'Bad Bank' Model May Be Best Exit from Financial Crisis for Many Banks

by: Research Recap

McKinsey makes the case for a “bad bank” solution to dealing with toxic assets in a new paper. However, the choices entailed are not straightforward.

McKinsey notes that after two years, the fallout from the financial crisis continues to afflict most banks, particularly those with significant levels of illiquid and difficult-to-sell securities—the so-called toxic assets, and especially collateralized mortgage obligations (CMOs), collateralized debt obligations (CDOs), and collateralized loan obligations (CLOs) With these assets still on the balance sheet, banks are finding it difficult to raise funds from wholesale markets or capital from equity investors. Short-term funding spreads are slowly returning to precrisis levels, but they are still well above the levels seen in the early part of this decade—this despite the still-significant support (including quantitative easing, repurchase programs, loan guarantees, liberalized collateral requirements, and so on) from the central banks.

Finding funds will soon get more difficult. Regulators are preparing new capital requirements and other changes that will impose fearsome new burdens on banks.

In response, banks are pursuing several channels. Most obviously, they are getting out of capital-intensive and structured businesses—in a word, deleveraging. They are pulling back from international operations to concentrate on domestic business. And they are dramatically overhauling their risk functions. All these steps are necessary and proper—but they may be insufficient. Capital is still scarce. Banks are still overleveraged, and unsalable assets still carry too much risk. Confidence is still wanting; so long as the illiquid assets sit on banks’ shelves, investors will be wary.

Hence the return of the bad bank. Dividing in two can help stricken institutions ring-fence their core businesses and keep them separate from the contamination of toxic assets. The separation allows the bank to lower its risk and to deleverage as first steps toward creating a sound business model for the future. A more efficient and focused management with clear incentives for portfolio reduction can maximize the value of bad assets. And the clear separation of good from bad can help banks regain the trust of investors, by providing more transparency into the core business and lowering investors’ “monitoring costs.” All these benefits do not, however, come for free: there are still economic losses and risks on the balance sheet that must be shared between the good-bank and bad-bank investors.

In sorting through the various structures banks are using today, we have identified five sets of choices that go a long way toward determining the bad bank’s structure and operations and eventual success. The paper explores each of these five variables here. (Click to enlarge)

Bad banks