Jonathan A. Neuberger

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 92-18, May 1, 1992
Is a Bad Bank Always Bad?
On a small number of occasions during the past
several years, bank holding companies have
chosen to clean up the balance sheets of their
subsidiary banks by collecting nonperforming
loans and spinning them off to a separate sub-
sidiary. The new entity, sometimes referred to as
a "bad bank:' then becomes the locus of the
company's workout efforts, and simultaneously
allows it to create a healthier balance sheet for
the primary bank, or the "good bank:'
On the surface, this form of corporate restructur-
ing appears to be little more than a reshuffling
of assets among differellt holding company sub-
sidiaries. Vievv'ed in this light, it is difficult to see
whyany bank holding company would go through
the trouble. However, there may be regulatory
reasons as well as market incentives for choosing
this form of corporate reorganization. In this Let-
ter/ I discuss the basic characteristics of the good
bank/bad bank spinoff and present arguments
both for and against this mechanism. I also con-
sider factors that may contribute to greater use of
this approach in the future.
The good bank/bad bank split
While there is no such thing as a typical good
bank/bad bank spinoff, the process generally
starts with a perceptioll by management that
nonperforming loans are imposing a particularly
heavy burden on the bank. This situation may
arise as the result of acquiring another bank or
completing an FDIC-assisted purchase of an
ailing institution. It also may be the result of re-
gional or national ecanomic weakness that has
left its mark on the bank's loan portfolio.
The burden of carrying the impaired loans often
includes costly workout efforts within the bank
that can distract loan officers from servicing good
loans or developing new business. Moreover, a
high proportion of subpar loans likely encourages
stricter scrutiny from bank examiners, thereby
imposing additional regulatory costs on the bank.
Finally, the announcement of large loan losses
often leads to a market reassessment ofthe via-
bility of the bank; possibly depressing equity
share prices.
Traditionally banks deal with this situation by
establishing or expanding a separate internal
group to handle the problem credits, thus con-
centrating their most appropriate personnel and
other resources on working out the problem
loans. Some institutions, however, have deter-
mined that it is more cost effective to establish a
separate corporation, to pool questionable assets
and transfer them to that corporation, and to
concentrate workout efforts outside the primary
bank. In many cases, the sole purpose ofthe new
entity is to dispose ofdelinquent assets and, even-
tually, liquidate itself. For this reason, the bad bank
is sometimes referred to as a self-liquidating trust.
At first glance, there appears to be little to dis-
tinguish the traditional method of dealing with
problem assets from the bad bank approach. This
is especially true ifthe holding company does
not sell off a portion of the bad bank to outside
investors. Under these circumstances, the non-
performing assets are still held by the holding
company, the problem loans continue to com-
mand resources from one or another of the par-
ent's subsidiaries, and losses arising from the
nonperforming loans affect the consolidated
holding company's income statement and bal-
ance sheet. However, in order for the holding
company to adopt the apparently costly ap-
proach of establishing a separate subsidiary,
there must be some value to segregating the
bank's problem loans outside the primary bank.
The source ofthis value is not immediately
apparent.
Origins of the bad bank approach
Interestingly, the good bank/bad bank spinoff has
its origins in the resolution policies of banking
and thrift regulatory agencies. When these agen-
cies take control of an insolvent institution, the
most frequently used resolution technique is the
so-called "purchase and assumption" transac-
tion. In this transaction, regulators arrange foraFRBSF
solvent institution to purchase the failed bank's
assets and assume its deposit liabilities.
In many cases, the failed bank or thrift has very
little in the way of performing assets, so the reg-
ulatory agencies must provide some inducement
to the purchaser to consummate the transaction.
This inducement typically involves purging the
asset portfolio of most or all ofthe problem cred-
its, leaving a relatively "clean" bank for the
acquirer. Of course, the government is left hold-
ing the bad assets, and must dispose of them in
the open market. Such disposal is often difficult,
as is apparent from the huge expenses incurred
by the FDIC in recent years.
When an operating financial institution adopts a
good bank/bad bank format, it usually does not
have the option of selling the bad assets to the
government. Instead, the good bank sells the
probiem ioans to the bad bank at a price that
may be substantially below book value. As a re-
sult, this sale typically involves substantial losses
for the good bank. Some of this loss is absorbed
by the bank's loan loss reserve. If the reserve is
insufficient to absorb all of the losses, however,
bank capital may be depleted. Depending on the
bank's capital position, it may need to obtain
additional funding to replenish bank capital and
restore the loan loss reserve to a level acceptable
to bank regulators.
Funding the bad bank
In principle, the holding company has a variety
of options available for financing the transaction.
Typically, it will choose some combination of
equity and debt to fund the bad bank spinoff. For
example, the holding company can issue new
equity, and spin off ownership of the bad bank to
(new and old) shareholders through a stock divi-
dend in the form of shares in the bad bank. It
also can sell various forms of senior and subor-
dinated debt to investors. The proceeds of this
funding pay for the purchase of the assets by the
bad bank, the capitalization of the bad bank,
and rebuilding the capital position of the good
bank.
Ofcourse, alternative methods of financing the
bad bank spinoff may have different effects on
the holding company and its investors. At one
extreme, the holding company could choose a
financing strategy that leaves it or one of its sub-
sidiaries as the only shareholder or creditor of the
bad bank. This would occur, for example, if the
holding company issued new debt, and subse-
quently "lent" it to the bad bank. In this case,
the holding company has done nothing to rid
itself ofthe bad bank's substandard assets. Con-
