Steps to making a bad bank

For a lot of reasons, I think a bad bank without prior national-isation is a bad idea. But if you were going to do it (as lots of people now seem to think is likely - see FT alphaville here for a summary), what would you do?

• The key problems are valuation and moral hazard.
  
• For valuation, establish a reasonable lower bound on the asset, such that it is rather unlikely to be worth less than x. Buy the asset for x in cash.
  
• To give the banks some incentive, give them a warrant granting them some participation in the upside over x when the asset is sold or in its long term cashflow, if it cannot be sold. The participation rate should not be too high: 50% at most.
  
• The state will need to backstop the bad bank in case the total value turns out to be less than the sum of the xs. Moral hazard considerations require that the state gets a return for its risk.
  
• Therefore for each dollar notional sold to the bad bank, the banks will be required to hand over, for nothing, warrants on their common stock. The conversion ratio can be debated, but given the likely adverse selection issues, it should be reasonably penal.
  
• And of course there should be limits on executive compensation, requirements to lend and so on as part of the price of participating.