Q&A: RBS 'bad bank' explained

RBS The UK government bought the shares in RBS at the height of the crisis at just over 500p a share

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Royal Bank of Scotland has announced it will not split itself into separate "good" and "bad" banks.

After reporting the biggest loss in UK corporate history at 2008 at the peak of the financial crisis, RBS was bailed out by the government and remains 81%-owned by the taxpayer.

There was much speculation that the bank would be split in an effort to restore profitability - but now that will not happen.

What is a bad bank?

When a bank runs into trouble, its balance sheet is usually weighed down with worthless loans. These assets are so poor that their losses outweigh any potentially profitable parts and prevent the bank from lending out money.

Without being able to lend more money, which is the point of its existence, a bank can't generate an income.

One way of dealing with this is to take out all the toxic assets from the so-called good bank, and put them with a bad bank, to be run by the government. That way the bank can get on with the job of being a bank and the government can deal with managing or selling off the bad assets in a measured way.

The best example of this is the 1990s Swedish banking crisis. Following a property boom in the 1980s, the inevitable bust followed, leaving most of the biggest banks in the country insolvent.

Sweden created two bad banks to take on the bad debts of its biggest banks. Securum, one of the bad banks, was created in 1992 and wound down in 1997, when the economy recovered and the banks had healed.

More recently, Ireland's overloaded banking sector collapsed following the banking crisis and the state formed the National Asset Management Agency - which is still going - to manage all the bad assets of its insolvent lenders.

In the UK, there is a recent precedent.

Northern Rock was nationalised in 2008, and the bank was split into two in 2010. Virgin Money bought the good part and the bad bits are still held by the government-owned Northern Rock (Asset Management) Plc.

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The new plan is for RBS to somehow get rid of up to 70% of this radioactive debt - which contains the worst of the bank's commercial property and Irish lending - over two years, with a hope that perhaps it can all be gone within three years”

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Why was there speculation that RBS would be split up?

At the end of March, RBS still had £54.6bn of what it calls non-core assets - or the toxic assets that would make a bad bank.

The then-Bank of England governor, Lord King, in March told the Parliamentary Commission on Banking Standards that there was a good bank and a bad bank. He added: "RBS is worth less than we thought and we should accept that and get back to finding a way to create a new RBS that could be a major lender to the UK economy."

Talk of splitting the bank grew after his comments but, in the end, the Banking Standards Commission did not call firmly for the splitting up of the bank in its report in June, instead urging the Treasury to carry out a forensic analysis of whether RBS actually needed to be restructured, which the commission did not have the time to do.

Chancellor George Osborne said he would look at a split of the bank but he did not want "a quick sale of our RBS shares".

The bank has now said that it will create an internal bad bank to "manage the run-down of high-risk assets" of around £38bn by the end of 2013. "The goal is to remove 55-70% of these assets over the next two years," RBS says.

So instead of splitting the bank into two, the bank is to create an internal bad bank full of its toxic assets.

What actually is an "internal bad bank"?

It means RBS's poor quality assets will be managed separately within RBS itself - under the name RBS Capital Resolution Group - rather than outside the bank by the government as it did with Northern Rock's worst bits.

This means that RBS still thinks it can solve its own problems and there is still some value to be extracted from these assets. It plans to sell the assets within three years.

The BBC's business editor Robert Peston said "perhaps most embarrassingly" RBS lacks what the bank calls the adequate "momentum" to generate the relevant capital it needs simply by generating bigger profits, so it needs to fix the bad assets on its balance sheet by selling them quickly at firesale prices.

Whether RBS will actually be able to sell these assets, keep enough cash on its books and lend more in those three years is open to question.

When will the government get its money back?

According to Mr Osborne, the move will make it easier to return RBS to the private sector.

The then-Chancellor, Alistair Darling, invested £45bn into RBS in 2008 order to save it. The government bought shares in RBS at a price of just over 500p, but they are currently trading at around 360p.

The bank's previous chief executive, Stephen Hester, said in the summer the Treasury would get its money back, but that privatising RBS could take up to 10 years. Many people want the bank to pay back that money much more quickly.

The situation at RBS contrasts with the other bank to receive UK government aid, Lloyds.

In 2008, the government injected a total of £20.5bn into Lloyds, buying shares at an average price of 73.6p.

Lloyds' shares are currently trading above this price, and in September the government sold a chunk of shares, reduced its stake in the bank from 39% to 33%.

Further sales of Lloyds shares are under consideration, although there is no fixed timetable.

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