Bad Bank(s) and Recapitalisation of the Banking Sector

Banking sectors worldwide are still suffering from the effects of the financial crisis. This column presents a plan of how governments can efficiently relieve ailing banks of toxic assets by transferring them into bad banks, an idea that is gaining popularity.

With banking sectors worldwide still suffering from the effects of the financial crisis, public discussion of plans to place toxic assets in one or more bad banks has gained steam in recent weeks. We present a plan of how governments can efficiently relieve ailing banks by transferring toxic assets into bad banks (Schäfer and Zimmermann 2009). Under the terms of our proposed plan, bad banks and nationalisation are not alternatives but rather two sides of the same coin. Although we refer mainly to the German situation, the elements of the plan will work in other countries as well.

Weak capital basis of German banks

The capital bases of German banks are seriously endangered by the high quarterly write-down of asset values. According to the Bundesbank, the total capital including reserves held by all German banks is approximately €415 billion. The president of the Federal Financial Supervisory Authority (BaFin) recently announced that toxic assets in German banks’ balance sheets amount to €180 to €200 billion. During the Swedish banking crisis in the early 1990s, write-downs amounted to more than 12% of GDP. Losses of this magnitude – by no means unrealistic in the present crisis – would seriously erode the capital bases of German banks.

The worsening capital position of the banks has a number of consequences with destabilising feedbacks for financial markets and the real economy. The threat of imminent bank closures is a source of insecurity for market participants and isolates the affected banks from capital flows. In addition, banks are forced to limit the amount of credit they provide if they lack the necessary equity capital. This risks a credit crunch. The US savings & loan crisis in the 1980s demonstrated that under the threat of bankruptcy, managers of over-indebted banks are prone to risky behaviour in attempt to rescue their institutions from failure (Schäfer and Zimmermann 2009b). Such risky behaviour is known as “gambling for resurrection” (Freixas, Parigi, Rochet. 2003).

Efficient design for a public bad bank: Key challenges

A public bad bank must be in a position to address numerous challenges. First, the transparent removal of troubled assets is necessary in order to ensure that the rescued bank has real prospects for a fresh start. Second, the costs of the bailout for the taxpayer should be minimised. Third, no incentives or new opportunities for opportunistic behaviour in the future should be created. To do this, the implemented bad bank model should limit the potential for “hold-up” problems while emphasising to shareholders and executives that entrepreneurial failure is a real possibility.

The toxic assets currently plaguing the German banking system are for the most part complex mortgage-backed securities originating in the US housing market. The anonymity of the US-based original borrowers and the large number of intermediate institutions involved in the packaging and onward sale of these securities represent serious impediments to the identification of the relevant counterparties for debt restructuring. Hence, there are fewer instruments available for restricting the bad bank’s losses than in the past. Basically, the tools are limited to the purchase price, the securing of additional time to sell assets at an opportune moment, and the governance structure of the bad bank.

Key elements of the proposed bad bank design

Our proposed bad bank plan consists of the following key elements in order to address the challenges:

• Troubled assets should be valued based on current market prices prior to their takeover by the bad bank. Troubled assets for which there is no market should be transferred to the bad bank at a zero price and therefore at zero cost for the government as the bad bank’s sponsor.
• The government should recapitalise the rescued bank (the remaining good bank) through the acquisition of a shareholder stake; in extreme cases, the remaining good bank should be taken over by the government.
• The bad bank should be funded by the government. External experts should be entrusted with the management and future sale of the troubled assets at the government’s expense. If a profit remains after the proceeds from holding the troubled assets until expiration date or selling those assets to the market have materialised and operating costs have been deducted, these profits should be distributed to the former shareholders.
• The government should announce its commitment to the future re-privatisation of its stake in the rescued bank. When establishing a bad bank, the government should make a binding commitment to how long it has to sell its shares in the good bank following the closure of the bad bank.
• All “systemically relevant” banks should be identified and required to participate in the plan.

The takeover of toxic assets by the government at zero cost and the corresponding write-down of assets will create transparency, avoid the high expense of pricing distressed assets, and insure that shareholders are the first ones to bear the cost of failure. The risk of moral hazard will also be effectively limited. A zero-cost acquisition is also justified based on the fact that the active management of the troubled assets is impaired by their complex structure. This approach will also keep the bad bank’s initial capital requirements at a minimum.

With the value of their toxic assets written down to zero, a number of banks will no longer meet the legislated core capital requirement. The government should take a stake in these banks in order to recapitalise them if they are unable to acquire sufficient private funds within a predetermined period of time. The prior removal of troubled assets will limit the risk taken on by the government and provide good prospects for the appreciation of its investment. The government’s risk of loss (through the bad bank) and opportunity for success (through the rescued good bank) would thus be clearly separated from one another. This would also contribute to transparency.

The government should bear the costs of running the bad bank and ensure that sufficient capital is available so that assets can be held until their date of maturity or an opportune moment for their sale. The risk of ex post exploitation for the party providing the initial capital would be limited by the acquisition of the assets at zero cost. The rule that profits of the bad bank should be returned would ensure that the former shareholders are not forced to suffer any unfair losses from the transfer of the troubled assets to the bad bank. In addition, proceeds from the resale of the government’s stake in the rescued bank would be used to cover the taxpayer’s initial investment for recapitalising the good banks and for possible losses incurred by the bad bank. In this case, the government would have no incentive to delay the resale of the stake it had taken in the rescued bank.

At the very most, the amount of funding that the government will need to provide to recapitalise the banking sector will equal the losses that accrue from the write-down of troubled assets – i.e. somewhere between €200 and €300 billion for Germany. The one-off set-up costs and annual operating costs for the bad bank have to be added to this.

The proposed design for a bad bank also provides the opportunity of solving the long-lasting problem of too many weak Landesbanken in Germany. These publicly owned regional banks are particularly affected by the financial turmoil. The majority of them is extremely debt-ridden and lacks a reliable business model. Our bad bank plan provides for an instrument that brings the central government in a strong shareholder position in the ailing Landesbanken. Mergers can be achieved much more easily if the party with the strong will to arrange the merging has also a strong shareholder position in the merger targets.

The bad bank plan of the German government

The German government’s bad bank program follows a different agenda than our proposal above. In its plan, government bonds are used to compensate the bank for the transfer of the toxic assets to the bad bank. These bonds burden the taxpayers’ with future debt owned by the participating bank. In addition, the program allows for the distribution of the losses over time and for a voluntary participation. Systemically important banks may gamble for resurrection in the sense that they dump the bad bank plan in order to avoid disclosure of losses and simply hope for better times. However, with such behaviour, the comeback of trust into the business models of the banking sector would most likely be undermined. In addition, the lacking intention of the central government to become a shareholder of the ailing Landesbanken is a severe obstacle to their consolidation.

References

Freixas, X., B. M. Parigi, J.-C. Rochet. 2003: The Lender of Last Resort: A 21st Century Approach, Working Paper Series 298, European Central Bank.
Schäfer, D. and Zimmermann K. F. 2009: Bad Bank(s) and Recapitalization of the Banking Sector, Discussion Paper 897 of DIW Berlin.
Schäfer, D. and Zimmermann K. F. 2009b: Federal Deposit Insurance: The Banking Crises of the 1980s and Early 1990s: Summary and Implications.

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