"No bad bank please," says analyst Whitney

BANGALORE (Reuters) - Creating a "bad bank" to absorb toxic assets from banks'' balance sheets would not cause banks to increase lending, nor would it address the root problem of shrinking capital, prominent banking analyst Meredith Whitney said.

U.S. President Barack Obama''s administration is increasingly focused on the possible creation of a "bad bank" that would let U.S. financial institutions move toxic assets off their books and could potentially take trillions of dollars of assets off banks'' balance sheets.

Lending standards have tightened dramatically, and there is an unavoidable restructuring of risk taking place, causing money to come out of the system and lending to contract, with or without a "bad bank" structure, Whitney said.

"Lower asset bases, higher credit losses and bloated expense structures will continue to pressure banks'' earnings power and capital creation," the analyst wrote in a note titled "no bad banks please."

A vast majority of toxic assets related to securities have already been written down and only few lenders would dominate the lion''s share of the "bad bank," Whitney added.

Sandler O''Neill analyst R. Scott Siefers called the idea of a "bad bank" a "potentially good news" for investors after a "terrible earnings season," but said still more questions remain than answers about the government''s plans.

"At the core is the dilemma of how the government can help save the industry without basically owning it," Siefers wrote in a note.

Realistically, any "bad bank" is likely to face many of the same obstacles that ultimately felled Treasury''s original intent to purchase assets from the banking system, he said.

"The bottom line is that regulators and legislators will likely try to act for the best interests of the financial system at large, which may not align well with the interests of existing common shareholders."

However, the U.S. Bank Research Group at Fox-Pitt Kelton said creation of a bad bank is "far more productive and common shareholder friendly than direct nationalization."

Given the limitations on the size of the bad-bank program, it is possible that smaller and weaker banks with very high proportion of problem assets to total assets might be forced to merge with stronger players, the brokerage said in a note to clients.

Acquisition of problem assets will motivate private capital, mostly distressed asset funds, to finally come off the sidelines and buy, Fox-Pitt said.

Sandler''s Siefers also said after widespread criticism of the government''s liberal approach in the Troubled Assets Relief Program, the government could take a more discriminating approach to doling out taxpayer money resulting in the industry getting more consolidated.

"Put simply, we doubt that more debt is going to solve the industry''s problems once and for all," he said referring to the issuance of potentially trillions of dollars of new debt by the Federal government to support the plan.

(Reporting by Anurag Kotoky in Bangalore; Editing by Amitha Rajan, Dinesh Nair)