Bad Banks and Recapitalisation

This working paper by Dorothea Schäfer and Klaus F. Zimmermann “Bad Bank(s) and Recapitalization of the Banking Sector” is interesting in the context of the NAMA debate. Paper is here.  Abstract below:

With banking sectors worldwide still suffering from the effects of the financial crisis, public discussion of plans to place toxic assets in one or more bad banks has gained steam in recent weeks. The following paper presents a plan how governments can efficiently relieve ailing banks from toxic assets by transferring these assets into a publicly sponsored work-out unit, a so-called bad bank. The key element of the plan is the valuation of troubled assets at their current market value – assets with no market would thus be valued at zero. The current shareholders will cover the losses arising from the depreciation reserve in the amount of the difference of the toxic assets’ current book value and their market value. Under the plan, the government would bear responsibility for the management and future resale of toxic assets at its own cost and recapitalize the good bank by taking an equity stake in it. In extreme cases, this would mean a takeover of the bank by the government. The risk to taxpayers from this investment would be acceptable, however, once the banks are freed from toxic assets. A clear emphasis that the government stake is temporary would also be necessary. The government would cover the bad bank’s losses, while profits would be distributed to the distressed bank’s current shareholders. The plan is viable independent of whether the government decides to have one centralized bad bank or to establish a separate bad bank for each systemically relevant banking institute. Under the terms of the plan, bad banks and nationalization are not alternatives but rather two sides of the same coin. This plan effectively addresses three key challenges. It provides for the transparent removal of toxic assets and gives the banks a fresh start. At the same time, it offers the chance to keep the cost to taxpayers low. In addition, the risk of moral hazard is curtailed. The comparison of the proposed design with the bad bank plan of the German government reveals some shortcomings of the latter plan that may threaten the achievement of these key issues.

One reply on “Bad Banks and Recapitalisation”

The reason for taking on the good performing loans as well as the bad non-performing loans:
“If a market price for an asset does not exist, then the bank being relieved of the asset has an informational edge over the buyer. In this state of affairs, “lemon market” effects are likely. An ailing bank will only transfer assets to a bad bank which have a value below the agreed-upon average price. As a result, the bad bank pays inflated prices and generates losses. In this scenario, an excessive burden is also borne by the taxpayer in the recapitalization of the banking sector.”

The priorities/goals (Note that the socialisation of profits and gain as favoured by Minister Lenihan is not one of them):
“A public bad bank must be in a position to address numerous challenges. First, the transparent removal of troubled assets is necessary in order to ensure that the rescued bank has real prospects for a fresh start. Second, the costs of the bailout for the taxpayer should be minimized. Third, no incentives or new opportunities for opportunistic behavior in the future should be created. ”

The stake in the good bank is seen as a way of offsetting the expected losses on the assets. Taking an equity stake in the cleansed bank is seen as necessary but full nationlisation is a last resort:
“The government should recapitalize the rescued bank (the remaining good bank) through the acquisition of a shareholder stake; in extreme cases, the remaining good bank should be taken over by the government.”
Ownership of the bank by the state is seen as assisting the bank behave properly in valuations. It appears that partial ownership is seen as sufficient. No doubt many would say total ownership is required.

It is assumed that the bad bank will have to be capitalised. I don’t know if this is for banking rules or just for financial credibility. It is suggested that taking some assets at zero value will lessen capitalisation requirements:
“The takeover of toxic assets by the government at zero cost and the corresponding writedown of assets will create transparency, avoid the high expense of pricing distressed assets, and will insure that shareholders are the first ones to bear the cost of failure. The risk of moral hazard will also be effectively limited. A zero-cost acquisition is also justified based on the fact that the active management of the troubled assets is impaired by their complex structure. This approach will also keep the bad bank’s initial capital requirements at a minimum.”
Do people think this applies to NAMA?

Note that corollary of zero cost acquisition is reimbursement for the shareholders if a profit is made. Again there is no socialisation of gains:
“The risk of exploitation for the party providing the initial capital would be limited by the acquisition of the assets at zero cost. The rule that profits of the bad bank should be returned would ensure that the former shareholders are not forced to suffer any unfair losses from the transfer of the troubled assets to the bad bank.”

I can’t get my head around the hold-up problem of potential ex post exploitation. Does this refer to the bad bank having to sell assets in a fire sale because its capitalisation falls below the regulatory minimums?:
“If the government provides 100 percent of the financing – whether in the form of liquid capital or government securities – future losses suffered by the bad bank must be borne first by the taxpayer. The greater the amount paid initially for the troubled assets, the higher the risk of future losses. The participation of the private sector in absorbing these losses can be achieved through negotiation once the bad bank’s final operating result is forthcoming. Alternatively, fixed terms for the distribution of losses can be agreed upon in advance. Such terms cannot foreclose all possibility of future renegotiation, however. In this way, the government is subject to the hold-up problem. This latent threat of potential ex post exploitation rises in direct relation to the amount of funding initially provided to establish the bad bank.”
Is this a uniquely German problem?

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