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Understanding the bad bank

For many, this is the best exit from the financial crisis—but the choices entailed are not straightforward.

DECEMBER 2009 • Gabriel Brenna, Thomas Poppensieker, and Sebastian Schneider

Source: Corporate Finance Practice

“Bad banks” are back. The concept is simple. 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.

In This Article

Exhibit 1: Short-term funding spreads are slowly returning to pre-crisis levels.

Exhibit 2: These variables help determine the bad bank’s structure and operations.

Exhibit 3: The bank’s model is primarily determined by choosing whether to keep assets on the balance sheet.

Exhibit 4: Choosing the right portfolio strategy can yield 1 percent to 2 percent of additional value.

Exhibit 5: It is essential to be clear on the unit’s goals with respect to liquidity, collateral, and gross risk reduction.