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Number 9, Autumn 2009 McKinsey on Corporate & Investment Banking The McKinsey Global CIB 50 Divergent paths for the new power brokers 4836 Understanding the bad bank 16 Commercial real- estate lending: Finding economic profit in a difficult industry 4 Hidden in plain sight: The hunt for banking capital 26 16 “Bad banks” are back. The concept is simple. The bank divides its assets into two categories. Into the bad pile go the illiquid and risky securities that are the bane of the banking system, along with other troubled assets such as nonperforming loans. For good measure, the bank can toss in non- strategic assets from businesses it wants to exit, or assets it simply no longer wants to own as it seeks to lessen risk and deleverage the balance sheet. What are left are the good assets that represent the ongoing business of the core bank. By segregating the two, the bank keeps the bad assets from contaminating the good. So long as the two are mixed, investors and counterparties are Gabriel Brenna, Thomas Poppensieker, and Sebastian Schneider Understanding the bad bank uncertain about the bank’s financial health and performance, impairing its ability to borrow, lend, trade, and raise capital. The bad-bank concept has been used with great success in the past and has today become a valuable solution for banks seeking shelter from the financial crisis. But while the idea is simple, the practice is quite complicated. There are many organizational, structural, and financial trade-offs to consider. The effect of these choices on the bank’s liquidity, balance sheet, and profits can be difficult to predict, especially in the current crisis. Capital and funding markets are still fragile in many regions, and many asset classes have been severely affected. For many, this is the best exit from the financial crisis—but the choices entailed are not straightforward. 17 Consequently, institutions have developed several variations on the bad-bank theme to handle their particular sets of troubled assets and their available financial resources. These banks have made their choices, for better or worse, and are now working through a range of operational problems. Others, however, are still stuck at square one and are understandably perplexed by the range of possibilities and how the choice of a bad-bank model might affect their future. An analysis of bad banks set up in the crisis suggests that there are five sets of choices banks must make—choices about the assets to be transferred, the structure, the business case, the portfolio strategy, and the operating model. Each of these choices must be made while consid- ering the impact on funding, capital relief, cost, feasibility, profits, and timing—a daunting array. Success depends on getting these choices right, and on a number of other factors. Chief among these is government support, to help banks understand and manage the many regulatory, accounting, and tax issues, and in some cases to provide financial backing. Again, each coun- try’s case is different, depending on the health of its banks, but broadly speaking, governments must smooth the way for the creation of bad banks and clearly establish the extent to which the state will assume the risk of the bad assets. In some countries, governments are considering a national bad bank to house the unwanted assets Exhibit 1 Wholesale funding Short-term funding spreads are slowly returning to pre-crisis levels. Top 30 EU banks Before credit crisis After credit crisis 2008 ECB2 liquidity supply (~€600 billion) Bear Stearns bailout Collapse of Lehman MoCiB 2009 Bad Banks Exhibit 1 of 5 Glance: Short-term funding spreads are slowly returning to precrisis levels. Exhibit title: Still expensive 1Spreads over three-month German government bonds; end-of-month data. 2European Central Bank. 3Excluding June. Source: Bloomberg; Dealogic; McKinsey analysis 20062005200420032002200120001999 –50 0 50 100 150 200 250 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q23 2007 2008 2009 Volume of new debt issued, by quarter, € billion Euro interbank offered rate, 3-month spreads,1 basis points 2007 ECB2 liquidity supply (~€300 billion) 9/11 attack 244 241 92 173 78 92 159 92 129 104 Three-month Euribor1 spreads2 and new debt issues by quarter3 Basis points, € billion 18 McKinsey on Corporate & Investment Banking Autumn 2009 of all domestic banks. Many governments have not gone that far, but most are concluding that their support is justified to ensure the future stability of the financial system. The bad-bank concept has attracted so much support lately that it is now widely viewed as the most likely savior in the rescue of the banking system. While that may be expecting too much, it is fair to say that an understanding of the bad bank is essential for the modern banker. From good to bad Two years on, the crisis continues to afflict most banks, particularly those with significant levels of illiquid and difficult-to-sell securities—the so- called toxic assets, and especially collateralized mortgage obligations (CMOs), collateralized debt obligations (CDOs), and collateralized loan obligations (CLOs). With these assets still on the balance sheet, banks are finding it difficult to raise funds from wholesale markets or capital from equity investors. Short-term funding spreads are slowly returning to precrisis levels, but they are still well above the levels seen in the early part of this decade—this despite the still-significant support (including quantitative easing, repurchase programs, loan guarantees, liberalized collateral requirements, and so on) from the central banks (Exhibit 1). Exhibit 2 Five key design elements These variables help determine the bad bank’s structure and operations. MoCiB 2009 Bad Banks Exhibit 2 of 5 Glance: These variables help determine the bad bank’s structure and operations. Exhibit title: Five key design elements 1Mark to market. 2Risk-weighted assets. 3Net present value. 4Balance sheet. 