Bad bank

A bad bank is a financial institution, often established by a government or a group of banks, to isolate and manage the bad loans and illiquid assets of a distressed or insolvent bank. This allows the original bank to focus on its core business and rebuild its financial health.
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Updated on May 29, 2024
Reading time 3 minutes

3 Key Takeaways

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  • Bad banks isolate and manage non-performing assets of distressed banks.
  • They aim to clean up the balance sheets of struggling banks and restore confidence in the financial system.
  • The creation of bad banks is often a controversial measure, with potential drawbacks and criticisms.
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A bad bank is a separate legal entity created to purchase non-performing assets (NPAs) and other toxic assets from a troubled bank at a discounted price. These assets are usually loans that are unlikely to be repaid or investments that have significantly declined in value. By transferring these bad assets to the bad bank, the original bank can clean up its balance sheet and focus on its core business of lending and deposit-taking.

Importance of Bad Banks

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  • Financial Stability: Bad banks can help to stabilize the financial system by removing toxic assets from the balance sheets of struggling banks, reducing the risk of contagion and systemic failure.
  • Restructuring and Recovery: They provide a mechanism for restructuring and recovering the value of non-performing assets, potentially minimizing losses for taxpayers and creditors.
  • Restoring Confidence: The creation of a bad bank can help to restore confidence in the banking sector by demonstrating a commitment to address the problem of bad loans.

How Bad Banks Work

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  1. Asset Transfer: The bad bank acquires the non-performing assets from the troubled bank at a discounted price, often funded by government or private investors.
  2. Management and Resolution: The bad bank then manages these assets, attempting to recover as much value as possible through restructuring, workouts, or sale to other investors.
  3. Wind-down: Once the bad assets have been resolved, the bad bank is typically wound down or dissolved.

Real-World Applications

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Bad banks have been used in various countries to address financial crises and stabilize banking systems. In the United States, the Resolution Trust Corporation (RTC) was created in 1989 to manage and dispose of assets from failed savings and loan associations during the savings and loan crisis. In the wake of the 2008 global financial crisis, several countries, including Ireland and Spain, established bad banks to address their banking sector problems.

However, the creation of bad banks is not without controversy. Critics argue that they can create moral hazard, as banks may be more likely to take excessive risks knowing that a bad bank can bail them out. There are also concerns about the fairness of using taxpayer money to fund bad banks and the potential for conflicts of interest in their management.


Sources & references

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