Banks are special institutions. In virtually every country, they dominate financial intermediation. The functions of banks are so vital to a country’s economy that, collectively, they comprise a public service. This position is commonly justified by three characteristics of banks, namely:
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Asset/liability mismatch (demand deposits/long-term loans), which is sensitive to maintaining public confidence to prevent massive deposit withdrawals (i.e., bank runs)
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Provision of financial services, which is fundamental to the functioning of the economy (primary source of liquidity for most companies)
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The link between the monetary policy process and the economy.1
Banks can be more susceptible to moral hazard because their profits are generated by using other people’s money (deposits).2 This tendency to take greater risks leads to a greater potential for problems, ranging from poor asset quality to fraud.
As with health matters, when dealing with problem banks, prevention is preferable to cure. The vital responsibility of bank supervisors is to respond promptly when problems emerge in banks. Moreover, despite the public service aspect of banking, disciplining excessive risk-takers who allow banks to fail is characteristic of an effective bank supervision regime in a strong economy.
The aphorism that “banking is essential; banks are not” is true: Although banking is necessary for a country in this modern world, a specific individual bank is not. Problem banks should be resolved as expeditiously as possible to reduce costs and maintain financial stability and public confidence in the banking sector. In other words, in a healthy economy banks should be allowed to fail.3
An effective bank supervision system is critical to a country’s financial stability. Prudential regulations set forth the framework within which banks must operate, and the supervisory authority is responsible for enforcing these regulations. When a bank faces financial difficulties or operates in an unsafe and unsound manner, the supervisory authority is responsible for taking action to resolve these problems.
Most effective banking laws contain provisions that allow the supervisory authority to take such corrective action. Action can range from moral suasion (appealing to the bank management and board of directors for their sense of public responsibility), informal and formal enforcement (including fines and removal of personnel), and appointment of a conservator to license revocation and appointment of a receiver. (Conservatorship is an appropriate action when, for example, fraud is detected in an otherwise good bank that has some franchise value. The bad management is then removed and the conservator runs the bank, conserving its assets while developing a resolution plan.)
Ultimately, a bank’s management, board of directors, and shareholders are responsible for its profitable operations and viability. The supervisory authority, however, is responsible for problem bank resolution. Many jurisdictions have implemented “prompt corrective action” in their banking laws, which requires the supervisory authority to take action when a bank’s capital falls to a certain level, even if it is not technically insolvent.
Maintaining public confidence in the banking system is critical to avoiding bank runs and sustaining financial sector stability. Public confidence can be enhanced by promptly paying depositors and by limiting the adverse economic impact of a bank failure in a community.4 When banks are resolved expeditiously, the cost is lower, and asset and franchise values are protected and maximized. Allowing problem banks to continue operating distorts the market and increases moral hazard. Forbearance or procrastination invariably increases the cost of problem bank resolution.
This manual contains comprehensive standard procedures that can serve as a practical guide for problem bank resolution. The measures described represent best practices for countries where there is macroeconomic stability and a sound banking system with appropriate regulations and effective supervision.
For purposes of this manual, the following definitions of some important terms are used:
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Supervisory authority. The institution responsible for licensing, regulating, and supervising banks, whether contained within the central bank or an independent body.
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Conservatorship. Also known as special or provisional administration, or simply administration. Conserva-torship is a supervisory action whereby a conservator is appointed to conserve the assets of a problem bank and prepare a resolution plan. Conservators generally, though not always, are granted all the powers of a bank’s management and board of directors.5 Usually, appointing a conservator does not involve license revocation.6 Depending on the banking law, conser-vatorship may or may not require public notice.
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Intervention. The process of securing and making an inventory of a failed bank’s assets and preparing a final set of financial statements.7 The process is also referred to as “closing.”
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Receivership. Used synonymously with liquidation in this manual, receivership is the condition resulting from a failed bank that has had its license revoked and closed down. A receiver is generally responsible for liquidating a failed bank’s assets and satisfying claims to the extent possible. Receivership usually requires public notice.
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Resolution. The decisive action to solve the problems of the bank. Problem bank resolution can involve private solutions (e.g., recapitalization, sale of bank shares, merger); assisted transactions (e.g., P&A transaction, insured deposit transfer; or liquidated payout (see Chapter 5).
