As bankers confront the challenges of distressed loans in the current environment, it is interesting to harken back to the late ‘80s and early ‘90s and the creation of the various “good bank/bad bank” structures designed to relieve institutions of some of the burdens and issues related to retaining problem loans, while maintaining a vehicle for recognizing and recovering some level of value in subsequent workouts.

A variety of creative strategies and structures emerged from those initiatives, including strategies and structures utilizing self-liquidating entities spun off to shareholders and formation of special purpose affiliates to hold and dispose of “bad” assets. Regulatory attitudes toward the “good bank/bad bank” strategies vary, and as the current economic situation evolves, institutions and agencies are showing some level of interest in revisiting the “good bank/bad bank” scenario for assistance in dealing with problem debt issues. Funding and structural issues remain the primary challenges.

Structures

Good bank/bad bank structures involve complicated and complex tax, regulatory, accounting and legal considerations that must be identified and addressed early on. The process typically involves formation of some form of special limited purpose trust, liquidating “bank,” corporation or partnership as the “bad bank” vehicle to receive the troubled assets. For affiliated “bad banks,” that process includes important regulatory considerations including Reg Y (and the Bank Holding Company Act) and Reg W (and sections 23A and B of the Federal Reserve Act) regarding transactions with affiliates. Investment Company Act considerations also may arise depending on the ownership structure of the “bad bank” and the relevant asset mix. Use of actual limited purpose special “bank” charters for the “bad bank” may involve additional bank regulatory oversight of the “bad bank” as well as operating conditions and restrictions not otherwise involved with non-bank entities.

Off-Balance Sheet and Regulatory Issues

Particularly following the Enron debacle and the subsequent focus on off-balance sheet issues and structures, institutions need to take special care that the creation of a good bank/bad bank structure does not result in more problems than it solves. Properly structured and implemented, the process can present unique opportunities for dealing with problem asset issues to enable lenders to move and focus on recovery and growth opportunities. One indirect (but very helpful) side effect of an effective “good bank/bad bank” strategy can be to relieve regulatory pressure on the “good bank” caused by the ongoing problem assets issues and their impact on the insured institution. Relieving pressure from the “good bank” can enable bank management and the board to focus on moving forward while relieving some of the ongoing distractions on the insured depository caused by the management of problem assets. It also can help relieve the “good bank” from all or certain parts of existing regulatory enforcement actions, and can help avoid existing actions from becoming worse.

Structuring the “bad bank” as a limited purpose bank or non-bank affiliate in a holding company environment also can be helpful (1) to retain the ultimate loan recovery within the holding company for holding company shareholders, and (2) to avoid the relationship and community issues that can sometimes arise in the context of selling problem loans to third-parties and the post-sale treatment of borrowers by loan acquirers. Regulatory approval is required for the affiliate formation. Funding for the transfer, ongoing accounting issues, and workout staffing are important early considerations.

Regulatory authorities as well as appropriate accounting, tax and legal advisors should be consulted early to determine whether the strategy is appropriate and advantageous for the institution before significant costs are incurred or irreversible transactions are implemented.

Impact

The good bank/bad bank structure typically has an immediate adverse impact on “good bank” capital (and shareholders) through market-to-market accounting for the assets subject to disposition, and institutions need to be ready to address the resulting capital issues and corresponding regulatory concerns. Likewise, the “bad bank” may be subject to ongoing market-to-market accounting treatment for its assets. For the transaction to qualify as a true sale transaction, any form of retained losses and ongoing involvement by the “good bank” may be problematic. As noted, shared staffing and funding issues also often arise in the case of affiliate “good bank/bad bank” structures.

Conclusions

Whether use of a “good bank/bad bank” structure to address problem loan issues is appropriate and provides a viable and positive alternative varies depending on the individual situation of the disposing institution and the nature and extent of the loans involved.

Hopefully, Congress and the regulatory agencies will look further into providing incentives for institutions to utilize a “good bank/bad bank” structure to address problem assets or will at least remove (or reduce) some of the disincentives, complexities and impediments that presently exist.

Organization and implementation of a viable “good bank/bad bank” strategy and structure can be costly and time-consuming, is subject to regulatory scrutiny, and can take time to implement. Institutions considering a “good bank/bad bank” solution should consult early with regulatory authorities and appropriate professionals to determine whether such an initiative is the right solution for the institution.