A bad bank is a bank that is set up to hold risky, problematic holdings of a banks. By doing so, the actual bank can clear them off their books. The transfer of assets take place at market price. Bad banks is a simple idea of moving away that bad parts of the portfolio into another one, so that it doesn't contaminate the rest. Allowing the bank to focus on it's core activity of lending. The creation of a bad bank can be done even if there are no problematic assets, but if the bank wants to shift it's core strategy.
This is a good way of reducing the risk of the depositors. But investors will still lose their money. By separating out the risky parts of the assets, it enables investors to better gauge the health of the company. Usually improving it's overall outlook and making it easier to raise money in the future.
From a systems point of view this make more sense. Divide and conquer. The manager of the bad bank can then focus on managing the risky assets. This gives more room for investment practice as they are not tied to non-risky assets. The time horizon and risk profile are quite different for different underlying assets.
Over speculation of property assets and the exchange rate of the Swedish Krona led to a majorin Sweden. By 1992, 3 major banks were insolvent. McKinsey & Company were bought in to solve the situation. They proposed two bad banks that moved the toxic assets of the remaining banks at market price. The government in the end had to bailout at a price reportedly about 2% of the GDP. However, it was a backstop measure for this turning into a larger catastrophe.
After the 2008 financial crisis, this idea gained more popularity. It was seen as a method to handle such crisis without leading large financial institutions to insolvency.the Indian union budget proposed to set up a bad bank to clean-up the bad assets in the financial system.