Working Paper: CEPR ID: DP7349
Authors: Dorothea Schaefer; Klaus F. Zimmermann
Abstract: 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.
Keywords: bad bank; financial crisis; financial regulation; toxic assets
JEL Codes: G20; G24; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| establishment of a bad bank (G28) | transparent removal of toxic assets (G33) |
| transparent removal of toxic assets (G33) | banks regain stability (G21) |
| banks regain stability (G21) | resume lending to the real economy (G21) |
| government managing toxic assets (H12) | prevent banks from writing down asset values (G21) |
| prevent banks from writing down asset values (G21) | reduce risk of insolvency (G33) |
| government taking an equity stake in the good bank (G28) | stabilize the banking sector (G28) |
| bad bank solution (G33) | stabilize the banking sector (G28) |