User:Pburka/Bad bank

A bad bank is a corporate structure created by a troubled bank to isolate illiquid and high risk securities. 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.

In a 2009 report, McKinsey & Company identified four basic models of bad banks. In an on-balance-sheet guarantee, the bank uses some mechanism (typically a government guarantee) to protect part of its portfolio against losses. While simple, situation is difficult for investors to assess. In an internal restructuring, the bank creates a separate unit to hold the bad assets. This solution is more transparent, but doesn't isolate the bank from risk. In a Special-purpose entity (SPE), the bank transfers its bad assets to another organization, typically government backed. This solution requires significant government participation. Finally, in a bad bank spinoff, the bank creates a new, independent bank to hold the bad assets. This completely isolates the original bank from the risky assets.

In addition to segregating or removing the bad assets from the parent bank's balance sheet, a bad bank structure permits more specialized management. The good bank can focus on its core business of lending, and the bad bank can specialize in maximizing value from the high risk assets.

The first bank to use the bad bank strategy was Mellon Bank. In 1988, the American bank created a bad bank entity to hold $1.4 billion of bad energy and real-estate loans. Initially, the Federal Reserve was reluctant to issue a charter to the new bank, Grand Street National Bank, but Mellon's CEO, Frank Cahouet, persisted and the regulators eventually agreed. Grand Street's early investors made handsome profits, and the bank was dissolved in 1995 after repaying all bondholders and meeting its objectives.