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In Portugal, a 'bad bank' saves the day

Banco Espirito Santo

Portugal announced it will inject 4.4 billion euros ($5.9 billion) into the crisis-hit Banco Espirito Santo amid fear of a catastrophic bank run.

A multi-billion dollar rescue is underway for a European bank, and global economy watchers are hopeful the fix will keep the problem from spreading beyond Portugal.

Banco Espirito Santo is getting chopped in two. Its toxic assets will be held in a so-called “bad bank,” a concept that drew attention during the worst of the global financial crisis.

The idea is that with bad loans and other toxic assets segregated from strong assets, the “good bank” can go on with the regular business of taking deposits and lending, without worries that customers will freak out and withdraw all their money, causing chaos.

When the bad bank tries to sell off the bad stuff, lots of money will be lost. But unlike previous bank bailouts, the burden doesn’t all land on taxpayers.

"The losses are gonna be borne by some of the creditors to that bank and the people that own stock in that bank, the shareholders," explains Matt Slaughter, associate dean at Dartmouth’s Tuck School of Business. "That’s a good move."

Slaughter says banks will manage risk better, if they don’t assume taxpayers will ultimately pay the bills for their screw-ups.

Mark Garrison: The basic idea’s actually quite simple. Raj Bhala, who teaches international law at University of Kansas, gives us a visual aid.

Raj Bhala: If you were drawing it out on a blackboard, you would be drawing out good assets and putting a big circle around them and then you’d be drawing bad assets and putting a big circle around them. They would not be linked.

European bankers call this ring-fencing and they love to reference herding cattle. Kerry Cornelius runs a real cattle ranch and directs the Ranch Management Program at Texas Christian University. He says fencing plays a role, but EU officials seem a bit off with their terms.

Kerry Cornelius: I think that’s something that bankers probably came up or dreamed up on their own.

Linda Hooks: Regulators and analysts look for analogies and the fence analogy makes a lot of sense. You’re trying to contain a problem and keep it from growing any further.

Washington and Lee economics professor Linda Hooks says when a bad bank fences off or herds in or does whatever to toxic assets, the good bank can thrive. It goes on with regular business of taking deposits and lending and customers won’t freak out and pull all their money, causing chaos. When the bad bank tries to sell off the bad stuff, lots of money will be lost. But as Dartmouth business school associate dean Matt Slaughter points out, unlike previous bank bailouts, it doesn’t all land on taxpayers.

Matt Slaughter: The losses are gonna be borne by some of the creditors to that bank and the people that own stock in that bank, the shareholders. And that’s a good move actually, going forward.

Slaughter says banks will manage risk better, if they don’t assume taxpayers will pay for their screw-ups. I'm Mark Garrison, for Marketplace.

About the author

Mark Garrison is a reporter and substitute host for Marketplace, based in New York.

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