A-Z of the Financial Crisis: Bad bank

What is it?

A bad bank is a place where bad things can stored out the way so that they can't cause any nasty problems.

Those bad things are so-called toxic assets. They might be anything from CDOs to other forms of horrible mortgaged backed securities.

Toxic assets were usually worth something once, and could be bought and sold easily (ie. they were liquid). However, once an asset becomes toxic no one wants to buy it any more - usually because it's based on loans that may never ever be paid back.

Any bank that owns the toxic asset is therefore stuck with it. And even worse, whenever a rival bank manages to sell a toxic asset at a reduced price, mark to market accounting rules mean all other banks holding similar assets on their balance sheets are obliged to cut their value to the same amount. As the value of toxic assets falls, this can result in wave after wave of big writedowns and big banking losses.

Creating a bad bank to buy up the toxic assets should therefore be a big help to the unfortunate banks afflicted by them. The unfortunate banks can then get on with their lives as if the toxic assets had never existed. They can become good banks.

The bad news and the good news about bad banks

Sadly, it doesn't always work out quite like this. The big problem with creating a bad bank is that it has to buy the toxic assets in the first place. It usually buys them at a reduced price, and when it does so the unfortunate banks which own the assets have to make big writedowns. The difficulties that arise when pricing toxic assets are described well a New York Times article visible here.

However, if the unfortunate banks won't sell their toxic assets to the bad bank, it's argued that they'll have a very uncertain future.

This is particularly so during a recession when toxic assets are likely to become more and more toxic as more and more loans go into default. Unfortunate banks will therefore have to make more and more writedowns. This will create a danger of a loss of confidence in the unfortunate banks because no one knows quite how many toxic assets they've actually got. This could prompt their creditors to withdraw all their good assets, making matters even worse.

Either way, owners of large numbers of toxic assets are unlikely to feel inclined to lend much money to anyone, just in case they need their existing capital to offset further writedowns or as protection against panicking creditors.

If all the toxic assets are dumped in a bad bank, it's argued that unfortunate banks will start lending again. There will be no more writedowns, so banks won't need to hoard their capital. And there will be no need for anyone to panic and withdraw their cash, so unfortunate banks won't need to hoard capital for that reason either.

In this way, it's hoped that creating a bad bank, or bad banks, can end a credit crunch once and for all.

What's it got to do with the financial crisis?

When the US came up with its TARP programme, it initially intended to spend the money buying up toxic assets and create a bad bank or something similar. Instead, the pace of events and problems valuing toxic assets meant it ended up either buying equity shares in unfortunate banks instead, or guaranteeing to pay for losses above a certain level at banks like Citigroup and Bank of America.

However, when these measures failed to end the credit crunch and unfortunate banks still wouldn't lend, the bad bank idea came back into fashion. Switzerland set a precedent, successfully creating a bad bank out of $60 billion of UBS's bad assets in October 2008.

In January 2008, Citigroup split itself into a good bank and a bad bank.

In 2009 the US government again considered forming a bad bank (AKA an aggregator bank, but gave up on it, as did the UK government.

Ultimately, bad banks were considered a bad idea because of the problems pricing the toxic assets: banks would only sell them for high prices; governments would only buy them for low prices.

Only Germany went for the bad bank model of government intervention, and it was criticised because banks weren't actually obliged to sell their toxic assets (meaning that very few of them were likely to participate).

Useful Links:

The bad bank model in Germany (Bloomberg)

Ireland opts for a bad bank (Wall Street Journal).

Willem Buiter on the good bank/ bad bank solution. (Financial Times )

Why bad banks are good. (Wall Street Journal )

Last updated 26th July 2009.