5Service-level agreements. • Define assets to be included in bad bank vs core bank – Strategic and nonstrategic assets – Performing and nonperforming loans • Complexity of assets • Sufficiently forward-looking selection that considers capital/ funding constraints • New risk types (MtM,1 RWA2) and external requirements (EU) • Develop basic bad-bank structure – On- vs off-balance sheet – Internal vs external unit • Trade-off between comprehensiveness of solution and speed of implementation • Create business plan to maximize economics and define speed of rundown • Primary focus on protecting capital, less on long-term NPV3 maximization • Also: additional constraints considered in business case, eg, B/S4 reduction, liquidity • Define optimum portfolio rundown strategies: passive rundown, transactions, workout on balance sheet • Set up reporting; implement/monitor portfolio strategies • Limited P&L budgets; illiquidity of markets for wind-down • Focus on longer- term, more complex strategies (also given heterogeneous assets) • Set up organization, operating model, and processes • Define interface, SLAs5 with core bank • Set up incentive system aligned with strategic objectives • More complex setups given constraints (costs, legal setup, external view) • Limitations on bonus-based incentives Description Specific challenges from the crisis Asset scope Structural model Business case Operating model and processes Portfolio business strategy 19Understanding the bad bank Finding funds will soon get more difficult. Regula- tors are preparing new capital requirements and other changes that will impose fearsome new burdens on banks. Regulators including the Financial Services Authority (FSA) are considering raising capital requirements for some institutions and asset classes by a factor of three to five. In response, banks are pursuing several channels. Most obviously, they are getting out of capital- intensive and structured businesses—in a word, deleveraging. They are pulling back from international operations to concentrate on domestic business. And they are dramatically overhauling their risk functions. All these steps are necessary and proper—but they may be insufficient. Capital is still scarce. Banks are still overleveraged, and unsalable assets still carry too much risk. Confidence is still wanting; so long as the illiquid assets sit on banks’ shelves, investors will be wary. Hence the return of the bad bank. Dividing in two can help stricken institutions ring-fence their core businesses and keep them separate from the contamination of toxic assets. The separation allows the bank to lower its risk and to deleverage as first steps toward creating a sound business model for the future. A more efficient and focused management with clear incentives for portfolio reduction can maximize the value of bad assets. And the clear separation of good from bad can help banks regain the trust of investors, by providing more transparency into the core business and lowering investors’ “monitoring costs.” All these benefits do not, however, come for free: there are still economic losses and risks on the balance sheet that must be shared between the good-bank and bad- bank investors. Divide and conquer As noted, the bad-bank idea is not new. It was pioneered at Mellon Bank in 1988 in response to deep problems in the bank’s commercial real- estate portfolio. It was applied in past banking crises in Sweden, France, and Germany. And in the current crisis, banks have been busily reinvigorating the idea. As suggested above, every self-dividing bank seeks to do three things: clean up the balance sheet and so restore confidence, protect the profit and loss (P&L), and assign clear responsibility for the management of both good and bad banks. In the early examples, the emphasis was on improving the bank’s profits through a better incentive system and a more focused and efficient wind-down of assets. In the current crisis, much of the focus is on rebuilding trust with investors and rating agencies by clearly separating the assets and providing transpar- ency into the bank’s operating performance. With trust restored and capital to back investors’ faith, banks are convinced that their economics will improve. In sorting through the various structures banks are using today, we have identified five sets of choices that go a long way toward determining the bad bank’s structure and operations and eventual success (Exhibit 2). We explore each of these five variables here. Asset scope Banks need to address two broad categories of assets. At the center of the discussion, as noted, are assets with a high risk of default, substan- tial mark-to-market risk, or substantial risks from “ratings drift” under Basel II. For most banks, that means structured credit and related asset 20 McKinsey on Corporate & Investment Banking Autumn 2009 classes that have come under strain in the crisis. The mark-to-market and Basel II risks that dominate toxic securities portfolios seem to have reached a peak. But as the global recession continues, the risk from credit defaults is still present and may even be on the rise. In the United States, the United Kingdom, southern Europe and Eastern Europe, commercial real-estate loans are poised to default; some consumer credits are also wobbly in these regions. Some structured credits are faring poorly in the United States and Western Europe. The second category, which we call nonstrategic assets, includes anything the bank wants to dispose of, either to deleverage or otherwise resize its business model. This might include the assets of entire business lines or regional operations. The key to determining the right assets to go into the bad bank is a forward-looking view on the bank’s risk and its future business model. A bank can only segregate bad assets once without losing its credibility. Organizational model There are four basic models for the bad bank; variants and hybrids are possible (Exhibit 3). The model is determined primarily by the choice of whether or not to keep the assets on the balance sheet. Moving them off the balance sheet provides greater comfort to investors and counterparties and better transparency into the core bank’s economics, but it is more complex and expensive. A secondary choice is whether to house and manage the bad-bank assets in a banking entity or to accomplish the transfer Exhibit 3 Four types of bad banks The bank’s model is primarily determined by choosing whether to keep assets on the balance sheet. MoCiB 2009 Bad Banks Exhibit 3 of 5 Glance: The bank’s model is primarily determined by choosing whether to keep assets on the balance sheet. Exhibit title: