What it is:
A bad bank is a new company created to buy poorly-performing assets from another bank.
How it works (Example):
For example, let's assume that Bank XYZ has made an extraordinary number of loans to borrowers who can't pay them back. As time goes by, it becomes increasingly clear that a majority of Bank XYZ's loans will not be repaid in full. The bad loans sitting on the bank's balance sheet are jeopardizing Bank XYZ's ability to stay in business.
Bank XYZ decides to create a wholly-owned subsidiary to buy the nonperforming loans from Bank XYZ. This new "bad bank" will buy the nonperforming assets and get them off Bank XYZ's balance sheet, thereby improving Bank XYZ's ability to start lending again. The bad bank can either hold the nonperforming loans and hope borrowers start paying on them, or it can sell the nonperforming loans to other investors.
Why it Matters:
Governments often encourage the creation of bad banks in order to stabilize a faltering financial sector. Sweden, Finland and Ireland have all used bad banks to help end financial crises. Even though the bad loans don't go away, getting the bad loans off a bank's balance sheet can give the bank additional time to repair itself.
Creating a bad bank is a way to segregate nonperforming assets from a bank's core business. In theory, once the bad assets are removed from the balance sheet, the bank will be able to start lending again. The idea is that over time, the bank will earn enough interest from new, good loans to cover the losses from the bad loans it made before the financial crisis.