Cyprus Mail
Business Cyprus

What is a ‘bad bank’?

By Angelos Anastasiou

A BAD bank would buy up toxic assets from troubled banks – for example, non-performing loans (NPLs) – at a discount and then try to sell any collateral for profit, if possible.

Government-backed bad banks have traditionally been vehicles of moral hazard. When failing banks are rescued by a bad bank buying up their non-performing assets, the burden of risk is automatically transferred from the person who made the risky banking decisions to someone else, which of course roughly translates to a blank cheque for bankers.

But that’s not the only problem with such solutions to banking crises. A bad bank would be established to buy assets – in this case, NPLs – from cash-strapped lenders, thus enhancing liquidity and facilitating credit in the local market, but would by definition be buying delinquent assets, i.e. the ones most likely to eventually default. So, the people providing the capital for the bad bank stand to lose much of their money.

The key point in the operation of an entity that would absorb toxic assets would be reaching agreement on the assets’ price.

The bad bank would go after as high a discount as possible, while the distressed bank would seek to minimise its losses by negotiating a price as close to the assets’ book value as possible.

The view that creating a bad bank is “one of the most important ways of normalising a banking system after a crisis” was aired in a February 2012 blog entry by Panicos Demetriades, two months before he was appointed Governor of the Central Bank of Cyprus, a post he has recently resigned but will retain until mid-April. In his commentary, Demetriades noted that although not necessarily suitable for Cyprus, the concept of a bad bank “merits careful consideration and debate.”

It was also one of the proposals of the Independent Commission on the Future of the Cyprus Banking Sector in its October 2013 report, which was commissioned by the Cyprus government and the Central Bank, only to be ignored.

“In our final report we said that the bank needs to be separated from its toxic assets, which should be bought up by a bad bank,” commission member and former BoC senior manager Yiorgos Charalambous said. “This was in October, and still nothing has been done.”

The bill for assets acquired by bad banks has traditionally been footed by governments – i.e. taxpayers – but if private investors were to be found, willing and able to gamble on the prospect of an economic recovery that would raise the assets’ value, the question of moral hazard vanishes. This is what Bank of Cyprus CEO John Hourican was alluding to when he spoke of “a private solution that doesn’t burden the Cyprus state,” but it’s easier said than done.

“Finding private investors to fund a bad bank is certainly a possibility,” Charalampous said. “Of course the negotiation (over the assets’ price) that will follow will probably take some time, during which the state of the BoC is bound to worsen, thus weakening its leverage – this is why the delay in making decisions has been disastrous.”

“Things would have been much different last summer, for example,” he concluded.

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