VOL 20 NO 157 REGD NO DA 1589 | Dhaka, Wednesday, April 03 2013

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The role of 'bad' bank in handling troubled assets

M S Siddiqui
shah@banglachemical.com

A purported suggestion that Sonali Bank may re-finance Hall-Mark group to re-start their business with a government nominated administrator has sparked criticism. Many experts - and even business leaders have opposed the idea. There is another concern. Sonali Bank and some other banks are in financial crisis due to non-performing loans (NPL) of some borrowers. The special handling of troubled assets is not uncommon in the day-to-day activities of the banking world. Non-performing loans are typically transferred to an Asset Management Companies (AMC) which is also named as Special Purpose Vehicle (SPV). Alternatively, when the illiquid assets on the banking industry's books endanger the entire financial system, a 'bad' bank has often been the solution of choice. A 'bad' bank is essentially a work-out department on a much larger scale. This concept was refined during the global savings and loan crisis of the 1980's. The key element of the 'bad' bank 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 companies assets' current book value and their market value. Under the plan, the government would bear responsibility for the management and future resale of companies' assets at its own cost and recapitalise 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 NPL. According to Wikipedia: "Bad bank is a term for a financial institution created to hold non-performing assets owned by a state guaranteed bank. Such institutions have been created to address challenges arising during an economic credit crunch wherein banks are allowed to take problem assets off their books. Securum, a Swedish bank founded to take on bad assets during the Swedish banking rescue of 1991 and 1992, is an example of such a bank." The 2002 World Bank paper titled "Managing the Real and Fiscal Costs of Banking Crises," examined banking crises over the past 50 years. It revealed accommodating measures such as open-ended liquidity support, blanket deposit guarantees, regulatory forbearance, repeated recapitalisations and debtor bailouts

which appear to increase significantly the costs of banking crises. In Ireland, a 'bad' bank, the National Asset Management Agency, was established in December 2009 in response to the financial crisis of that country. The financial crisis of 2007-2010 resulted in 'bad' banks being set up to handle the crisis in a variety of countries. For example, a 'bad' bank was suggested as part of the Emergency Economic Stabilisation Act of 2008 to help address the subprime mortgage crisis in the US. German 'Bad Bank Act' came into effect on July 23, 2009. The act provides the opportunity for short-term relief of bank balance-sheets, thus promoting lending to the real economy. The act is targeted at financial institutions, financial holding companies, their subsidiaries in Germany and abroad and Special Purpose Vehicle (SPV). At the end of the 1980s, more than 1,000 financial institutions (FIs) in the United States were threatened by insolvency due to financing with divergent maturity dates in connection with high interest rates for depositors but comparatively low rates on mortgage lending. In 1989, the Resolution Trust Corporation (RTC) - a 'bad' bank - was founded. The RTC was set up with government funding and to a limited extent with money from private investors. Between 1989 and 1995, the RTC took over 747 bankrupt companies with a book value of 394 billion dollars. The sick companies' bailout cost US taxpayers a total of 124 billion dollars, 76 billion of which fell to the RTC. In the early 1990s, Sweden attempted to master its banking crisis with several asset management companies. The two most important 'bad' banks - Securum and Retriva - were set up by the Swedish government. Some 3,000 non-performing loans that had been extended to 1,274 troubled companies were transferred from Nordbanken - which had been completely taken over by the government - to Securum. This corresponded to 21 per cent of the bank's asset portfolio. Retriva, for its part, took over 45 per cent of Gota Bank's assets shortly after the bank was nationalised. In Germany, ailing FIs have also made use of 'bad' banks as a method for repairing the balance sheets without governmental interference. Between 2003 and 2005, Dresdner Bank transferred 35.5 billion euros in toxic loans and shares which had lost strategic relevance to a so-called Institutional Restructuring Unit (IRU). In 2008, WestLB, the Landesbank, partially owned by the state of North Rhine-Westphalia, founded a consolidation vehicle named "Phoenix" in Dublin, Ireland. As an off-balancesheet special purpose vehicle (without a banking license), Phoenix has already taken over assets with a book value of 23 billion euros. The owners have guaranteed these assets for five billion euros. In total, WestLB is planning to hive off assets with a book value of some 80 billion euros. The Swedish government firstly guaranteed all bank deposits and creditors of the nation's 114 banks. They acted quickly and comprehensively: investing government funds and setting up 'bad' banks to manage the banks' non-performing assets i.e. bad debts. The state-owned 'bad' banks, named Securum and Retriva, then restructured the non-performing assets before selling them back into the market when the time was right. The initial outlay was about 4.0 per cent of gross domestic product (GDP) and, in return, the State received a 20 per cent stake in the banks. Eventually markets stabilised and with the banks reorganised, by 1994, they were back in profit. The Swedish state then sold their 20 per cent stake back to

