Bad Bank(s) and Recapitalization of the Banking Sector

32 Pages Posted: 1 Sep 2009

See all articles by Dorothea Schaefer

Dorothea Schaefer

German Institute for Economic Research (DIW Berlin); JIBS

Klaus F. Zimmermann

Global Labor Organization (GLO); UNU-MERIT; Maastricht University, Department of Economics; Free University Berlin; University of Bonn; Centre for Economic Policy Research (CEPR); Journal of Population Economics

Multiple version iconThere are 2 versions of this paper

Date Written: May 1, 2009

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: financial crisis, financial regulation, toxic assets, bad bank

JEL Classification: G20, G24, G28

Suggested Citation

Schaefer, Dorothea and Zimmermann, Klaus F., Bad Bank(s) and Recapitalization of the Banking Sector (May 1, 2009). DIW Berlin Discussion Paper No. 897, Available at SSRN: https://ssrn.com/abstract=1464773 or http://dx.doi.org/10.2139/ssrn.1464773

Dorothea Schaefer (Contact Author)

German Institute for Economic Research (DIW Berlin) ( email )

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Klaus F. Zimmermann

Global Labor Organization (GLO) ( email )

Bonn
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UNU-MERIT ( email )

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Maastricht University, Department of Economics ( email )

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University of Bonn

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Centre for Economic Policy Research (CEPR)

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Journal of Population Economics

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