Four types of bad banks Structured solution Banking entity Management model/risk transfer On balance sheet Off balance sheet Ac co un tin g m od el On-balance-sheet guarantee • No balance-sheet ‘deconsolidation’ • High structural complexity – External guarantee – Specific regulatory/legal framework • Capitalization available • Faster, simpler • Limited risk transfer Internal restructuring unit • No balance-sheet deconsolidation • Transfer of assets into one separate business unit (locations, subsidiaries) • Separate org. and operations • Internal risk/profit split between business units and bad bank Bad-bank spinoff • Structural complexity – Legal, tax, accounting, regulatory – Asset transfer vs carveout • Capitalization and funding restrictions • Operational complexity and setup Special-purpose entity • Limited asset scope (living loan portfolios) • Complexity in current market – External rating/funding – Asset transfer, P&L implications – Capitalization needs • Maximum risk transfer/protection • Higher complexity 21Understanding the bad bank of risk in a less concrete way—what we call a “structured solution.” The four basic models are as follows: • On-balance-sheet guarantee. In this structured solution, the bank protects part of its portfolio against losses, typically with a second-loss guar- antee from the government. The model can be implemented quickly and minimizes the need for upfront capital, but it results in only limited risk transfer. The continued presence of the bad assets on the balance sheet and the lack of clear legal separation make this the least attrac- tive model to new investors; for them, the bank’s core performance is still not transparent. The approach might best be used as a first step to stabilize the bank, buying enough time to develop a more comprehensive solution. That was the case at Citibank, where government guarantees were provided as a first step to ring- fence the economic risks on the balance sheet. • Internal restructuring unit. Establishing an internal bad bank or restructuring unit becomes attractive when the toxic and nonstrategic assets account for a sizable share—20 percent or more—of the balance sheet. In this scheme, the bank places the restructuring or workout of the assets in a separate unit, which ensures management focus, efficiency, and clear incen- tives. As an example, Dresdner Bank established an internal restructuring unit in 2003 and dedicated about 400 FTEs1 to the asset restruc- turing and workout of a €35 billion portfolio. The unit shut down ahead of schedule in 2005. While this on-balance-sheet solution still lacks efficient risk transfer, it provides a clear signal to the market and increases transparency into the bank’s performance—particularly if the results are reported separately. Any bank that wants to create a fully separated bad bank (described below) is likely to first create an internal restructuring unit. • Special-purpose entity. In this off-balance-sheet structured solution, the bank offloads its unwanted assets into a special-purpose entity (SPE), usually government-sponsored, which is then taken off its balance sheet. An example of a bank that has followed this approach is UBS, which transferred around £24 billion of illiquid securities to an off-balance-sheet SPE funded 1 Full-time equivalents. 22 McKinsey on Corporate & Investment Banking Autumn 2009 by the Swiss National Bank. This solution works best for a small, homogeneous set of assets, as structuring credit assets into an SPE is a very complex move and for many banks is not practical. The heterogeneity of the assets involved, investors’ mistrust of securitization structures, and new regulatory penalties make most securi-tizations too expensive for banks. • Bad-bank spinoff. This is the most familiar model and also the most thorough and effective. In the spinoff, the bank shifts the assets off the balance sheet and into a legally separate banking entity. Such an external bad bank ensures maximum risk transfer, increases the bank’s strategic flexibility (for example, for potential M&A), and is a prerequisite for attract- ing outside investors. However, the complexity and cost of the bad-bank spinoff and its operation are very high because of the need for com- pletely separate organizational structures and IT systems and a doubling of the effort needed to comply with legal and regulatory requirements. There are further complexities surrounding asset valuation and transfer; funding for the bad bank may not be readily available, and there is no ready-made legal or accounting framework for asset transfer to bad-bank entities. For all these reasons, the bad-bank spinoff is a last resort, a step to be taken only after other measures prove insufficient in efficiently manag- ing all toxic and nonstrategic assets. The challenges involved in a bad-bank spinoff will typically require that governments play a key role, especially in creating a common legal and regulatory framework and in supporting bad banks through funding or loss guarantees. Business case Each of the four structural solutions must be evaluated against a clear set of predefined criteria in order to create a comprehensive business case that calculates their effects, today and in the future, on balance-sheet reduction, liquidity, and capital protection—the goals of the exercise. The criteria should include those relating to solvency and the balance-sheet (capital and RWA relief under Basel II, mark- to-market volatility, expected losses), cost (transfer costs, funding costs, guarantee and capital costs, operating costs), and legal, regulatory, and accounting issues. The result will be a business plan that will maximize the bank’s economics and suggest the speed at which the portfolio is wound down. The mechanics of that winding-down are deter- mined in the next step. Portfolio strategy Identifying and pursuing the optimal strategy for the bad assets once the appropriate structure has been chosen will be crucial to maximizing their value. Given that some proposed bad-bank portfolios are very large, up to €100 billion in size, an improvement of a portfolio’s return by only a few percentage points creates enormous value for the bank. There are three common strategies for extracting value from the assets (Exhibit 4): • Passive rundown. The bank monitors the assets an