation.

How Bad Banks Work

When a bad bank has gone through its credit work-out process, the remains of the bad bank is often asset ownership. 

Therefore, the bad bank in its life span changes dramatically from being at the outset basically a bank with a large number of loans to later in life a large asset-owning company. 

A common mistake is to think of this last phase of the bad bank as a kind of investment company. An investment company has very well defined objectives regarding what type of assets they want to acquire. They choose the assets they want to acquire. A bad bank gets all the assets that are left after the credit work-out process.

A lifetime of 10–15 years is too long for planning purposes. The world changes substantially in such a long lifespan. Most banking crises are over in a 5–6 year period. A 5–6 year time span is the logical time to use for planning purposes and the timeline to use for winding down a bad bank.

More about Bad Banks

A bad bank structure may also assume the risky assets of a group of financial institutions, instead of a single bank.

The first year of the bad bank determines its success. 

The challenge is the large number of non-performing loans in a wide variety of situations with regards to geographical location, type of industry, size and type of problem. 

If the bad bank does not quickly get control of the loans, a lot of value is lost and the capital requirements of the bad bank can change dramatically. 

To be successful, a well-defined process on how to handle the different loans has to be established. This process has to be followed and managed with force and speed in the organisation. If not, the bad bank will easily end up in chaos.

A bad bank might be established by one bank or financial institution as part of a strategy to deal with a difficult financial situation, or by a government or some other official institution as part of an official response to financial problems across a number of institutions in the financial sector.

Similarity with Side Pocketing in Mutual Funds

I do see a starking similarity in creation of bad banks with that of creation of side pockets in Mutual Funds. The idea is the same: 

- Segregate good from the bad. 

- Let the majority deal with the good.

- Let a specialised team handle the bad.

[Recommended Article : Side Pocketing in Mutual Funds]

Drawbacks of Creating a Bad Bank

Critics of bad banks say that the option encourages banks to take undue risks, leading to moral hazard, knowing that poor decisions could lead to a bad bank bailout. This leads to lack of focus on governance and process improvements within the bank.

And the same issue exists with the side pocketing of mutual funds. Mutual Fund Managers take more risk in search of more returns, knowing very well that they always have an option of side pocketing in case of defaults with the underlying securities.

Examples of Bad Banks cross the globe

USA

The first bank to use the bad bank strategy was Mellon Bank, which created a bad bank entity in 1988 to hold $1.4 billion of bad loans. Grant Street National Bank was created to house the bad assets of Mellon Bank. 

Bad banks were also considered during the financial crisis of 2008 as a way to shore up private institutions with high levels of problematic assets. 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.

Ireland

In 2009 the Republic of Ireland formed a bad bank, the National Asset Management Agency, in response to the nation’s own financial crisis.

Finland

The Finnish banking crisis of the 1990s caused the collapse of two major banks, the Säästöpankki group/SKOP and STS Bank. The government founded the bad banks ("property management companies") OHY Arsenal and Sponda, which took over the bad debt. 

Germany

Germany has several bad banks dating as far back as the 1980s, Bankaktiengesellschaft (BAG)

Austria

Hypo Alpe Adria: Nationalised in 2009 by the Austrian government to avert a bank collapse, dismantled in 2014.

Bad Banking in India

The Indian Banks’ Association is said to have requested the central government to set up a “bad bank" to reduce the impact of the losses banks will face because of provisioning for non-performing assets (NPAs) on account of Covid 19. 

The government response has been tepid as of now. 

Let us wait and watch.

Regards

Manoj Arora

Official Website