the market. The eventual cost was somewhere between 0 per cent - 2.0 per cent of GDP, as estimates vary widely. Even if nearer 2.0 per cent, it was cheap as the economy was swiftly put on the road to recovery. The amount of capitalisation required by a 'bad' bank is essentially determined by two factors: operating costs and acquisition costs. When a low price is paid for the acquired troubled assets, this not only minimises the risk of future losses but also keeps the initial capital requirements of the 'bad' bank low. The source of financing determines whether the government or private sector provides the required startup funding. The need for liquid funds depends on how the banks being freed of their troubled assets will be "paid." Liquid funding is not immediately required if a "payment" is made with government securities. However, in this regard the amount of the write-downs and a possible need to re-capitalise the bank are contingent upon whether the book value of the distressed assets exceeds the book value of the government securities provided in exchange. If the government provides 100 per cent 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 FIs may be used to form a consortium of banks in order to prevent coordination failures. The loans may also be converted into share capital and takeover management of borrowers. The Swiss government also set up replica and a 'bad' bank with $60B for bad loan of their regular bank UBS. The UBS Bank took the losses on the first 10 per cent ($6B) and then the government stand guarantor for any potential losses after that. UBS's benefit is that they now know how much they are going to lose through write-downs. They can now move forward with their normal operations and start planning with more certainty for the future. The Swiss government benefits from a generous yearly payment and a 9.3 per cent stake in the company. Accordingly, although a 'bad' bank may be initially established as a subsidiary of a good bank, sufficient external capital is required to deconsolidate the 'bad' bank subsidiary. At most, the good bank may maintain a non-controlling minority interest in the 'bad' bank. In forming a 'bad' bank, consideration must be given to corporate, banking and securities laws. Assuming the 'bad' bank's sole purpose is to liquidate troubled assets, limited regulatory oversight is required. Although the new entity is referred to as a 'bad' bank, whether the new entity needs to be chartered as a bank depends on the assets transferred to it and the business activities of the new entity. Transfer of ongoing business operations, in addition to troubled assets, is more likely to require a banking charter or satisfaction of relevant regulatory requirements. This concept of 'bad' bank has been proved to be effective during the savings and loan crisis of the 1980's in the West. The rationale and driving force behind providing a safety net for banks by the western governments were twofold: first, to protect the depositors and second, to help break what could be a catastrophic death spiral in the economy. Learning from global experience, there seems to be no alternative proven way out of Hall-Mark-type

crises other than establishing a 'bad' bank as in Sweden, USA, Germany and Ireland. Otherwise, the system will remain as corrupt and vulnerable as before. The bad assets will continue to suck resources out of the economic system in the form of zombie borrowers, misallocation and mispricing of capital, public sector debt, and budget deficits. The machines should run for productions and the workers should get their salary and contribute to the national economy and at the same time the bad people should be tried. The company Hall-Mark and the Managing Director of Hall-Mark are separate legal entities. The person may be punished but not the legal entity Hall-Mark. In that case, all the stakeholders like Sonali Bank, employees, suppliers, sellers, buyers and the nation will suffer a loss.