'Bad Bank' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
A Bad Bank refers to a special bank which a government agency typically establishes in order to purchase the failing loans from one or more banks that possess a large number of non-performing assets. They purchase these at the market price in order to not wreck the bank. Through the action of transferring such toxic assets from the institution’s balance sheet over to the new bad bank, such damaged banks are able to free up their balance sheet from the toxic assets that they would eventually be writing down otherwise.
Bondholders and shareholders alike will likely lose money off of such a solution, not the bank depositors. These banks which devolve into insolvency from such actions can be liquidated, nationalized by the government authorities, or recapitalized and kept going on life support (hoping that their situation will improve with time).
There are countless examples of bad banks. In 1988, Mellon Bank created its own bad bank which it named Grant Street National Bank. The 2008 global financial crisis renewed the old interest in this solution for dealing with the assets of bad banks. The managers of many of the world’s largest banks started thinking seriously about segregating out the toxic assets into these bad banks.
It was the then Chairman Ben Bernanke of the Federal Reserve Banking System who put forward the idea to set up a government administered and backed bad bank following the recession created by the subprime mortgage crisis. He wanted to clean up the balance sheets of the commercial banks which were suffering from devastating levels of poorly performing assets so that they could start over with their lending. Another competing strategy they contemplated was issuing a guaranteed form of insurance plan that could allow the banks to maintain their toxic assets on the books. At the same time it would pass the risks from the banks on to the taxpayers.
Banks can easily build up a massive portfolio position of financial instruments and debts that can suddenly grow in risk. This makes it far harder for the banks in question to raise additional fresh capital by selling more bonds. In such scenarios, the bank may decide it is a good idea to separate out their bad assets and good assets with the bad banks concept. This goal lies in permitting the investors to contemplate the financial health of the bank with more certainty. The bad bank could be set up in order to help deal with a worsening financial situation, or alternatively by a government agency as part of their official government response to the various financial problems in a range of financial institutions throughout the financial sector.
Besides removing these debilitating assets off of the balance sheet of the parent bank, the bad bank will allow them to have special management teams to work on the problems of the badly performing debts. This concept helps the banks to do what they do best, which is to concentrate their efforts on the primary business model of lending. Meanwhile, the bad bank itself will be able to concentrate on delivering the optimal value which it can from the remaining high risk assets.
Thanks to the global financial crisis which raged from 2007 through 2010, a number of nations established their own bad banks. The Emergency Economic Stabilization Act of 2008 suggested a bad bank to deal with the subprime mortgage crisis across the United States. Over in Europe, Ireland set up its own bad bank the National Asset Management Agency in 2009 to deal with the financial crisis as it spread in Ireland.