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.
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.
The Mellon Bank Story," Pages 8-9. Accessed Oct. 1, 2021.
