A bad bank is a financial entity whose balance sheets are largely composed of toxic assets of other banks .Although the creation of such entities is not very frequent, it is a real possibility in the event that the financial sector of a country is generally affected by assets of doubtful quality, which harms all entities. In that case, the creation of a bad bank (usually sponsored by the country’s central bank) would allow the concentration of all toxic assets in a single entity and free others from that problem,allowing them to resume their activities normally.
The relationship of the bad bank with the other entities from which its assets come depends on several factors and the variety of banks involved . The simplest modality would be the creation by a bank of a subsidiary entity to manage its toxic assets. In this case, no external intervention would be required, but it would not isolate the entity from potential losses. The most extreme solution, as has been done in Sweden, Finland, Great Britain and Spain, would be the creation of a totally independent entity with assets from different affected banks , which would require external intervention (usually from the public sector) but in return, it would free the other entities from the problems of low asset rating.
Advantages and disadvantages of creating a bad bank
The main advantage of this type of entities is the isolation of low quality assets from the rest of the financial sector, whose creditworthiness and credit rating would improve . The effects of a financial crisis would be limited in this way and the recovery of the sector could be much faster.
On the other hand, the strategy of a bad bank poses the problem of the market launch of its assets , since after all its purpose is none other than the sale of these at more realistic prices and adjusted to its low rating. Precisely for this reason, toxic assets end up selling below their acquisition price of home entities (that is, with losses) and it is very difficult to find investors interested in participating in the bad bank. This difficulty of financing and the pessimistic forecasts on its results mean that in practice the new entity is usually formed with capital from the central bank, which implies a cost for the taxpayer and a political measure that is not without controversy.