What is a Bad Bank?
Bad Bank is a set up with the purpose of buying bad loans or non-performing assets of other banks/financial institutions which it is not able to recover. After taking the bad loans, such banks try to recover the amount by using the various recovery methods and the original bank or the institution may clear the balance sheet after transferring those assets.
Most recently, Deutsche Bank announced its plan to close the stock trading business and shift Euro75 billion risk-weighted assetsRisk-weighted AssetsRisk-weighted asset refers to the minimum amount that a bank or any other financial institution must maintain to avoid insolvency or bankruptcy risk. The risk associated with each bank asset is analyzed individually to figure out the total capital requirement. to Bad Bank.
- The corporate structure of this bank may also assume risky assets of the group of the financial institutionsGroup Of The Financial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. rather than buying only of the single bank.
- Generally, at the time of taking over such loans, such banks inspect the quality and recoverability of those loans and keep the high margin for the takeover.
- By segregating the bad loans from the other loans, the original bank can keep bad assets separately from the good ones so that the good ones do not get contaminated with the bad ones.
Example of the Bad Bank
For example, Grant Street bank was created in the year 1988 to house bad assets of the Mellon Bank. This was the first bad bank creation, and the Mellon bank became the first bank to use this strategy. In this, it was decided that Grant Street bank will hold $ 1.4 billion of Mellon bank’s bad loans.
The shareholders of the Mellon bank have then issued the sharesIssued The SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet. of the bad bank as well as the dividend on the one for one basis. The early investors of Grant street bank made good profits, and after some years, i.e., in the year 1995 bank was dissolved after repaying the amount of all bondholders and meeting its all objectives.
- By segregating the bad loans from the other loans, the bank can keep non-performing assetsNon-performing AssetsNon-Performing Assets (NPA) refers to the classification of loans and advances on a lender's records (usually banks) that have not received interest or principal payments and are considered "past due." In the majority of cases, debt has been classified as non-performing assets (NPAs) when loan payments have been outstanding for more than 90 days. away from contaminating good ones. By segregating the two and keeping them mixed, the investors and the other stakeholders may get to know the financial health and the performance of the banks with the certainty, impairing the ability to lend, trade, borrow, and raise the capital.
- As the new bank will be formed with the main purpose of the recovery of the non-performing loans, so the speed of the recovery will also be more, and hence the loans will be recovered soon, and the bad bank will get the specialization in that.
- With the creation of such a bank, the burden of recovery of bad loans will be reduced from the original bank’s side, which can then look into the main business.
- Profits can be made by such banks as usually a high level of margin is kept by them before the acquisition of the non-performing loans.
- The idea of creating such a bank for managing the bad loan is a simple one, but in practicality, it is quite complicated. Many factors are there which have to be considered before taking steps to transfer the bad loans to the band banks such as organizational factors, structural factors, and the financial trade-offs. The effect of the factors on the liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. of the bank, on the bank’s profit, and the balance sheet of the bankBalance Sheet Of The BankThe bank's balance sheet is different from the company's balance sheet. It is prepared on the mandate by the Bank's Regulatory Authorities to reflect the tradeoff between the bank's profit and its risk and its financial health. is difficult to judge, especially in the situation of the crisis.
- It is possible that such a bank may not go for acquiring the critical loans of the other bank, which are somehow difficult to recover for it and may concentrate only on acquiring the easily recoverable loans.
- Sometimes the situation of the pressure may arise for the bank, and in that, it might adopt the unethical ways for the recovery of the loans.
- It is possible that the other bank may disclose the wrong information or may not disclose the actual position of the loan account with the help of the window dressing to the bank who is acquiring the loan.
- High margin taken by the bad banks for taking the non-performing loans may curtail the profits of the other bank.
Important points of the Bad Bank
- The main goal of segregation of the non-performing loan for the other loan is to allow the investors to know the financial health of the bank with a greater level of certainty.
- At the time of taking over such loans, generally, the bad banks inspect the quality and recoverability of those loans and keep the high margin for the takeover.
- They may not go for acquiring the critical loans of the other bank, which are somehow difficult to recover for it and may concentrate only on acquiring the easily recoverable loans.
The idea of creating a bad bank for managing the non-performing loan is a simple one, but in practicality, it is quite complicated. Many factors are there which have to be considered before taking steps to transfer the non-performing loans to the ban banks such as organizational factors, structural factors, and the financial trade-offs.
This article has been a guide to Bad Bank and its definition. Here we provide an overview of what bad banks actually do along with examples, advantages, and disadvantages. You may learn more about our articles below on investment banking –