A bad bank buys bad assets from other banks to remove them from their books, helping to resolve financial crises caused by an abundance of non-performing or toxic assets. The bad bank must be run by the government or a government agency, have a cooperation agreement involving multiple banks, and distressed assets must be written down before being sold to the bad bank. However, if a bad bank buys toxic assets at a fair market price, it could be very expensive and prolong the financial crisis.
A bad bank, also known as an aggregating bank or collection bank, is a bank that buys bad assets to remove those assets from other banks’ books. If all banks cooperate with the bad bank, the bad bank essentially seizes those assets so they can’t drag down the credit ratings and performance of other banks. The bad bank can in turn sell those assets, invest them or otherwise dispose of them.
The point of a bad bank is to help resolve a financial crisis caused by an abundance of bad assets on the books of major banks. Non-performing assets or “toxic assets” are assets that theoretically have value, but are considered unmarketable because nobody wants to buy them. A bank with distressed assets has lots of money on paper, but less access to cash in reality, and this can cause a credit crunch, as banks struggle to raise funds for day-to-day operations and start limiting the loans.
Several governments have used the wrong banks to deal with credit crises before they get worse. For this technique to be effective, many economists agree that it must meet several criteria. First, the bank is run by the government or a government agency that insures bank deposits and is usually set up as a self-liquidating trust, meaning that after the bank’s mission is completed, it is dissolved. The bad bank is a nationalized bank, run by and for the people, a concept some nations have difficulty with.
Another critical factor is a cooperation agreement involving multiple banks. If banks A, B and C agree to sell their bad assets to the nationalized bank and bank D disagrees with the plan, the market will continue to be unstable. Finally, distressed assets must be written down before being sold to the bad bank. In other words, banks cannot ask for the “fair market value” or paper value of their toxic assets. They must agree to write down the total debt and pay a loss to get the business off their books.
If a bad bank buys toxic assets at a fair market price, it will be a very expensive endeavor. Since the funds to buy the assets come from the government, this could bring the national economy to its knees, as huge funds are locked into running toxic assets. This may prolong the financial crisis that triggered the formation of the bad bank in the first place.
Bad banks are just one of many potential solutions to an economic crisis and need to be weighed carefully, along with other options. Government officials’ tendency to panic in the face of financial crises can contribute to some very bad decisions that can have long-lasting repercussions, making it important to avoid rushing into any particular plan of action, from a bad bank to a stimulus Floor.
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