Reestablishing stability and avoiding a credit crunch: Comparing different bad bank schemes

•We model two different bad bank schemes: a scheme similar to an outright sale of toxic assets to a bad bank and a scheme similar to a repurchase agreement over the toxic assets.•We derive a critical transfer payment that induces a bank manager to participate.•We examine the bad bank schemes’ effects on credit supply, financial stability and costs to the taxpayers.•An outright sale will be less costly to taxpayers than a repurchase agreement if the transfer payment is sufficiently low.

This paper develops a model to analyze two different bad bank schemes, an outright sale of toxic assets to a state-owned bad bank and a repurchase agreement between the bad bank and the initial bank. For both schemes, we derive a critical transfer payment that induces a bank manager to participate. Participation improves the bank's solvency and enables the bank to grant new loans. Therefore, both schemes can reestablish stability and avoid a credit crunch. An outright sale will be less costly to taxpayers than a repurchase agreement if the transfer payment is sufficiently low.