What Is a Bad Bank?
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.
A bad bank structure may also assume the risky assets of a group of financial institutions, instead of a single bank.
Key Takeaways
- Bad banks are set up to buy the bad loans and other illiquid holdings of another financial institution.
- 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.
- Examples of bad banks include Grant Street National 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.
Understanding Bad Banks
Bad banks are typically set up in times of crisis when long-standing financial institutions are trying to recuperate their reputations and wallets. 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. 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), wherein the bank transfers its bad assets to another organization (typically backed by the government)
- A more transparent internal restructuring, in which the bank creates a separate unit to hold the bad assets(a solution not able to fully isolate the bank from risk)
- A bad bank spinoff, wherein 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
A well-known example of a bad bank was Grant Street National Bank. This institution was created in 1988 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 Chair 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 keep the toxic assets on the banks' books but eliminate the banks' risk, instead of 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.
FAQs
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.
What are the characteristics of a bad bank? ›
A bad bank is a financial institution that is created to purchase and hold bad assets that a bank or financial institution wants to offload from its balance sheet. These bad assets can include non-performing loans, bad debts, and other toxic assets that pose significant risks to the financial institution.
What are the disadvantages of a bad bank? ›
The reason behind the bad loan accumulation is lack of focus on the quality of credit provided by banks. Establishing a bad bank might create a mindset that there is a system in place to recover the loans. This can lead to careless lending by banks in a larger manner and worsen the present bad loan crisis.
What is another name for a bad bank? ›
Unlike commercial banks, bad banks do not undertake deposits, lending or other usual banking operations. Another name for a bad bank is Asset Reconstruction Company (ARC). It is a company which buys the bad loans of banks or any other financial institution, to let them clear their books and resume lending.
What is a bad loan in banking? ›
Bad Loans Meaning
Loans from a bank that have not paid interest for more than 90 days are known as Bad Loans or Non – Performing Assets (NPAs). In other terms, a loan is considered a non-performing asset (NPA) if the bank ceases receiving payments on the principal and interest for more than three months.
What is an example of a bad bank? ›
A well-known example of a bad bank was Grant Street National Bank. This institution was created in 1988 to house the bad assets of Mellon Bank.
What are unethical banks? ›
What is an unethical bank? Banks use the money they hold to fund companies and projects around the world – including some of the most environmentally damaging. For example, UK banks are behind the expansion of a coal mine in Colombia, destroying Indigenous towns and causing widespread drought.
What is failure of a bank? ›
A bank failure is the closing of a bank by a federal or state regulator when the bank can't meet its obligations to depositors, borrowers, and others. The federal government has the power to close national banks and banking commissioners have the power to close state-chartered banks.
What are the three bank failures? ›
Between March 10 and May 1, 2023, state banking supervisors closed SVB, Signature Bank, and First Republic Bank and named FDIC as receiver. The three failed banks had borrowed substantial secured loans (known as advances) from their respective FHLBanks before their failures.
What happens if bank is negative? ›
If you have a negative bank account, that means you've taken out more money than was available in the account. Letting an account go negative can be costly, because banks charge fees when this happens. And your bank could close your account if it stays negative for too long.
Here are seven signs to watch out for if you think your bank is in trouble:
- Deteriorating financial ratios. You can get detailed financial ratios from the Federal Financial Institutions Examination Council. ...
- Deposit migrations. ...
- Delayed financial reporting. ...
- Layoffs. ...
- Branch closures. ...
- Cuts in services. ...
- Sharp hikes in fees.
The major risks faced by banks include credit, operational, market, and liquidity risks. Prudent risk management can help banks improve profits as they sustain fewer losses on loans and investments.
What makes a bank fail? ›
Banks can fail for a variety of reasons including undercapitalization, liquidity, safety and soundness, and fraud. The chartering agency has the authority to terminate the bank's charter and appoint the FDIC to resolve the failure.
What are the weaknesses of a major bank? ›
These could include factors like a lack of diversification, outdated technology, high employee turnover, limited branch network, or poor customer service. Create custom fields in ClickUp to list and categorize your bank's weaknesses.
