The Financial Cesspools. A Critical Analysis of "Bad Banks" as Financial Instruments

Essay 2012 6 Pages

Business economics - Miscellaneous




"The cardinal maxim is that any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank" wrote the British economic journalist Walter Bagehot in 1873. In his evaluative analysis, Bagehot stretched the potential problems that may arise as a result of government's interventions. Although there has been more than a century since his comments on the pre-mature idea of a bad bank and interventions, the discussions on the utility of bad banks persists in today's financial spectrums. In economic terminology, bad banks are used to take risky assets from otherwise good banks. This essay will first address the idea of so-called bad banks as a new financial instrument and then will focus on the analysis of their impacts on crises development.

Bad Banks as Financial Instruments:

Bad bank system is operationalized as a bank setup to buy the considerably non-performing assets of a state guaranteed bank. These institutions have been created in order to cope with the financial problems in banking sector such as balance sheet insolvencies(liabilities exceed the assets), credit crunches( reduction in the availability of loans) and toxic assets (Schafer & Zimmermann, 2009). Bad banks have a vacuum impact on toxic assets of state-guaranteed banks and by absorbing these risky assets (with high potential risk to not be paid, such as subprime mortgages) they clear the balance sheet of good banks. By getting such junky assets off their books, banks can actually survive and stay in business by further lending and issuing processes.

One may ask the question of how much do the bad banks pay in order to get these junky/worthless assets. This question is basically at the heart of the bad bank trade-off. In order to have a certain positive influence, the bad banks should pay enough purposefully to keep the good banks in business (Brenna, Poppensieker & Schenider, 2009). However, the amount of payment should not be higher than "sufficient" since it may abrogate the incentive for a good bank to follow good banking practices. This brings us to the problem of a moral hazard which will be discussed in following section. It should also be stated that the bad banks differ from the good ones in terms of their organizational-orientation. Bad banks are project banks that require constant and dynamic monitoring over processes and they may fade away after the resolution of credit problems.

Along with this organizational difference, a bad bank should immediately get the control over toxic assets in order to protect the value and stabilize the relevant capital requirements. Otherwise, bad banks may easily end up in a chaotic situation. Typically, bad banks life span should be limited to half of a decade since most of the financial crises occur in no more than 5-6 years. As a result of well- defined credit work-out practices, bad banks might even be seen as an attractive, high-performance assets owning company; however, it should be considered that these assets were the leftovers from the credit work-out processes and one should not compare them to the assets of a solid investment bank.

Different approaches related to the risk-assessments, fair distribution of gains and losses and the funding of these bad banks created two different "schools". Firstly, the Swiss school suggests the full transfer of the toxic assets' risks to a bad bank. Secondly, the German model asserts the retention of risks by the initial bank. As it can be predicted, both of the models put a large emphasis on transfer value of the junky assets. This is simply because of the key trade-off involved in the whole instrument between the enhancement of credit supply and minimization of expected costs to taxpayers (Neyer & Vieten, 2011). Neyer and Vieten (2011) conclude that the price of transfer depends on the importance level of credit crunch.

Bad Banks' Impact on the Development of Financial Crises:

One of the well-known example of a bad bank is Grant Street National Bank which was founded in order to get the toxic assets of the Mellon Bank(New York) in 1988. However, the most radical implementation of bad banks occurred in Sweden when the country undergone severe banking crisis. In this case Swedish banks were facing with severe insolvency problems (Cooley, 2009). Hence, the government decided to intervene in the process by establishing two bad banks; namely, Retriva and Securum. These banks took over the toxic assets of Gotabank and Nordbanken(these banks had to write down losses and issue a common stock to government). The discussions on the appropriateness of bad banks reincarnated during the Great Recession especially when Ben Bernanke addressed this solution as a supplement of Emergency Economic Stabilization Act of 2008.

Apart from this, the Irish National Asset Management Agency was founded in 2009 in order to address country's financial crisis. Nowadays, the same discussions take place in Spain due to the creation of The Spanish Bad Bank with the aim of absorbing problematic real estate assets from the good banks (Durden, 2012). All in all, the bad banks have been used and discussed in various different economies and spectrums. However, this section, in contrary the first one in which we chiefly covered its positive influences on banking system, will focus on its potential impact on cultivating crises with three main arguments; moral hazard, subsidy on corporate bankruptcy and loss of confidence.

The first argument is the moral hazard problem. Moral hazard suggests that people will take risks if they have an incentive to do so (Pritchard, 2010). Hence, this analogy based on the trade-off between the reward(transfer to the bad banks) and risk (toxic assets) is at the core of the discussions. This criticism towards bad banks mainly underline the fact that the system may encourage banks to take the risks beyond their scope. It was this kind of a moral hazard problem that caused the Great Recession in USA where the banks issued "risky" mortgages. Considering this experience, we can easily assert that the implementation of a bad bank system may reduce the incentive on banks to be careful about their actions and this may cultivate financial crises.

Bad Banks may also contribute to the financial crisis by their unintentional subsidy on the corporate bankruptcy. Basically, the system allows the bondholder to immediately sue for bankruptcy instead of giving a company a chance to develop its productivity. This quick mechanism to sue reduces potential pressures that may lead a company to get better since it makes these assets eligible for the bad banks.



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Title: The Financial Cesspools. A Critical Analysis of "Bad Banks" as Financial Instruments