New reporting requirements due to bad banks

Bad Bank is a term for a financial institution created to hold nonperforming assets owned by a federally insured bank. The purpose of such institutions is to address challenges arising during an economic credit crunch wherein private banks are allowed to take problem assets off their books.

In the United States, the Emergency Economic Stabilization Act of 2008 (commonly referred to as a bailout of the U.S. financial system) suggested the creation of such bad banks as a response to the ongoing subprime mortgage crisis in the U.S.

Other countries like Germany followed this idea as a result of the financial crisis.
The problem with bad banks is the moral hazard effect. The construct that allows a financial institution to transfer their risks to the bad bank and the government will create an incentive for such financial institutions to take on higher risks in the confidence that they can pass on these risks. In addition, the bad bank is not a ‘normal’ market participant. The banks may gain trust by transferring their bad assets (e.g. asset backed securities), the bad bank itself not. The bad bank is – until it is reincorporated – dependent on government funds.

A positive example of a bad bank is Securum, a Swedish bank founded in 1992 for the purpose of taking on and unwinding bad debts from the partly state-owned Nordbanken bank during the financial crisis in Sweden 1990-1994. Many of the debts were owed by real-estate companies and it became a goal for Securum to stabilize the property market.

The company took over a quarter of the bank's credit portfolio, comprising 3000 credits with 1274 companies and the management of Securum were given free hands. By 1994 a large number of credits were unwound and by summer 1997 Securum itself could be wound down.
The ways bad banks are structured differ. In Germany for example, banks are now allowed to transfer their bad assets into such a bad bank to adjust and unburden their balance sheet. That will enable the banks to get fresh equity capital. However, it is not that simple. The banks have to build a special purpose community that buys the toxic papers for 90% of their value as of 30th June 2008. Since their value is currently much less, the banks have to pay the difference in equal installments over a period of 20 years (and a fee for the government securities). This means they cannot get rid of the problematic assets in total.

For a financial institution that follows this path (it is voluntary!) the finance and controlling departments as well as the risk management department will have more work to do. Additional reporting requirements will occur.

The normal financial statement will not include the toxic papers and will reduce the balance sheet. However, the bank has to build accruals for the installments (if their reporting GAAP allows accruals to be built). In addition, they will also build an internal management view of the financial statement which will include the impact of the bad assets, i.e. the installments.
Additional reporting will be also required for banks that are evaluating the possibility of using the bad bank on the risk management side. The calculation of risk needs to be reviewed and new KPIs have to be included in the dashboards that simulate the impact of the toxic papers on and off the balanced sheet.

Furthermore, the executive board, which is now sometimes influenced or controlled by the government, has additional reporting needs that give them better oversight of the business.

The risk appetite of financial institutions (despite the bad banks in place) may have changed but is still apparent. yet the risk models and the funds transfer pricing calculations are adjusted to the new circumstances. These will most likely impact the reporting needs as well. More in-depth knowledge of the loans, mortgages etc. by various attributes / dimensions is required in order to fully understand the loss given default (LGD), probability of default (PD), and the expected exposure rate (EE) – to name just a few risk indicators.

The analysis of risk is complicated and requires a vast amount of data. It is not sufficient to concentrate on a “risk cube” or “risk data mart” for reporting. The financial institutions demand an analysis across multiple source systems, including external benchmarks, as well as low level detail information (probably down to the transaction level).

A reporting tool that can fulfill this multi-sourcing without any problems and can drill anywhere to the detailed data is therefore mandatory, at least that is the feedback that I am receiving from my customers.