A bad bank is a new company created to buy poorly-performing assets from another bank.
It isolates liquidity and high risk assets held by a bank or a financial organisation, or perhaps a group of banks or financial organisations.
A bank may accumulate a large portfolio of debts or other financial instruments which unexpectedly increase in risk, making it difficult for the bank to raise capital, for example through sales of bonds.
In these circumstances, the bank may wish to segregate its "good" assets from its "bad" assets through the creation of a bad bank.
The goal of the segregation is to allow investors to assess the bank's financial health with greater certainty.
A bad bank might be established by one bank or financial institution as part of a strategy to deal with a difficult financial situation, or by a government or some other official institution as part of an official response to financial problems across a number of institutions in the financial sector.
In addition to segregating or removing the bad assets from parent banks' balance sheets, a bad bank structure permits specialized management to deal with the problem of bad debts.
The approach allows good banks to focus on their core business of lending while the bad bank can specialize in maximizing value from the high risk assets.
How Does a Bad Bank Work ?
For example, let's assume that Bank XYZ has made an extraordinary number of loans to borrowers who can't pay them back.
As time goes by, it becomes increasingly clear that a majority of Bank XYZ's loans will not be repaid in full.
The bad loans sitting on the bank's balance sheet are jeopardizing Bank XYZ's ability to stay in business.
Bank XYZ decides to create a wholly-owned subsidiary to buy the nonperforming loans from Bank XYZ. This new "bad bank" will buy the nonperforming assets and get them off Bank XYZ's balance sheet, thereby improving Bank XYZ's ability to start lending again.
The bad bank can either hold the nonperforming loans and hope borrowers start paying on them, or it can sell the nonperforming loans to other investors.
Why Does a Bad Bank Matter?
Governments often encourage the creation of bad banks in order to stabilize a faltering financial sector.
Sweden, Finland and Ireland have all used bad banks to help end financial crises.
Even though the bad loans don't go away, getting the bad loans off a bank's balance sheet can give the bank additional time to repair itself.
Creating a bad bank is a way to segregate nonperforming assets from a bank's core business.
In theory, once the bad assets are removed from the balance sheet, the bank will be able to start lending again.
The idea is that over time, the bank will earn enough interest from new, good loans to cover the losses from the bad loans it made before the financial crisis.