sequently, its consolidated earnings and capital
will directly reflect over time the performance of
the bad bank's liquidation efforts.
At the other extreme, the holding company could
choose a complete divestiture of the bad bank by
selling it entirely to outside investors. Here, the
bad assets are completely removed from the hold-
ing company's books, leaving a clean institution.
In practice, a funding approach between these
two extremes is typically used, with the holding
company maintaininga diluted interest in the
bad bank. In this way, it is able to share the risk
of the bad bank's activities with outside investors
while still maintaining some control over the
liquidation process. This dilutive funding also
reduces the impact of the bad bank's impaired
assets on the holding company's financial
position.
Is the bad bank a good idea?
Proponents of the good bank/bad bank spinoff
argue that segregating good from bad assets en-
ables the banking firm to manage the bad assets
more efficiently. By concentrating workout efforts
in the bad bank, they claim, the company can
take advantage of economies of "management
specialization" that would not be available under
alternative corporate structures.
Another argument in favor of the bad bank ap-
proach relates to investors' demands for bank
assets. According to this argument, the assets
held by the good bank may appeal to one type
of investor while the problem assets ofthe bad
bank may appeal to another type. Bad bank assets
may require considerable time before a settle-
ment can be negotiated between borrowers and
lenders. Investors in the bad bank also may need
patience to ride out temporarily depressed con-
ditions in real estate and other markets. As a
result, these investors must have a longer invest-
ment horizon and be willing to hold riskier assets
than more traditional bank investors. By segre-
gating the assets, it is claimed, the bank holding
company may be able to attract investors whose
demands are more in line with the specific asset
characteristics of the good and bad banks. If this
is true, then with the same portfolio the good
bank/bad bankmay command a better price in
the market than the original bank.Of course, the good bank/bad bank approach
has not received universal support in financial
markets. Detractors argue that there is little or no
advantage to the expensive process of creating
and funding a separate holding company sub-
sidiary. Any efficiencies that a specialized work-
out group can accomplish in a bad bank, they
argue, also can be realized by a similar effort
within the original bank. Moreover, transferring
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good bank of its best credit evaluation staff.
The response of investors also has not been uni-
formly positive. Most notably, some of the earlier
spinoffs in the late 1980s were greeted by signif-
icant declines in holding company share prices.
Part ofthis negative impact probably was due to
announcements that funding for the bad bank
(say, by the issuance of new holding company
stock) would significantly dilute the holdings of
existing shareholders. Additional negative re-
sponse may have been the result ofthe bank's
recognition of loan losses with immediate charge-
offs once the problem credits were transferred to
the bad bank.
Additional considerations
As the preceding discussion indicates, differ-
ences of opinion persist regarding the desirability
ofthe good bank/bad bank spinoff. However, sev-
eral additional considerations generally weigh in
favor.of the spinoff approach. The first of these
relates to the treatment of the bank by regulators.
A bank with a large portfolio of nonperforming
assets likely will receive particularly close scru-
tiny by bank examiners. Such scrutiny involves
substantial costs to the bank, both in terms of
more frequent examinations and, perhaps, stricter
application of examination standards. These
costs likely will become more important in the
future, as recent bank legislation has mandated
progressive discipline for banks with lower cap-
ital levels. If a bank can alleviate some of this
regulatory pressure by cleaning up its loan port-
folio, selling problem assets to a subsidiary, and
replenishing bank capital, then the good bank/
bad bank approach may be worth the costs of
creating and funding the new entity.
Moreover, spinoffs often are accompanied by de-
mands from regulators that the holding company
dilute its holdings in the bad bank by selling a
portion of it to outside investors. By sharing the
risks involved with restructuring or liquidating
the bad bank's assets, the holding company can
reduce its overall financial risk. In fact, if the
holding company is no longer a majority share-
holder in the bad bank, it may not be required to
include the activities ofthe bad bank in its con-
solidated balance sheets and income statements.
Finally, the spinoff of the bad bank may actually
help to overcome problems related to informa-
tion asymmetries in financial markets. When the
good and bad assets are combined in the same
institution, it may be difficult for outside investors
to value the bank accurately. This problem may
be particularly acute in the bidding for failed
banks. Unsure about the extent of problem loans
in the banks' portfolio, investors may assume the
worst and require a premium before they will in-
vest. By spinning off the bad assets, and leaving a
clean portfolio,the good bank/bad bank split may
reveal important information about the condition
of the tvvo institutions and enable investois to
make more accurate assessments of risk and ex-
pected return.
Will the process continue?
With the expected continuation of consolidation
in the bankingindustry, it is likely that the good
bank/bad bank spinoff will become more com-
mon in the future. Financial markets have gotten
used to the spinoff idea and seem more willing
to accept this type of transaction as a reasonable
form of corporate reorganization. Moreover, if
such a transaction can alleviate regulatory pres-
sures, then the costs of the spinoff are mitigated.
And if regulators want to encourage the purchase
of weak institutions by healthier ones, the good
bank/bad bank approach may actually deepen
the market for bank assets and bring needed
capital to the banking industry.
Jonathan A. Neuberger
Economist
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
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Is a bad bank always bad?

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Is a bad bank always bad?

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