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Explainer: Can 'Bad Banks' Resolve The Banking Crisis?

It is tempting to dismiss recent calls in Western media for "bad banks" as silliness. After all, aren't there already enough bad banks?

But it's a tricky term: a "bad bank" is an institution that is used to free banks of their past mistakes so they can begin operating normally again. And proponents argue that it's just what the current global banking crisis requires.

One of the most worrisome signs in the global economic crisis is how hesitant private investors have become to put any more capital into banks.

Usually, private investors do that by buying bank shares, which gives them an ownership stake in the institution. That is different from ordinary savers, who get interest from making deposits, but not a voice in the bank's affairs.

But these days investors are more inclined to sell their shares than buy new ones because they see banks as deeply troubled businesses. As a result, the price of bank shares has plunged around the world.

Just one recent example is Britain's Barclay's Bank. The price of its shares fell 25 percent last month to just under one British pound, the lowest level since 1993.

Why have investors lost confidence in the banks? Because of the way banks worldwide speculated so heavily in the U.S. housing market, only to be left with massive debts when that market collapsed.

In fact, the way the banks loaned money to unqualified home buyers, then borrowed more money from other banks to make still more loans, and then passed on to yet other banks the right to collect the payments from the homeowners as an investment opportunity for the public is so complicated that, today, many banks cannot calculate exactly what their debts and assets are.

Worse still, the speculation happened on such a massive scale that as homeowners default and housing values have plummeted many banks appear to have more debts than they can afford. That fear has made them hold on to their existing capital and virtually stop making new loans -- even to healthy businesses. This is a major reason the global economy is slowing down.

More banks have not collapsed yet because many of the weakest ones are being kept alive by government rescue plans. The governments provide the capital that private investors won't. But this temporary solution has yet to convince the banks (and auditors) that they have enough money to begin operating normally again.

Now, increasing numbers of financial experts are calling for governments to take a more radical step.

That is to transfer the banks' riskiest investments -- such as mortgages or mortgage-based securities whose values are now sharply declining or impossible to predict -- to a single government-run institution. The institution would be a so-called bad bank.

"The problem is that banks are not really aware of the state of the assets on their balance sheet, they are not making a distinction between the good assets and the bad assets, they are just looking at the overall position," says Peter Dixon, a financial strategist at Commerzbank in London. "And what a 'bad-bank' option would do is to allow the toxic assets to be taken off the balance sheet, give banks a much clearer idea of the state of their balance sheet, and that would be one of the key factors which I think will help them to start lending again."

Bad-bank options are currently being discussed by officials in the United States, Britain, Germany, and Italy. In all these countries, the bad assets held by banks are believed to reach staggering amounts.

Just figuring out what are the amounts is the first challenge.

Goldman Sachs in January put the cost of buying bad assets held by U.S. banks at $4 trillion, or equivalent to about one-third of the U.S. Gross Domestic Product.

David Roche, president of a London based financial consultancy, Independent Strategy, recently tried to tally the amounts in an article in "The Wall Street Journal" and came up with smaller figures.

Roche estimates that U.S. banks have some $800 billion worth of bad assets, Germany has 300 billion euros' worth, and Britain has some 200 British pounds' worth.

A bad bank buys up the riskiest assets that are causing the crisis of confidence in the banking sector.

It can work in two different ways.

One approach is to pay the banks the current depressed market value of assets such as defaulted mortgages, causing the banks to lose money but also to emerge with a clear idea of how much money they have left.

The second approach is for the government to buy the banks riskiest assets at artificially high prices, so that the banks do not lose so much money.

At the end of both processes, healthy banks can then be recapitalized by attracting private investors and insolvent ones can be nationalized or liquidated.

Then, ideally, the government in the future recovers at least some of its costs by re-selling the assets once market values -- such as home prices -- begin rising again.

Could the idea work? There are precedents, notably Sweden's successful containment of a banking crisis in the early 1990s. The Swedish government nationalized its banks, forced them to segregate assets into "bad banks" and "good banks" and emerged with a stronger banking sector.

Are other Western governments now ready to contemplate such radical steps -- including "bad banks" with or without nationalization?

"The situation in the global financial community has clearly gotten significantly worse over the course of the past few months, and I think that governments are now willing to try the more radical measures which they perhaps were trying to avoid back toward the end of last year," says Dixon.