A bad bank is a bank set up to acquire illiquid and risky assets (like bad loans) from a troubled financial institution. Particularly in times of economic crisis, when struggling banks often need to clear problematic assets off their balance sheets, bad banks are used to take on risky assets and loans.
Moving so-called toxic assets to a bad bank and keeping stable assets and investments on their balance sheets can help financial institutions avoid insolvency while appearing more financially stable to investors.
Learn more about what bad banks are, examples of bad banks, and how they work.
Definition and Examples of Bad Banks
A bad bank takes on risky debts, loans, and assets from a beleaguered bank. In addition to clearing their balance sheets, banks typically unload bad assets to a bad bank in an effort to shore up their reputation with credit rating agencies and rebuild trust with investors, as well as improve their finances by protecting profits and minimizing losses.
Grant Street National Bank is an example of a bad bank that was set up in the 1980s to acquire assets from Mellon Bank and its subsidiaries. It wasn’t part of the Federal Reserve system, nor did it accept deposits. Grant Street National Bank existed solely as a bad bank established to acquire specific assets seized in foreclosures.
Bad banks have also been used in several European countries, including Ireland and the United Kingdom. The Swiss National Bank, for example, set up and funded a special-purpose bad-bank entity that purchased $60 billion in troubled assets from Swiss bank UBS in 2008.
In December 2020, the European Commission announced its support to establish several asset management companies (“bad banks”) to help banks throughout the European Union remove nonperforming loans from their balance sheets in an effort to staunch the blow of a severe economic downturn.
How Bad Banks Work
Typically established during times of financial crisis, bad banks’ purpose is to restore stability to the banking industry, allow credit to flow, and reestablish investors’ trust. Bad banks may acquire troubled or risky assets such as loans that have been defaulted on, or assets that may have lost value due to current market conditions.
Bad banks may also acquire financially sound assets to assist banks with their restructuring efforts. For example, bad banks were used prolifically during and after the 2008 financial crisis to stabilize the banking industry and prevent several large financial institutions from failing after asset values plummeted. In the recession’s wake arose increased government regulation, bailouts, and funding demand, which bad banks were established in part to mitigate.
A general criticism of bad banks and bailouts is they create “moral hazard,” meaning banks and financial institutions may be more inclined to take on debt and risky investments because they can unload those bad investments later without any consequences.
How Bad Banks Are Structured
A bad bank’s structure and strategy depends on its goals and whether or not a financial institution wants to keep assets on its balance sheet. There are four models for structuring bad banks:
- Bad-bank spinoff: The most common structure, in which a bad bank is created as a legally separate entity to hold bad assets.
- On-balance sheet guarantee: Banks protect a portion of their portfolio against losses with a guarantee backed by the government.
- Internal restructuring: Establishes a separate, internal unit to isolate bad assets; often used when toxic assets account for more than 20% of a bank’s balance sheet.
- Special-purpose entity: What Is the Income Approach? Undesirable assets are transferred from a bank’s balance sheet to a bad bank, which is usually sponsored by the government.
- Bad banks are banks set up to acquire bad debts and illiquid assets from another bank, typically during times of economic crisis.
- The downside of bad banks is they create a “too-big-to-fail” mentality among financial institutions that recognize the benefits of these structures.
- There are four types of bad-bank structures: On-balance sheet guarantee, internal restructuring, special-purpose entities, and bad-bank spinoffs.