‘Bad Bank’ Report Links Recovery Prospects to Economic Improvement

Fitch Ratings says that bad bank schemes implemented post-2008 were an aid to economic stability but continue to be challenged, due primarily to the prolonged economic downturn. At the same time many ‘good’ banks emerging from these schemes are struggling with the challenge of implementing a new strategy in a difficult market environment.

The report, entitled ‘Bad Bank Schemes: Recovery Prospects Will Depend on Economic Improvement’, comes at a time when a new bad bank scheme, the Sociedad de Gestion de Activos Procedentes de la Reestructuracion Bancaria (SAREB), is about to be established in Spain. SAREB will facilitate winding down non-core and non-performing banking assets. Details are yet to emerge around ownership, funding and the volume of assets.

Fitch says that under bad bank schemes ‘good’ banks transfer their weaker and non-core asset portfolio to a run-off institution so as to benefit from improved asset quality, stronger capitalisation and increased confidence from the capital markets. Alternatively, viable business can be transferred to a newly established ‘good bank’ and the legacy entity (bad bank) is run down. Bad bank structures became more commonplace after the onset of the financial crisis as they helped to stabilise the financial sector by preventing the widespread failure of ailing banks.

Bad banks are mostly financed by asset redemptions or repayments and often also by annual levies paid by the sector’s banks. They may be part of a resolution scheme that would also include imposing burden-sharing on subordinated debt holders as a way of relieving the risk borne by the state. Initial funding is often provided by the state, which has put further pressure on public finances in Ireland, for example, but is a less important part of the national budget in other countries. In addition, the state guarantee given to some bank issuances also increases the level of contingent liabilities to be borne at a sovereign level.

Good banks that were initially nationalised are in many cases still state-owned, and privatising these banks is likely to be challenging in current market conditions. In restructuring it has been common for good banks to return to their traditional core activities, which are typically lower-risk and more domestically focused than their pre-crisis strategies. Such business focus should make profitability less volatile in the long term, although the increasing focus on lower-risk business puts profit margins under pressure. In addition, the costs of downsizing bank operations in non-core areas can be high in the short term.

Where a viability rating has been assigned to a good bank this is often much lower than the bank’s support-based long-term international depository receipt (IDR), reflecting the challenge of successfully implementing a new business model in the current market.

Finding an appropriate valuation for assets to be transferred to the bad bank is challenging given the continued uncertain market environment. Many bad bank assets are related to real estate, which is particularly vulnerable to market fluctuations. The use of external valuation experts helps to mitigate the risk of further losses, although subsequent fluctuation in asset values is dependent on market developments.

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