Should Investors Celebrate Or Fear Barclays PLC’s Bad Bank?

When Barclays (LSE: BARC) (NYSE: BCS.US) revealed its strategic plans to investors at the beginning of May, the bank’s creation of a “bad bank”, as part of its strategic overhaul, was praised by analysts.

Barclays’ bad bank is designed to house a significant chunk of the company’s investment banking business and European retail operations. In total, the bad bank will eventually sell or run down £116bn of non-core operations, initially costing Barclays £800m to set up, on top of the original £2.7bn restructuring costs it announced back in February 2013.

As mentioned above, analysts praised this move by Barclays to separate its underperforming, non-core assets into a bad bank, but is this good news for investors and what does a bad bank actually do?

What is a bad bank?

Bad banks are separate corporate structures, designed to hold all the poor assets of the parent bank. These assets can include instruments such as complex derivative products, underperforming ventures abroad and underperforming loans, as well as toxic loans.

The biggest of these bad banks here in the UK is the government-owned and sponsored UK Asset Resolution, which contains all of Northern Rock’s and Bradford & Bingley’s unwanted, toxic assets. UK Asset Resolution is also responsible for guaranteeing mortgages under the controversial Help to Buy scheme.

Creating a bad bank allows the parent bank to improve the quality of its balance sheet, effectively window-dressing the balance sheet, spinning all the rubbish into a separate entity. As a result, the theory is that the bank’s balance sheet will look stronger.

However, the bank, in this case Barclays, is still responsible for the bad bank assets and will need to shrink, or wind down the bad bank entity over the next few years. 

Are there any issues with this approach?

Bad banks should be welcomed by investors, as they have proven their worth during the past five years. Indeed, bad bank entities have been key in help banks successfully wind down many of the toxic assets born during the run up to the financial crisis.

For the most part, these entities have worked as they were designed to, however, running off the bank’s toxic assets into a separate entity can be time-consuming, although the clear divide established as to what stays and what goes is beneficial for both investors and bankers.

Still, running these assets down can drag on profits. Even non-core bad banks still have to book charges and loses from the sale of products, which then eat into the bank’s core earnings.

Other problems include the potential for ‘asset shifting’ where the bank shifts non-core assets between divisions, or postponing the wind down date of the bad bank, making a temporary structure permanent.

Overall, though, bad banks are generally considered to be a good thing in the long run.

Foolish summary

So, Barclays' bad bank should be a good thing for investors over the long-term, however, whether Barclays is a suitable investment for your portfolio is question only you can answer.

Understanding the banking industry is never a simple task, and I'd strongly suggest you look a little closer at Barclays before making any trading decision.

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Rupert does not own any share mentioned within this article.