A bad bank is a corporate structure which isolates illiquid and high risk assets (typically non-performing loans) held by a bank or a financial organisation, or perhaps a group of banks or financial organisations. A bank may accumulate a large portfolio of debts or other financial instruments which unexpectedly become at risk of partial or full default. A large volume of non-performing assets usually make 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. The goal of the segregation is to allow investors to assess the bank's financial health with greater certainty. 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.
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.
Such bad bank institutions have been created to address challenges arising during an economic credit crunch to allow private banks to take problem assets off their books. The financial crisis of 2007–2010 resulted in bad banks being set up in several countries. For example, a bad bank was suggested as part of the Emergency Economic Stabilization Act of 2008 to help address the subprime mortgage crisis in the US. In the Republic of Ireland, a bad bank, the National Asset Management Agency was established in 2009, in response to the financial crisis in that country.
Models
In a 2009 report, McKinsey & Company identified four basic models for bad banks.
In an on-balance-sheet guarantee, the bank uses some mechanism (typically a government guarantee) to protect part of its portfolio against losses. While simple to implement, this situation is difficult for investors to assess. In an internal restructuring, the bank creates a separate unit to hold the bad assets. This solution is more transparent, but does not isolate the bank from risk. In a Special purpose entity (SPE), the bank transfers its bad assets to another organization, typically government backed. This solution requires significant government participation. Finally, in a bad bank spinoff, the bank creates a new, independent bank to hold the bad assets. This completely isolates the original bank from the risky assets.
Examples
Mellon Bank (1988)
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. Initially, the Federal Reserve was reluctant to issue a charter to the new bank, Grant Street National Bank (in liquidation), but Mellon's CEO, Frank Cahouet, persisted and the regulators eventually agreed.
A dumping ground for non-performing energy and real estate loans, Grant Street was spun off with its own five-member board of directors and about $130 million in Mellon capital; it was named for a main street in Pittsburgh which was home to Mellon Financial headquarters. It took no public deposits. Mellon shareholders were issued shares in both the good and bad banks on a one-for-one basis, as a dividend. After the Grant Street National Bank had fulfilled its purpose, issuing preferred shares and equity purchase contracts to finance the purchase of $1 billion in Mellon's bad loans at 57% of face value, then collecting what it could on the individual loans, it was liquidated and its employees quietly returned to Mellon Bank. Securities collateralized by the bank's assets were structured and sold by Drexel Burnham Lambert. The securities were divided into two tranches: Senior, which received investment grade rating, and Junior which were high yield securities. Internally at Drexel they were nicknamed CLOWNS which stood for "Collateralized Loan Obligations Worth Nothing Securities". All bonds were paid off at full.
Grant Street's early investors made handsome profits; the bank was dissolved in 1995 after repaying all bondholders and meeting its objectives.
Swedish banking crisis of 1992
The Swedish banking crisis of 1992 was the direct result of a combination of over-speculation in property assets and the exchange rate of the Swedish krona. By 1992 three of the four major banks were insolvent.