Note that although this manual is linear and sequential as it describes corrective measures, conservator appointment, and other key matters, not all actions are necessarily a required step in problem bank resolution. Often a bank’s condition may be so serious that it may be necessary to skip some corrective measures or conservatorship, or both, and proceed directly to appointment of a receiver and final bank resolution.
LEGAL FRAMEWORK
Problem bank resolution is difficult to complete through commercial bankruptcy courts because of shareholder and creditor rights (e.g., time-consuming appeals, hearings), which can postpone various actions (e.g., license revocation, depositor repayment), resulting in asset deterioration and less recovery through liquidation. These problems can often be exacerbated by bankruptcy trustees, who may be responsible for a bank’s liquidation but know little about the banking business. One of the biggest problems regarding bank resolution in countries without a special bank insolvency regime is the common inability to make prompt payment to depositors.
The commercial bankruptcy system is primarily concerned with protecting creditors.8 In bank bankruptcies, therefore, there is conflict between public and private interests. Some jurisdictions solve this problem by establishing special bankruptcy regimes for banks, whether as a separate proceeding, such as that enjoyed in the United States by the Federal Deposit Insurance Corporation (FDIC), or as an administrative function within the banking law, subject to review and finalization by the commercial bankruptcy court. In either case, any damages that a shareholder or creditor may be awarded are limited to financial amounts and not injunctions or reversals of decisions (to close the bank, for example). One argument against involving bankruptcy courts in the problem bank resolution process suggests that “Since banks are already subject to special regulation which determine the conditions of their operation, it is only the bank supervisor who is in a position to determine whether a bank is viable.”9
The policies and procedures specified in this manual work best in countries with a special insolvency regime for banks; that is, where supervisors and liquidators are not hampered in taking expedient action by shareholder and creditor appeals processes that are common to commercial bankruptcy law.10 See Table 1.1 for a comparison of selected elements for the two systems.
Contrasting a Special Bank Insolvency Regime with Commercial Bankruptcy Law
Contrasting a Special Bank Insolvency Regime with Commercial Bankruptcy Law
| Level of Judicial Review | Special Bank Insolvency Regime | Commercial Bankruptcy Law |
|---|---|---|
| Judicial review | A judge cannot substitute his opinion for the supervisory authority’s expertise and reverse that authority’s actions (e.g., bank license revocation). Successful shareholder (or other) appeals are restricted to monetary damages, not reversal of action. | Based on a successful shareholder appeal, a bankruptcy judge can often reverse the supervisory authority’s actions (e.g., order the banking license restored). |
| Claims process | A receiver has the power to allow or disallow claims. The holder of a disallowed claim may litigate its claim in federal court. | A bankruptcy trustee can object to a claim, but the bankruptcy court makes the allowance decision. |
| Contract repudiation | A receiver may repudiate any burdensome contract within a “reasonable time” of appointment. | A bankruptcy trustee can repudiate only executory contracts. |
| Stay of litigation | A receiver can request a stay of legal proceedings of up to 90 days. | The automatic stay in bankruptcy becomes effective immediately upon the bankruptcy petition filing. |
| Avoidance powers | Both a receiver and bankruptcy trustee have avoidance powers, that is, the ability to pursue fraudulent transfers by obligors made with the intent to hinder, delay, or defraud the institution. | A bankruptcy trustee generally can use only the defenses that were available to the debtor to defeat claims. |
| Special defenses | A receiver has special statutory defenses that it can use to defeat the defenses of obligors of a failed bank. |
Contrasting a Special Bank Insolvency Regime with Commercial Bankruptcy Law
| Level of Judicial Review | Special Bank Insolvency Regime | Commercial Bankruptcy Law |
|---|---|---|
| Judicial review | A judge cannot substitute his opinion for the supervisory authority’s expertise and reverse that authority’s actions (e.g., bank license revocation). Successful shareholder (or other) appeals are restricted to monetary damages, not reversal of action. | Based on a successful shareholder appeal, a bankruptcy judge can often reverse the supervisory authority’s actions (e.g., order the banking license restored). |
| Claims process | A receiver has the power to allow or disallow claims. The holder of a disallowed claim may litigate its claim in federal court. | A bankruptcy trustee can object to a claim, but the bankruptcy court makes the allowance decision. |
| Contract repudiation | A receiver may repudiate any burdensome contract within a “reasonable time” of appointment. | A bankruptcy trustee can repudiate only executory contracts. |
| Stay of litigation | A receiver can request a stay of legal proceedings of up to 90 days. | The automatic stay in bankruptcy becomes effective immediately upon the bankruptcy petition filing. |
| Avoidance powers | Both a receiver and bankruptcy trustee have avoidance powers, that is, the ability to pursue fraudulent transfers by obligors made with the intent to hinder, delay, or defraud the institution. | A bankruptcy trustee generally can use only the defenses that were available to the debtor to defeat claims. |
| Special defenses | A receiver has special statutory defenses that it can use to defeat the defenses of obligors of a failed bank. |
In countries where there is no special insolvency regime for banks, supervisors and liquidators may have to modify the guidance from this manual to adapt to the local situation. (Many of the measures described here can work equally well in circumstances where banks are liquidated through commercial bankruptcy courts.) Moreover, this manual (especially Chapter 7) assumes that reasonable creditor rights exist in the country (e.g., enabling a liquidator to take possession of collateral securing a nonperforming loan).
