Time to Dust Off the Old 'Good Bank-Bad Bank' Plan

There have been references in recent news reports that a version of a good bank-bad bank structure is under consideration in some European countries as one means for strengthening the banking sector. That approach was very successfully used by Mellon Bank NA in a private-sector restructuring in October 1988.

From a strategic standpoint, the goal was to put the "good bank," Mellon Bank NA, in a position of high asset quality so that it could successfully carry on its business. The goal was achieved quickly and, in fact, over the following ten years, Mellon's common stock had the greatest percentage of market appreciation of any major U.S. bank holding company. In the case of the "bad bank," Grant Street National Bank (in Liquidation), its indebtedness was repaid in three years and it was ultimately liquidated in 1995 after the payment of all its obligations, including retirement of its preferred stock and payments on its common.

Similar restructuring efforts have been successfully implemented in the past, not just in the U.S. An early variation was when Crocker National Bank, in exchange for a capital injection from its British parent, Midland Bank, upstreamed $3.5 billion of its nonperforming loans to a workout subsidiary of its parent, and removed those assets from Crocker's balance sheet. Crocker was then sold "clean" to Wells Fargo. Japan, Sweden and Germany have also employed similar structural approaches since the mid-1980s.  

There are a number of advantages in proceeding down the good bank-bad bank path. First, if the goal is to maximize the value of the good bank and obtain a high market value for government shares, shareholder-investors will place a much higher valuation on a banking organization whose balance sheet reflects higher-quality assets with a low proportion of troubled assets. That kind of balance sheet should translate into higher earnings, lower writedowns and, ultimately, an improved capital position.

Second, removing the lower-quality assets from the good bank's balance sheet and placing them in an unaffiliated entity should translate into a higher debt rating for the good bank, reduced funding costs and an immediate earnings impact. In addition, the bad bank's collectors will not be forced sellers, but rather can operate in a way to maximize the assets' sale prices and at a reduced haircut.

Third, following a restructuring, the good bank's management can more readily turn its full focus on future strategies without having to look over their shoulder.

Fourth, natural banker mentality is that the lender-borrower relationship needs to be protected at all costs. The goal of a bank lender is to sell loans to clients through all phases of the business cycle. Preservation of an amicable relationship with a borrower is critical to ongoing business dealings, but a strong collections process, at times, requires very tough, demanding and upsetting negotiations with a long-established borrower. Thus, placing the problem assets into an unaffiliated entity with the goal of maximizing the return on those assets is a real advantage.

The good bank-bad bank model was not employed during the recent economic crisis starting in late 2007, due, in part, to downward-skewing and, often, unrealistic valuations. Transfer or sale of assets to a bad bank requires that the good bank mark down the "to be disposed of" assets on its books to market value. Markets were either frozen or in free fall during the early part of the recent economic crisis. A skewed instant-in-time market valuation would have likely caused the selling bank to be put into liquidation mode due to the significant size of the valuation writedown and the timing of the sale, not due to any intrinsic valuation or absolute worth of the asset. Further, the structure of the bad bank, which includes working capital to permit an orderly liquidation of the troubled asset portfolios, should result in a higher valuation for the bad bank's assets as a whole than would occur if the assets were sold directly.

More realistic valuations, however, are now possible, thanks to the passage of time and the unfreezing of the markets, prompted primarily from a globally driven looser monetary policy approach of the Federal Reserve and U.K. authorities, and the intrinsic benefits of the good bank-bad bank structure.

During the intervening time, banks have increased their capital positions and can better absorb the necessary writedowns. In addition, while further capital will undoubtedly be necessary upon disposition of "bad assets" in any type of transaction, given the passage of time, the market has probably accounted for much, if not all, of the inevitable writedown.

Delaying the medicine will not make the cure pain free. In fact, it may result in a major operation in lieu of simply medicine. Once Mellon Bank NA divested of its problem assets, it was quickly restored to health. Less than two years after the good bank-bad bank restructuring, Mellon significantly expanded its presence in the Philadelphia market by acquiring, with federal bank regulatory approval, the 54 branch offices of  the Philadelphia Savings Fund Society from Meritor Savings Bank.

Governments need to consider the advantages of a good bank-bad bank restructuring while loan assets currently have determinable and probably higher values than earlier in the crisis. The good bank needs to have the available capital resources to incur the capital writedowns. However, if done successfully, the improved condition of the good bank should enable government authorities to realize a higher return on their share ownerships than they would have earlier in the crisis when market valuations were much lower and, at times, frozen.

Michael E. Bleier is a partner at Reed Smith LLP in its Financial Institutions Group. He has previously served as assistant general counsel for the Federal Reserve and general counsel of Mellon Bank.