Banking What Is a Bad Bank? Bad Banks Explained in Less Than 4 Minutes By Cheryl Wagemann Cheryl Wagemann Cheryl Wagemann has been a writer, reporter, and editor for more than seven years. She has written dozens of articles on news, economics, shopping trends, saving money, budgeting, and more. Cheryl has worked for Finder.com, Gannett newspapers, TAPinto, North Jersey Media Group, and other online publications. learn about our editorial policies Updated on April 26, 2022 Reviewed by Erika Rasure Reviewed by Erika Rasure Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator. She is a financial therapist and transformational coach, with a special interest in helping women learn how to invest. learn about our financial review board Photo: Oscar Wong / Getty Images Definition A bad bank is a bank set up to acquire illiquid and risky assets (like bad loans) from a troubled financial institution. Definition and Examples of Bad Banks A bad bank takes on risky debts, loans, and assets from a beleaguered bank. In addition to clearing their balance sheets, banks typically unload bad assets to a bad bank in an effort to shore up their reputation with credit rating agencies and rebuild trust with investors, as well as improve their finances by protecting profits and minimizing losses.Grant Street National Bank is an example of a bad bank that was set up in the 1980s to acquire assets from Mellon Bank and its subsidiaries. It wasn’t part of the Federal Reserve system, nor did it accept deposits. Grant Street National Bank existed solely as a bad bank established to acquire specific assets seized in foreclosures. Note Bad banks have also been used in several European countries, including Ireland and the United Kingdom. The Swiss National Bank, for example, set up and funded a special-purpose bad-bank entity that purchased $60 billion in troubled assets from Swiss bank UBS in 2008. In December 2020, the European Commission announced its support to establish several asset management companies (“bad banks”) to help banks throughout the European Union remove nonperforming loans from their balance sheets in an effort to staunch the blow of a severe economic downturn. How Bad Banks Work Typically established during times of financial crisis, bad banks’ purpose is to restore stability to the banking industry, allow credit to flow, and reestablish investors’ trust. Bad banks may acquire troubled or risky assets such as loans that have been defaulted on, or assets that may have lost value due to current market conditions. Bad banks may also acquire financially sound assets to assist banks with their restructuring efforts. For example, bad banks were used prolifically during and after the 2008 financial crisis to stabilize the banking industry and prevent several large financial institutions from failing after asset values plummeted. In the recession’s wake arose increased government regulation, bailouts, and funding demand, which bad banks were established in part to mitigate. Note A general criticism of bad banks and bailouts is they create “moral hazard,” meaning banks and financial institutions may be more inclined to take on debt and risky investments because they can unload those bad investments later without any consequences. How Bad Banks Are Structured A bad bank’s structure and strategy depends on its goals and whether or not a financial institution wants to keep assets on its balance sheet. There are four models for structuring bad banks: Bad-bank spinoff: The most common structure, in which a bad bank is created as a legally separate entity to hold bad assets. On-balance sheet guarantee: Banks protect a portion of their portfolio against losses with a guarantee backed by the government.Internal restructuring: Establishes a separate, internal unit to isolate bad assets; often used when toxic assets account for more than 20% of a bank’s balance sheet.Special-purpose entity: What Is the Income Approach? Undesirable assets are transferred from a bank’s balance sheet to a bad bank, which is usually sponsored by the government. Key Takeaways Bad banks are banks set up to acquire bad debts and illiquid assets from another bank, typically during times of economic crisis.The downside of bad banks is they create a “too-big-to-fail” mentality among financial institutions that recognize the benefits of these structures.There are four types of bad-bank structures: On-balance sheet guarantee, internal restructuring, special-purpose entities, and bad-bank spinoffs. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. McKinsey & Company. "Managing Successful Bank Restructuring:The Mellon Bank Story," Pages 8-9. Accessed Oct. 1, 2021. McKinsey. "Bad Banks: Finding the Right Exit From the Financial Crisis," Pages 12-13. Accessed Oct. 1, 2021. McKinsey. "Understanding the Bad Bank." Accessed Oct, 1, 2021. Yale School of Management. "European Commission Gives Tentative Support for 'Network' of Public Asset Management Companies." Accessed Oct. 1, 2021. Massachusetts Institute of Technology. "Criticisms of Bailouts Generally." Accessed Oct. 1, 2021.