A bad bank, also known as an aggregator bank or a collection bank, is a bank which purchases nonperforming assets to remove these assets from the books of other banks. If all banks cooperate with the bad bank, the bad bank essentially sequesters such assets so that they cannot drag down the credit ratings and performances of other banks. The bad bank can in turn sell those assets, invest them, or dispose of them in other ways.
The point of a bad bank is to help resolve a financial crisis caused by an abundance of nonperforming assets on the books of major banks. Nonperforming assets or “toxic assets” are assets which theoretically have a value, but are considered unsalable because no one wants to buy them. A bank with nonperforming assets has a lot of money on paper, but less access to cash in reality, and this can cause a credit crisis, as banks struggle to raise funds for daily operations and start restricting lending.
Several governments have used bad banks to address credit crises before they get worse. In order for this technique to be effective, many economists agree that it must satisfy several criteria. In the first place, the bank is run by the government, or by a government agency which insures bank deposits, and it is usually set up as a self-liquidating trust, which means that after the mission of the bank is accomplished, it is dissolved. The bad bank is a nationalized bank, run by and for the people, a concept which some nations have difficulty with.
Another critical factor is a cooperation agreement involving multiple banks. If Banks A, B, and C agree to sell their nonperforming assets to the nationalized bank, and Bank D doesn't go along with the plan, the market will continue to be unstable. Finally, nonperforming assets must be written down before they are sold to the bad bank. In other words, banks cannot demand “fair market value” or the paper value of their toxic assets. They must agree to write down the total debt and pay a loss to get the asset off their books.
If a bad bank buys up toxic assets at fair market price, it will be a very expensive endeavor. Since the funds to buy the assets come from the government, this could bring the national economy to its knees, as substantial funds become tied up in managing toxic assets. This can prolong the financial crisis which precipitated the formation of the bad bank in the first place.
Bad banks are only one of many potential solutions to an economic crisis, and they must be weighed carefully, along with the other options. The tendency to panic when faced with financial crises on the part of government officials can contribute to some very bad decisions which may have long-lasting repercussions, making it important to avoid rushing into any particular plan of action, from a bad bank to a stimulus plan.