Bad Bank

Bad banks are bad news for savers

4 February Feb 2016 1106 04 February 2016
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Last week, the European Commission and Italy reached an accord on a scheme to help Italian banks sell some of their 200 billion euros of bad loans. “This intervention will not create any burdens for our public finances,” the finance ministry said. However, Professor Luigi Zingales is not so optimistic.

The bad-bank concept has attracted so much support lately that it is now widely viewed as the most likely saviour in the rescue of the banking system. Under the agreement with the European Commission, Italian banks in distress will be able to package their bad loans into securities and then sell them off to private investors. To make the bonds appealing and cheaper to issue, Italy would offer a state guarantee only on the senior tranches, the safest portions, of the securitisations. The scheme, according to the European Union, would not constitute state aid because the guarantee will be priced at market rates, on the basis of the credit default swap prices of banks that carry a risk level equal to that of the loans guaranteed.

Therefore, it remains to be ascertained whether the implementation of a series of bad bank-style measures might help banks to clean up their balance sheets and start providing fresh credit to the economy. However, Luigi Zingales, a professor of entrepreneurship and finance at the University of Chicago's Booth School of Business, says that bad banks are a bad news for savers.

Bad loans are transferred from existing banks to a newly created ‘bad’ bank so that existing banks are insulated from these bad loans and their consequences. Is a bad bank the only solution to drive economic growth?

The original idea of bad banks was to bail out the banks, to support them with credit guarantees and taxpayers' money. But it is a combination of factors that causes a loan to go bad. Economic downturn has certainly weakened the ability of many borrowers to repay their loans on time. At the same time, not all bad loans are the result of a slowing economy. If the banks are now saddled with €200 billion in bad loans, it also due to poor management and ineffective supervision. We could leave the banks able to solve their problems alone, but this would also affect the process of granting loans. The government intervention is intended to accelerate economic recovery. As I said to Il Sole 24 Ore, using public money to recapitalize banks is less costly than bailing them out. For example, in the Unites States, during the 2008 bailout, using public funds to acquire stakes in banks in the form of preferred shares and warrants, ended up being cheaper than expected.

The bad-bank idea is not new idea. It was applied in past banking crises in Sweden, France, and Germany. The mechanism might have helped managers and governments deal with the crisis and effectively stabilize the banking system, but it did not protect customers from unfair practices. What needs to be done to revive investors and depositors’ confidence in the banking system?

Bank recapitalization is supposed to make them more solid, strengthen their capacity to lend to the real economy, as well as contributing to build a stable and credible banking system. We need to understand why the supervision of the Bank of Italy did not function optimally in order to avoid the lending mistakes seen in the past. More than that, it is essential to engage a broad set of expertise to examine the events of recent years and to make proposals for reform in financial and banking supervision. Yet, an Authority for Consumer Protection is necessary to protect consumers against predatory lending and other abusive practices.

The Italian-style bad bank is based on “on demand” state guarantees for banks, which will set up vehicles to transfer their impaired loans. The finance ministry said there is no cost to public finances. Is it true?

It depends on the price of these guarantees. If the government guarantee will really be priced at market rates, the bad bank would not help create better banks, or restore investors’ confidence, as well as new lending.

Italy and the European Commission agreed on a plan to help banks offload bad debts, ending months of negotiations. There is also the question of the selling price of impaired loans. What do you suggest to solve it?

It is not easy to solve the problem. Even in the United States, in 2008, the initial idea was to purchase troubled assets to stabilize the financial system. But within a week, attention shifted to buying equity in financial institutions. This is why there is such uncertainty about the value of the securities offered for sale. This is the heart of asset ‘toxicity’.

How can investors benefit from a bad bank? And what are the risks?

The Italy-EU deal on “bad banks” would most likely not bring any advantages to the investor. There are two primary types of risk that the investor will face. Firstly, Italy will guarantee only the safest loans. In this way the banks would be attempted to fool rating agencies, so as to make them overstate the value of collateralized securities. This means that the banks would be able to buy the state guarantee at a lower price than what the market charges to insure comparable risk. Then it will be a state aid, putting a potential burden on the taxpayer. On the other side, if they fail in doing so, the bad bank would not succeed in adding fuel to an economic recovery.