Old Money: Bad Banks
Bad banks from Barings to Bradford & Bingley
byProfessor Richard Roberts, King’s College London
A decade on from the beginning of the 2007-2008 financial crisis, eurozone banks are still burdened by €1tr of toxic loans, with weaker countries troubled the most — in Greece and Cyprus around half of loans are non-performing.
Recent months have seen calls for action to clean up bank balance sheets, perhaps through the creation of “bad banks”, either at the national level following an EU template, or, as suggested by the European Banking Authority (EBA), through a new EU-wide institution. A bad bank/good bank solution transfers troubled assets to the bad bank that focuses on their orderly liquidation, allowing the “good bank” to operate without the distraction and disruption of managing legacy assets — an approach with a long and varied history.
The bad bank stratagem was pioneered in the management of the Baring crisis of 1890. As a result of overexuberant underwriting commitments in Argentine bonds, Baring Brothers, a top London investment bank, faced a liquidity crisis, and was supported by the Bank of England to the tune of £7.5m ($9.83m).
Barings’ on-going business was transferred to a new company (the good bank) while the assets of the old partnership (bad bank I) were liquidated to repay the Bank of England. By 1894 the sum outstanding to the Bank was down to £2m. The outstanding assets — illiquid Argentine bonds and other suspect assets — were transferred to a new entity, Baring Estate Company (bad bank II) that paid off the Bank with funds raised through issuing debentures. As the bonds became marketable the debentures were paid off; BEC was liquidated in 1898.
The bad bank stratagem took another form in America during the Great Depression — an era which saw the failure of thousands of small banks.
The Federal Deposit Insurance Corporation, established in 1933, effectively acted as a public bad bank acquiring the assets of failed lenders. By 1940, the FDIC had accumulated liquidation assets of $136m and had a liquidation staff of 1,600.
US bank failures almost disappeared in following decades and FDIC’s staff dwindled to just 32. But the early 1980s saw a succession of big US bank failures, culminating in Continental Illinois in 1984, in the wake of which the FDIC’s liquidation inventory soared to $10bn.
The adoption of the bad bank stratagem by banks themselves was led by the late Frank Cahouet, a banking business troubleshooter, who used it to sort out US banks burdened by real estate and petroleum non-performing loans (NPLs) in the 1980s.
Cahouet was brought in to fix troubled Crocker National Bank of California. He persuaded Crocker’s owner, Midland Bank of the UK, to buy $3.5bn of bad loans that were placed in a Midland bad bank subsidiary. The de-toxified Crocker was sold to Wells Fargo in 1986.
In 1988, Cahouet was hired to sort out Mellon Bank of Pittsburgh. He used Grant Street National Bank, a defunct chartered bank, as a vehicle to acquire and liquidate Mellon’s lousy loans. Cleaned up, the good bank evolved into the globally successful BNY Mellon.
Sweden adopted a bad bank solution in response to the Swedish banking crisis of the early 1990s with the creation in 1992 of Securum, a state-owned bad bank that acquired the distressed loans of Swedish banks bailed-out by the state.
These were mostly real estate loans that were quite straightforward to liquidate as the property market recovered. Securum rapidly ran down its assets and closed in 1997. It was judged a notable success, helping to limit the cost to taxpayers of the Swedish banking crisis to no more than 2% of GDP. The Swedish experience was much studied in the wake of the bank nationalisations and bailouts of the 2007-08 financial crisis.
Britain established a state-owned bad bank, UK Asset Resolution, in 2010 to manage £116bn of assets stemming from the nationalisation of Northern Rock and Bradford & Bingley. By summer 2017 UKAR’s assets were down to £23bn.
British banks RBS and Barclays established internal bad banks to manage their troubled assets, as did US lenders including Citigroup and Bank of America. By 2017 the private sector bad banks had largely done their job and were being shut down.
But despite extensive use of the internal bad bank approach, the toxic loan problem persists among eurozone banks, where state aid rules and asymmetric information have been blamed for hampering progress. But hopefully, examples from history can help lift this €1tr millstone.