Bad banks: A financial do-over

Bad banks are not homes for [naughty bankers](. In fact, sometimes they’re run by the best and the brightest talent in the banking sector. These entities are created so that a bank that’s gambled and lost on risky investments can wall off problematic assets and reassure investors. The technique may sound shady, but it often succeeds in protecting the core business of a troubled bank. Some research indicates that the maneuver is the fastest way to recover from a banking crisis, according to Francesc Rodriguez Tous, a finance professor at Cass Business School in London. “You make a clean break from the problem,” he says. [That’s what Deutsche Bank is hoping](. Its new bad bank (it prefers the term “Capital Release Unit”, for fairly obvious reasons) will house some €74 billion ($83 billion) of risk-weighted assets (€288 billion of leveraged exposure). That amounts to around 20% of the Frankfurt-based bank’s balance sheet. This division will [reportedly]( hold dodgy loans, as well as businesses that Deutsche Bank is exiting, like some stock trading operations. The German bank has been here before. In 2012 it created a bad bank to get rid of wealth management and retail banking businesses. The move made Deutsche Bank stronger, by some financial standards, but it was also expensive, taking nearly [€14 billion]( of losses according to Bloomberg’s calculations. Let’s take a look at the balance sheet. 🐦 [Tweet this!]( 🌐 [View this email on the web]( [Quartz Obsession] Bad banks July 19, 2019 When banks misbehave --------------------------------------------------------------- Bad banks are not homes for [naughty bankers](. In fact, sometimes they’re run by the best and the brightest talent in the banking sector. These entities are created so that a bank that’s gambled and lost on risky investments can wall off problematic assets and reassure investors. The technique may sound shady, but it often succeeds in protecting the core business of a troubled bank. Some research indicates that the maneuver is the fastest way to recover from a banking crisis, according to Francesc Rodriguez Tous, a finance professor at Cass Business School in London. “You make a clean break from the problem,” he says. [That’s what Deutsche Bank is hoping](. Its new bad bank (it prefers the term “Capital Release Unit”, for fairly obvious reasons) will house some €74 billion ($83 billion) of risk-weighted assets (€288 billion of leveraged exposure). That amounts to around 20% of the Frankfurt-based bank’s balance sheet. This division will [reportedly]( hold dodgy loans, as well as businesses that Deutsche Bank is exiting, like some stock trading operations. The German bank has been here before. In 2012 it created a bad bank to get rid of wealth management and retail banking businesses. The move made Deutsche Bank stronger, by some financial standards, but it was also expensive, taking nearly [€14 billion]( of losses according to Bloomberg’s calculations. Let’s take a look at the balance sheet. 🐦 [Tweet this!]( 🌐 [View this email on the web]( Giphy Brief history [1988:]( Mellon Bank pioneers the bad bank. [1989:]( US president George H.W. Bush unveils the savings and loan bailout plan. [1992:]( In the aftermath of its own banking crisis, Sweden [nationalizes]( much of the sector. [1994:]( France bails out Crédit Lyonnais. [1997:]( The Asian financial crisis spreads from Thailand across East Asia. [1998:]( Indonesia establishes the Indonesian Bank Restructuring Agency to stabilize the financial sector in the face of massive debt. [2008:]( Lehman Brothers collapses. [2009:]( Swiss bank UBS starts a bad bank. [2012:]( Deutsche Bank sets up its first bad bank. [2014:]( Barclays launches a bad bank. [2018:]( India debates setting up bad banks amid a wave of souring loans. [2019:]( Deutsche Bank starts a second bad bank. Explain it like I’m 5 Bad banks do what now? --------------------------------------------------------------- When a financial company has made a bunch of risky loans that have gone sideways, it becomes difficult for the company’s investors to assess how much its assets are worth. Are all of the loans and other types of securities going to go sour and default? Half of them? A quarter? When investors can’t answer those questions, they may avoid the bank for fear that it could default. This can make it difficult for the bank to secure new funding and roll over its debts, cutting off its financial oxygen. A dangerous loop begins: A bank is vulnerable because it has risky loans on its books and can’t raise cheap funding to make more loans. That makes the bank less profitable, making it harder to pay its debts, making it even more likely to default, feeding a cycle that increases the chances of the bank collapsing. Enter the bad bank. Something has to break the cycle and that’s where the bad bank comes in. A bank that’s stuck with dud loans can try to draw a line under the crisis by taking those assets, putting them in a new entity (that’s the bad bank), and taking an accounting loss. This, in theory, is a come-to-Jesus moment: The bank has accepted the losses and made them transparent to investors, who now have a better understanding of what they’re dealing with. Assuming those losses haven’t eaten through the bank’s capital, and it’s still a sound institution, the bank can get on with life, attract investors again, and start anew. In some cases, the assets it quarantines in the bad bank turn out to be not so sour as feared, and give the parent company a boost when they mature or are sold on. Sponsored by Envision Virgin Racing Watch the highlights --------------------------------------------------------------- A leader in race car driving takes on climate change. We joined the Envision Virgin Racing Formula E Team in Brooklyn for their Innovation Summit, where global business figures and leading sustainability experts debated how best to tackle climate change.