"No bad bank please," says analyst Whitney

(Reuters) - The idea of creating a "bad bank" is unlikely to address the root problem of contracting system capital as simply removing "toxic" assets from bank balance sheets would not cause banks to increase lending, veteran banking analyst Meredith Whitney said.

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," she wrote in a note to clients.

Apart from writedowns from structured securities and illiquid assets, commercial banks also face problems from rising defaults on balance sheet loans, Oppenheimer's Whitney said. "If a bank were to sell its "bad" assets into a "bad bank," it would still be left with lower earnings power from higher losses on "good loans" and the requirement to build reserves, lower earnings power from lower assets and a higher legacy expense structure, or both," she said.

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.

"Those lenders, we argue, should monetize their "good" assets to cover their "bad" assets."

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.

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