What follows is an edited excerpt from "Is a Bad Bank Always Bad?" by Jonathan A. Neuberger, an economist with the Federal Reserve Bank of San Francisco. The original appeared in the bank's Weekly Letter.

At first glance, there seems to be little to distinguish the traditional method of dealing with problem assets from the bad-bank approach.

This is especially true if the holding company does not sell off a portion of the bad bank to outside investors.

Under these circumstances, the nonperforming assets are still held by the holding company, the problem loans continue to command resources from one or another of the parent's subsidiaries, and losses arising from the nonperforming loans affect the consolidated holding company's income statement and balance sheet.

Finding the Source of Value

However, in order for the holding company to adopt the apparently costly approach of establishing a bad-bank subsidiary, there must be some value to segregating the bank's problem loans outside the primary bank. The source of this value is not immediately apparent.

Proponents of the good bank-bad bank spinoff argue that segregating good from bad assets enables the banking company to manage the bad assets more efficiently.

By concentrating workout efforts in the bad bank, they claim, the company can take advantage of economies of "management specialization" that would not be available under alternative corporate structures.

Another argument in favor of the bad-bank approach relates to investors' demands for bank assets.

According to this argument, the assets held by the good bank may appeal to one type of investor while the problem assets of the bad bank may appeal to another type.

Bad-bank assets may require considerable time before a settlement can be negotiated between borrowers and lenders. Investors in the bad bank also may need patience to ride out temporarily distressed conditions in real estate and other markets.

As a result, these investors must have a longer investment horizon and be willing to hold riskier assets than more traditional bank investors.

By segregating the assets, it is claimed, the bank holding company may be able to attract investors whose demands are more in line with the specific asset characteristics of the good and bad banks.

If this is true, then with the same portfolio, the good bank and bad bank together may command a better price in the market than the original bank.

Of course, the good bank-bad bank approach has not received universal support in financial markets.

Detractors argue that there is little or no advantage to the expensive process of creating and funding a bad-bank subsidiary. Any efficiencies that a specialized workout group can accomplish in a bad bank, they argue, also can be realized by a similar effort within the original bank. Moreover, transferring workout personnel to the bad bank can rob the good bank of its best credit-evaluation staff.

The response of investors also has not been uniformly positive. Most notably, some of the earlier spinoffs in the late 1980s were greeted by significant declines in holding-company share prices.

Part of the negative impact probably was due to announcements that funding for the bad bank (say, by the issuance of new holding-company stock) would significantly dilute the holdings of existing shareholders.

Additional negative response may have been the result of the bank's recognition of loan losses with immediate chargeoffs once the problem credits were transferred to the bad bank.

Markets Adapting to Idea

With the expected continuation of consolidation in the banking industry, it is likely that the good bank-bad bank spinoff will become more common. Financial markets have gotten used to the idea and seem more willing to accept this type of transaction as a reasonable form of corporate reorganization.

Moreover, if such a transaction can alleviate regulatory pressures, then the costs of the spinoff are mitigated. And if regulators want to encourage the purchase of weak institutions by healthier ones, the good bank-bad bank approach may actually deepen the market for bank assets and bring needed capital to the banking industry.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.