DEFINITION of 'Bad Bank'

A bad bank is one, set up to buy the bad loans of another bank with significant nonperforming assets 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).

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

BREAKING DOWN 'Bad Bank'

 

While shareholders and bondholders generally stand to lose money from this solution, depositors usually do not. Banks that become insolvent as a result of the process can be recapitalized, nationalized or liquidated. If they do not become insolvent it is possible for a bad bank’s managers to focus exclusively on maximizing the value of its newly acquired high risk assets.

Some criticize the setup of bad banks, highlighting how, if states take over non-performing loans, this encourages banks to take undue risks, leading to a moral hazard.

McKinsey outlined four basic models for bad banks in 2009. These included:

  • An on-balance-sheet guarantee (often a government guarantee), which the bank uses to protect part of its portfolio against losses.

  • A special purpose entity (SPE), where the bank transfers its bad assets to another organization (again, typically backed by the government).

  • A more transparent internal restructuring, in which the bank creates a separate unit to hold the bad assets. This solution is not able to fully isolate the bank from risk.

  • A bad bank spinoff, where the bank creates a new, independent bank to hold the bad assets, fully isolating the original entity from the specific risk.

 

Examples of Bad Bank Structures in Recent History

A well-known example of a bad bank was Grant Street National Bank. This institution was created in 1988 in order 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.

Federal Reserve Bank Chairman Ben Bernanke proposed the idea of using a government-run bad bank in the recession, following the subprime mortgage meltdown. The purpose of this would be to clean up private banks with high levels of problematic assets and allow them to begin lending once more. An alternate strategy, which the Fed considered, was a guaranteed insurance plan. This would would keep the toxic assets on the banks' books but eliminate the banks' risk, instead passing it on to taxpayers.

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

RELATED TERMS
  1. Bank

    A bank is a financial institution licensed as a receiver of deposits. ...
  2. Bankers' Bank

    A bankers' bank is a specific type of bank, which a group of ...
  3. Universal Banking

    Universal banking is a banking system in which banks provide ...
  4. Bad Debt Expense

    An entry found on a business's income statement that represents ...
  5. State Bank

    A state bank is a financial institution, which a state has chartered ...
  6. Risk-Weighted Assets

    Risk-weighted assets are the amount of capital that is required ...
Related Articles
  1. Investing

    Will the Next Financial Crisis Come From Europe? (DB, CS)

    Discover why the European financial system might be in trouble, why the European Central Bank may turn to bailouts, and why that is probably a mistake.
  2. Personal Finance

    How Will Bank Regulation Affect British Banks?

    We look at the proposed changes to Britain's banking system, and see whether it will be able to stay competitive.
  3. Investing

    Bank of America's 3 Key Financial Ratios (BAC)

    Discover some of the key financial ratios that show the quality of Bank of America's loan portfolio and how profitable the bank has been.
  4. Financial Advisor

    Why Banks Don't Need Your Money to Make Loans

    Contrary to the story told in most economics textbooks, banks don't need your money to make loans, but they do want it to make those loans more profitable.
  5. Investing

    EU Bank Stress Test Results: A Preview

    The tests of 51 banks covering 70% of total banking assets across the EU come at a time of great turmoil in banking when many financial shares have plunged
  6. Tech

    Regional, Community Bank Stocks the Next Big Thing

    The very best opportunities are often in the less exciting stocks and sectors. Community banks may not be sexy, but they can be very profitable investments.
  7. Investing

    5 Ways Bad Credit Screws Up Your Life

    When your credit score slumps, many other things in your life can also start to slide downward. How to recognize the situation and start dealing with it.
  8. Tech

    The Pros And Cons Of Internet Banks

    Learn how internet banking services stack up against their brick-and-mortar peers. Find out what internet banks have to offer and where they fall short.
RELATED FAQS
  1. Why do banks write off bad debt?

    Learn more about the practice of banks writing off bad debts and removing them from their books, including a hypothetical ... Read Answer >>
  2. What factors are the primary drivers of banks' share prices?

    Find out which factors are most important when determining the share price of banks and other lending institutions in the ... Read Answer >>
  3. What is the banking sector?

    Why the banking sector is a vital industry, what it does to drive economic growth and examples of companies in this sector. Read Answer >>
  4. What economic indicators are important to consider when investing in the banking ...

    Find out which economic indicators are most useful for investors in the banking sector, especially those influenced by central ... Read Answer >>
  5. What are the major categories of financial institutions and what are their primary ...

    Understand the various types of financial institutions that exist in today's economy, and learn the purpose each serves in ... Read Answer >>
Trading Center