[Click for more.]( Reuters/Suzanne Plunkett Quotable “It’s quite an Orwellian term if you ask me.” —[Olaf Storbeck]( Frankfurt financial correspondent for the Financial Times, on Deutsche Bank’s “Capital Release Unit.” Charted [Deutsche Bank]( latest, massive restructuring—which includes a bad bank—may be hogging the headlines lately, but there have been a number of bad banks since the financial crisis in 2008, many of which were much bigger than either of Deutsche Bank’s bad banks. Giphy Origin story The first big bad bank --------------------------------------------------------------- When financial types talk about the first bad bank, they’re usually referring to Mellon Bank, which pioneered the technique in 1988. The Pittsburgh-based company binged on loans to Latin America, the oil industry, and real estate developers, and it needed a way out. Technically speaking, Grant Street National Bank was the first bad bank: that was the entity that problem loans were stuffed into. (It was named after the street where Mellon Bank was located.) Grant Street raised money by issuing bonds and preferred stock. It (the bad bank) used that money to buy problem loans from Mellon (the good bank). Grant Street paid $577 million, according to [Bloomberg News]( a discounted price of 41 cents on the dollar for the problematic assets. Bankers and regulators had their doubts about the plan, but it worked. Grant Street was laser-focused on selling the assets—the bonds and preferred stock yielded as much as 17%, giving the bankers a major incentive to pay investors back as quickly as possible. Four years later (and five years ahead of schedule), specialists had unloaded just about all the bad bank’s assets. Mellon Bank CEO Frank V. Cahouet, meanwhile, was just as focused on reinventing his company. The strategy allowed management to get back to business—lending money and making acquisitions—instead of worrying about souring loans. In 2008, as the global financial system teetered and a few days before Lehman Brothers collapsed, the [Wall Street Journal]( published an interview with Michael Bleier, the former Mellon general counsel who worked on the “bad bank” spinoff in the 1990s, which some credited with saving the bank. The technique would become a vital part of restructuring the American banking industry in the months ahead. “You allow management to focus on the future, not having to deal with the problem assets,” Bleier said. “The good remaining piece is in a stronger financial position, therefore its funding is cheaper and you get a direct impact on your earnings.” Have a friend who would enjoy our Obsession with Bad banks? [ [Forward link to a friend](mailto:?subject=Thought you'd enjoy.&body=Read this Quartz Obsession email – to the email – Fun fact! Bad banks don’t just hold loans and securities. Bankers can throw all sorts of things they don’t want in there, like businesses they want to exit. [Deutsche Bank’s bad bank in 2012]( was used to sell off casinos and a New Jersey port. Giphy By the digits [$1.4 billion:]( Size of Mellon Bank’s bad bank in 1988 [$160 billion:]( Cost of the savings and loan crisis [$700 billion:]( Size of the US bailout program (Troubled Asset Relief Program, better known as TARP) in 2008 [$15.3 billion:]( Profit the US government made on TARP when it was closed in 2014 [$1 trillion:]( Size of Bank of America’s bad bank in 2011 Listen to this! What the hell happened in 2008? --------------------------------------------------------------- [This American Life]( explains the banking crisis in 59 minutes: “The problem is not the banks, greedy though they may be, overpaid though they may be. The problem is us. We have overborrowed.” Getty Images / Oli Scarff Pop quiz How many US banks defaulted in 2009, the year after Lehman fell? 110180150140 Correct. Incorrect. If your inbox doesn’t support this quiz, find the solution at bottom of email. Billion-dollar question What happens to the bad bank? --------------------------------------------------------------- The bad bank is just something that holds a bunch of unwanted assets, which may be delinquent or overly complex or problematic for other reasons, meaning it’s hard to know what they are worth. Some investors who specialize in buying shaky assets on the cheap will look out for the hidden diamonds and come along to purchase them. In other cases, the specialists who run the bad bank will slash prices to find a buyer. These entities are temporary, perhaps lasting a few years, or however long it takes for the problem assets to either be unloaded to new owners, mature, or default. Bad banks aren’t all bad news. In 2014, [Royal Bank of Scotland]( made some money from its problem bank when its losses proved less severe than expected. Running a bad bank can be a resume booster. Depending on how they’re structured, executives may rope in the financial institution’s brightest talent. Problem portfolios are complicated, and are designed to cope with a potentially existential danger to the bank. People working in a bad bank get a hell of a learning experience, because [it’s a crash course in]( “chasing delinquent payments, restructuring complex securities, and bargaining with potential buyers.” One notable bad-bank alum is [Michael Corbat]( who used to run Citigroup’s. Now he runs the whole darn company. take me down this 🐰 hole! Quartz has been obsessed with bad banks for years. Check out this [“bad bank”]( reader we published in 2014 if you’re feeling a little obsessed, too. AP Photo/Hussein Malla Poll Do you trust your bank to keep your money safe? [Click here to vote]( Of course, the money is backed by the government. What could go wrong?Not entirely but I don’t have much choice.Nope—I keep my cash in my freezerI’ve gone full crypto 💬let's talk! 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