1. Skip to content
  2. Skip to main menu
  3. Skip to more DW sites

Bad banks

November 25, 2009

In the case of the WestLB rescue, Germany is for the first time creating a "bad bank" as an answer to the crisis. But what exactly is a bad bank, and how does the concept work?

https://p.dw.com/p/Kg4O
Crane hook in front of WestLB logo
The future of WestLB hangs on regulators' bad bank strategyImage: picture-alliance/ dpa

A bad bank is a financial institution created to hold non-performing assets owned by a state-guaranteed bank. Regulators set up a government-controlled fund to buy loans which have lost most or all of their value -- so-called toxic assets. The bad bank then holds the loans until they've eventually been repaid.

One of the best-known examples of a bad bank is Securum, a bank that was founded to take on bad assets during Sweden's financial crisis of 1991 and 1992. Securum was managed as an independent company, with the aim of disposing of its assets at a minimal cost to taxpayers.

A good bad bank?

According to David Roche, president of the London-based consultancy Independent Strategy, Securum is an example of a "good" bad bank.

"A good bad bank forces banks to write down their bad assets and cleanse their balance sheets with those made insolvent being recapitalized, nationalized or liquidated by the state," Roche wrote in an article for the Wall Street Journal at the beginning of the year. "But it is equally possible to use a bad bank to buy the banks' toxic waste at inflated prices so that the bank can start lending again. That's when it becomes a bad bad bank."

He adds that, until now, policy makers in the United States and Europe have rejected the good bad bank approach, with the result that "we are now entering the third year of credit crunch with most banks already on their knees."

A rubbish skip in front of a Hypo Real Estate sign
The bad bank option has also been floated as possible solution for Hypo Real Estate

The decision by German policy makers to adopt the bad bank strategy in the case of WestLB is therefore something of a milestone. WestLB is seeking to offload some 85 billion euros worth of toxic assets into the bad bank, which will be spun off by April 2010. The bank will get three billion euros in capital from WestLB and one billion euros in guarantees from shareholders to cover potential losses from the portfolio.

"The idea of the bad bank has been around for a while, but so far, few banks have taken advantage of this instrument," said Martin Ruckes, professor at the University of Karlsruhe's Institute for Finance and Banking, adding that banks given a government guarantee against failure don't have enough of an incentive to form a bad bank.

For Ruckes, it's a missed opportunity. "The benefit is that you can separate the toxic assets, meaning that banks would be more willing to lend. If more banks chose this option, the discussion about the credit crunch wouldn't be as prevalent as it is now."

The final details of the rescue plan still have to be hashed out, so whether WestLB's spin off turns out to be a good bad bank or a bad bad bank remains to be seen.

Reporter: Deanne Corbett
Editor: Sam Edmonds