What’s a Bad Bank and How Can It Help Deutsche Bank?

(Bloomberg) -- When a lender is in trouble and decides to switch strategy, the solution can be what’s commonly referred to as a “bad bank.” It’s a plan that Deutsche Bank AG is using to help it return to profit by reducing its focus on investment banking. But while the idea might sound simple, carrying out the task efficiently can be very costly.

1. What’s a bad bank?

It’s place where a financial institution that’s struggling to make money or in worse shape can put assets to sell them or wind them down. Often it’s made up of businesses or holdings that are dragging the bank down, such as risky and illiquid derivatives or delinquent loans. But the nickname can be misleading, as everything inherited isn’t necessarily bad. It can also include unwanted assets that are no longer core to a firm’s strategy. Many lenders, including Deutsche Bank, set up such divisions in-house after the 2008 financial crisis. Countries like Germany, Spain and Ireland also established taxpayer-funded vehicles to shore up the industry and keep banks lending to households and companies.

2. What’s Deutsche Bank doing now?

Deutsche Bank is creating what it’s calling a “capital-release unit” to handle the wind-down of non-strategic assets so it can focus on its primary businesses. The holdings and related businesses being moved to the unit represented 74 billion euros ($83 billion) of risk-weighted assets and 288 billion euros of leveraged exposure at the end of last year. That’s about 21% of the bank’s balance sheet weighted according to risk at the end of March. The division will probably house some holdings from the equities business, assets related to interest-rate trading outside of Europe as well as performing and non-performing loans, according to the people familiar with the matter.

3. What’s the appeal?

Placing non-core assets in a separate division can help make a restructuring more efficient and transparent by providing investors with financial disclosures to better track the progress of a lender’s overhaul and hold management accountable. Shedding the assets in the bad bank then frees up capital that can be used to bolster a firm’s financial strength or be redeployed to more profitable businesses. If it’s a separate entity, it can also allow a bank to clean up its balance sheet, stem losses and protect depositors.

4. What’s hard about it?

The first step is tough because it means declaring swathes of a bank’s business to be undesirable. Placing assets into a bad bank can mean the lender has to recognize that the holdings are worth less than previously estimated. That means either lowering their value in the company accounts and booking losses upfront or later on when they’re sold. That said, some of these assets may be correctly valued already and some will probably run off over time without losses. The bank faces a challenging trade-off between selling fast and minimizing losses. Buyers are in a strong position because they know that the bank wants to get rid of the assets and may accept lower prices if a sale helps lower risk. The same logic applies to financial institutions who are counterparties on derivatives or other trades.

5. Has this worked before?

Yes. The most famous example is Citigroup Inc., which in 2009 started a division to wind down hundreds of billions of dollars of unwanted assets. Michael Corbat, who led the unit, went on to run the bank. Royal Bank of Scotland Group Plc pulled off a similar feat to return from the brink after the financial crisis and later to focus on its U.K. roots. While those two lenders benefited from taxpayer funds, Deutsche Bank and several peers sought to restructure on their own. In retrospect, many might be in better shape today if they had taken public money. Others have pulled it off. Credit Suisse Group AG closed what it called its strategic resolution unit last year as part of a pivot away from volatile trading businesses to more stable wealth management. Since the financial crisis, European Union policy makers have sought to limit the use of public funds in bank rescues. Bad banks remain a way to deal with large failing lenders, but taxpayers can’t be asked to simply pick up the tab.

6. How did it work last time for Deutsche Bank?

It was a success, but it was expensive and took a long time. In 2012, the unit absorbed unwanted parts of companies acquired during a retail banking and wealth management expansion. But the trading arm accounted for the largest share of hived off assets. That included asset-backed securities, commercial real estate loans, derivatives and exposure to bond insurers. It also sold off businesses ranging from casinos to a New Jersey port. The division ultimately added about 2% points to the bank’s key measure of financial strength through 2016. That’s about the same effect as the 8 billion euros of capital that Deutsche Bank raised from investors in 2017. Still, it came at a great cost: The unit faced more than 13.7 billion euros ($15.5 billion) of pretax losses after selling assets for less than they were valued at, pulling out early from trading contracts and litigation costs.

The Reference Shelf

• How Deutsche Bank might stack up in the history of bad banks.
• How much Deutsche Bank ended up paying the last time it set up a non-core unit.
• Deutsche Bank is said to be sounding out potential buyers for unwanted assets.
• A chart showing Citigroup’s progress on winding down unwanted assets.
• Bloomberg Opinion: Deutsche Bank’s new CEO deserves a chance.

--With assistance from Steven Arons.

To contact the reporter on this story: Nicholas Comfort in Frankfurt at ncomfort1@bloomberg.net

To contact the editors responsible for this story: Dale Crofts at dcrofts@bloomberg.net, Melissa Pozsgay

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