Are "Bad Banks" Good for Business?

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It is no secret that some of the largest banks have troubled assets on their books that strain confidence in their businesses. A few European banks may be ready to do something about it -- by forming separate "bad banks" to house those assets.

Toxic assets
After Ireland's mortgage market came crashing down, Irish banks were left with billions in toxic assets. Bank of Ireland (NASDAQOTH: IREBY  ) , along with other major Irish financial institutions, used the state-run National Asset Management Agency to shift those toxic assets off their books. Although Bank of Ireland still required billions of euros in additional capital, the removal of many of these toxic assets served to restore a degree of confidence in the battered bank.

Meanwhile, across the Irish Sea, Royal Bank of Scotland Group (NYSE: RBS  ) remains 81% state-owned as the government tries to decide what to do with the bank. Among many of the proposals floated is that RBS could form a "bad bank" that would house the its toxic assets separately from "good bank" RBS.

One proposal calls for RBS to create a relatively small "bad bank" to hold the most toxic of assets. However, a proposal submitted after an analysis by Swiss bank UBS calls for a much larger "bad bank" that would house billions in these assets.

The rationale is that by separating out the "bad bank," shares of RBS would be worth around 540 pence, according to the UBS analysis -- slightly above what the government paid for them. The government could then begin liquidating its politically unpopular stake at a profit and eventually allow the healthy "good bank" RBS to go private. Over the long term, the government would try to recoup as much value as possible as it wound down the "bad bank."

But even if the split ever happens, it still has many hurdles to clear. George Osborne, chancellor of the exchequer, is seeking European Union permission to split RBS without having stricter EU rules in effect regarding state bank bailouts applied to the RBS breakup. And beyond that, the plan still needs final approval from the British government as a whole.

A Greek bank tragedy
With its major economic crisis, Greece has become home to banks that are full of non-performing loans that are undermining confidence in their businesses. But recent reports suggest that National Bank of Greece (UNKNOWN: NBG.DL  ) and Piraeus Bank are both planning to set up "bad banks" to remove these non-performing loans and rebuild confidence.

So far, the market seems to love the idea, with shares of National Bank of Greece up around 9% in New York trading after the reports surfaced.

If this setup does restore confidence in National Bank of Greece and Piraeus Bank, it would be a major positive for both. A healthier outlook for the banks would reduce fears, both inside and outside Greece, that depositors might get spooked and launch a run on the banks.

Bad banks to the rescue?
The idea behind these "bad banks" is to restore public and investor confidence by removing toxic assets from major financial institutions. A successful transfer of those assets would be a plus in terms of financial stability -- and in RBS's case, it would allow the British government to begin reducing its stake. None of these banks are out of the woods yet, and they all face critical challenges, but setting up "bad banks" to clean up their books would at least be a step in the right direction. Stay tuned.

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