A bad bank is a separate entity created to buy, hold, and work out distressed assets (such as non-performing loans) from one or more banks. The goal is to separate “bad” assets from the rest of the banking system so that surviving banks can recapitalize, fund themselves more easily, and resume normal lending.
Bad banks can be privately funded, publicly funded, or hybrid structures. They are closely related to bank-resolution policy and often involve explicit or implicit fiscal risk.
Core Mechanics
The mechanics center on the transfer price:
- If impaired assets are transferred at realistic (low) prices, the originating bank realizes losses immediately, which improves transparency but may require recapitalization.
- If assets are transferred at inflated prices, the originating bank looks healthier, but the bad bank (and ultimately taxpayers or investors) absorb losses later.
A simplified way to see the capital effect is:
[ \text{Capital Ratio} = \frac{\text{Equity}}{\text{Risk-Weighted Assets}} ]
Removing bad assets can reduce risk-weighted assets, but if the transfer crystallizes large losses, equity can fall. Whether the capital ratio improves therefore depends on the balance-sheet arithmetic and on who absorbs the losses.
Why Policymakers Use Bad Banks
Bad banks are used when:
- banks’ balance sheets are clogged with uncertain asset values,
- uncertainty is preventing private funding or interbank lending,
- authorities want centralized expertise and scale for restructurings and asset sales.
Key Risks
Common risks include:
- Moral hazard: future risk-taking may increase if banks expect assets to be transferred out in crises.
- Fiscal exposure: if the public sector funds the vehicle or guarantees its liabilities, taxpayers bear downside risk.
- Execution risk: recoveries depend on legal processes, asset-management skill, and macro conditions.