Bad Bank (Definition, Example) | Overview of What Bad Banks Actually Do!

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, bad 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 their plan to close the stock trading business and shift Euro75 billion risk-weighted assets to Bad Bank.

The corporate structure of the bad bank may also assume risky assets of the group of the financial institutions rather than buying only of the single bank.
Generally, at the time of taking over such loans, such banks inspect 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 for using 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 shares of the bad bank as well as the dividend on the one for one basis. The early investors of the 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.

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Advantages

There are several different advantages for both the bad bank as well as the original bank who transferred its assets. Some of the advantages are as follows:

By segregating the bad loans from the other loans, the bank can keep non-performing assets 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 banks 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.

Disadvantages

Apart from the advantages, there are several disadvantages or the limitations of the Bad banks which include the following:

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 the 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 liquidity of the bank, on the bank’s profit and on the balance sheet of the bank is difficult to judge, especially in the situation of the crisis.
It is possible that the bad 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 loans which are easily recoverable.
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 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 quality and recoverability of those loans and keep the high margin for the takeover.
A bad 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 loans which are easily recoverable

Conclusion

The idea of creating the 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 the steps to transfer the non-performing loans to the ban banks such as organizational factors, structural factors, and the financial trade-offs.