[Song Seungseop's Financial Light] The 'Bulryang Bank' That Helps the World

Bad Bank Focusing Solely on Purchasing Non-Performing Loans
Thanks to This, Banks' Soundness and Profitability Indicators Rise
Bad Bank Generates Revenue Through Collateral Sales and Securities Issuance
Concerns Grow Over "Moral Hazard" Risks

Finance is difficult. It is tangled with confusing terms and complex backstories. Sometimes, you need to learn dozens of concepts just to understand a single word. Yet, finance is important. To understand the philosophy of fund management and consistently follow the flow of money, a foundation of financial knowledge is essential. Therefore, Asia Economy selects one financial issue each week and explains it in very simple terms. Even if you know nothing about finance, you can immediately understand these ‘light’ stories that ignite a bright ‘light’ on finance.

[Image source=Reuters Yonhap News]

[Asia Economy Reporter Song Seung-seop] Did you know that there are ‘bad’ banks that are absolutely necessary in the world? They do not engage in deposits or loans. They disappear quietly once their role is over. They take on tasks that other banks find difficult and help ‘good’ banks to thrive. We will explain the role and importance of financial companies called bad banks.

Bad Banks Buying Non-Performing Loans Cheaply at 9-15%

Bad banks are banks that specialize in purchasing only non-performing loans (NPLs) from financial institutions. Non-performing loans are loans where the principal and interest have not been repaid for a certain period, and it is expected that they will essentially be defaulted on. Imagine lending 10 million won in principal and 1 million won in interest but receiving nothing back. From the bank’s perspective, the loss is considerable.

What if someone buys the ‘right to collect money (bond)’ worth 11 million won for 5 million won? Since the bank can recover at least 5 million won, it would be a relief. Having many non-performing loans also worsens external evaluations, but by offloading them, the bank’s soundness indicators improve significantly. Bank executives can focus on future innovation rather than worrying about bad debts. That is why bad banks are necessary.

So how do bad banks make money from non-performing loans? First, since non-performing loans are practically difficult to recover, they are purchased at a very low price?about 9-15% of the total value. According to a bad bank establishment plan discussed in India last year, the cash given to banks was only ‘15%’. The rest was replaced with securities. Considering that a 100 million won non-performing loan was bought at a bargain price of 15 million won, recovering just 30 million won would yield a 2x return.

Also, bad banks do not have bank clerks handling deposits and loans. Instead, they have experts who evaluate, manage, and recover assets from those who failed to repay. Typical professionals include investment banking experts, restructuring management specialists, lawyers, and accountants. They track and sell various collateral related to non-performing loans to recover money.

There is also a method of using the securities market. They sell asset-backed securities (ABS) based on non-performing loans as underlying assets. This means securitizing the right to collect money and cashing it again. If the economy is weak, they wait for the stock market to be active to sell or use strong restructuring to dispose of assets.

The first appearance of such bad banks was in 1932 during the Great Depression. At that time, the U.S. Reconstruction Finance Corporation (RFC) was established and provided bailout funds to banks suffering from bank runs.

Melon Bank in the United States succeeded in overcoming the crisis and regrowing through the establishment of a bad bank. Overcoming the crisis, growth accelerated sharply in 1991. Source: McKinsey Report

The term ‘bad bank’ became established and widely known due to the ‘Mellon Bank’ incident in the late 1980s in the U.S. Founded in the 1860s, Mellon Bank started in Pennsylvania and became a promising financial company ranked around 15th in the U.S. However, during aggressive loan expansion, non-performing loans increased sharply, putting the bank in serious danger. The bank president was dismissed by financial authorities, and the new management tried to overcome the crisis through cost-cutting and strategy setting, but the losses were too large to easily recover.

At this time, a venture capital company in New York planned to establish a very unique bank called GSNB. The plan was to create a bad bank that does not accept deposits and only buys very poor-quality bonds (junk bonds). Mellon Bank immediately signed a contract with GSNB and sold 1 billion dollars of non-performing loans. In return, it received GSNB shares worth 525 million dollars.

Mellon Bank was able to cover urgent short-term debts with the funds raised. As non-performing assets disappeared, internal members began to think about the future rather than being stressed by bad assets. Mellon Bank was able to shed its stigma as a failing financial company and return to growth. Inspired by Mellon Bank’s case, Norway, Sweden, and Finland in Europe overcame crises around 1990 through bad banks.

Due to Increased Non-Performing Risks... Ahn Requests "Consider Establishing a Bad Bank"

Ahn Cheol-soo, Chairman of the Presidential Transition Committee, is briefing the Special Committee for COVID-19 Emergency Response at the Transition Committee briefing room in Tongui-dong, Jongno-gu, Seoul on the 30th. Photo by Transition Committee Press Corps

Korea has also used bad banks. When the International Monetary Fund (IMF) crisis hit in 1997, the Korea Asset Management Corporation (KAMCO) was created as a dedicated organization to handle non-performing loans. In 2004, a bad bank was established to resolve debts of credit-impaired individuals. During the global financial crisis, the Credit Recovery Fund was created, and under the Park Geun-hye administration, the National Happiness Fund was established with a bad bank character.

Currently, the presidential transition committee formed by President-elect Yoon Suk-yeol has reportedly mentioned bad banks. Ahn Cheol-soo, chairman of the presidential transition committee, said at the end of last month during an economic division briefing, "Please actively consider in the relevant division the creation of a kind of bad bank jointly funded by the Small Enterprise and Market Service, the government, and banks to repay long-term overdue loans similar to mortgage loans at low interest rates."

The background for the emergence of the bad bank establishment theory is the massive increase in loans to small business owners and self-employed individuals. According to the Bank of Korea, the loan size for self-employed individuals in the third quarter of last year was 887.5 trillion won, a 14.2% surge in one year. However, due to loan maturity extensions and interest payment deferrals as financial support measures, the actual bad debt situation is unknown. Since financial support measures will end in September, there are concerns that defaults may explode, so the proposal is to establish a bad bank for restructuring.

Applicants visiting the Korea Asset Management Corporation National Happiness Fund reception desk are consulting. [Image source=Yonhap News]

However, bad banks are not entirely good. Imagine if bad banks continuously buy non-performing loans. Banks might not conduct thorough loan screenings as before. They might lend to many people and, if defaults occur, just sell the loans to bad banks. This phenomenon is called ‘moral hazard.’ During debt restructuring, benefits such as partial forgiveness of principal and interest are repeatedly given, and debtors tend to avoid repaying money properly.

There is also criticism that bad banks only clean up past non-performing loans and are a temporary measure. There are various reasons why people fail to repay money well?economic recession, pandemics like COVID-19, problems with government and financial authorities’ regulations, etc. However, bad banks do not solve these ‘causes.’ If a bad bank is established without fundamental solutions, continuous outbreaks of non-performing loans may be observed.