Additionally, many countries may have social contracts or labor union rights that may hinder problem bank resolution. The supervisory authority and the legal adviser must resolve these problems with the union or employee representatives. Reasonable severance may be called for; however, employee issues cannot justify forbearance in resolving a problem bank.
The legal representative of the supervisory authority will have ongoing duties throughout the resolution process. Generally, the representative will be involved in drafting corrective measures, legal documents, and any required notices. Additional duties will consist of providing legal assistance to a conservator or liquidator on broad matters, such as challenges to the supervisory authority’s actions, and more specific matters, such as assets in litigation, foreclosures, bankruptcies, etc.11 To the extent that the legislative system permits, the legal representative should assist outside counsel or liquidation staff, or both, in actively pursuing insider abuse and professional liability claims (e.g., actions against the failed bank’s directors and officers, auditing firms, legal firms), when there is negligence.
Finally, the supervisory authority and the deposit insurance agency (DIA), as applicable, may want to consider providing legal protection for their employees’ actions taken in good faith and in the normal course of their duties during the conservatorship or receivership process.
DEPOSIT INSURANCE DURING BANK FAILURES
To be thorough, this manual assumes that a narrow-mandate DIA exists. A narrow-mandate DIA has the primary responsibility of repayment of insured depositors; its bank resolution responsibilities are limited.12 In countries with no extant DIA, however, modifications to this guidance will be necessary.
Countries that have a DIA generally require repayment of insured depositors within a specified period. Many DIAs have adopted the European Union Directive on Deposit Insurance, which requires repayment within three months;13 however, to maintain confidence in the banking system, more prompt payment is preferred. DIA legislation generally specifies a trigger event (i.e., intervention, appointment of receiver, or revocation of a banking license) after which insured deposit repayment is to begin. Following the trigger event, the DIA is to compensate insured depositors according to the law.14
To maintain confidence in the banking system and minimize financial disruption, payments to insured depositors must be made as promptly as possible. Therefore, it is important that the DIA be involved early in the problem bank resolution process and work closely with the supervisory authority to accomplish this goal. Involvement early in the process helps to (1) prepare for insured deposit repayment and (2) analyze the impact of bank failure(s) on the deposit insurance fund (i.e., determine whether emergency funding will be needed).
There should be official documentation (e.g., legislation, regulation, or a memorandum of understanding) to formalize this agreement and set forth the responsibilities of each party. The agreement must provide for information, and possibly resource sharing between the two parties, along with division of responsibilities during a bank failure. As mentioned above, the DIA should be involved in, or at least informed about, marketing and negotiations of an assisted transaction (i.e., P&A and insured deposit transfer) or contracting with another bank to act as paying agent for insured deposits, among other duties.
This partnership arrangement is crucial, especially during the following periods:
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Bank intervention where the DIA would bear responsibility for reconciliation of deposit liabilities and computation of insured deposit amounts (in cases that go directly to receivership)
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Conservatorship where plans for final resolution take shape
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Bank resolution when negotiations for an insured deposit transfer or other paying agent bank transaction may take place
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Liquidation during the receivership, because the DIA, in subrogation to insured depositors, is likely to have the largest claim against the receivership (or especially when the DIA has a broad mandate and acts as liquidator or receiver).
MEDIA AND PUBLIC RELATIONS
Public awareness and education are important to maintain confidence in a country’s banking system. Any government body (supervisory authority, DIA, etc.) that implements new or reform programs has the responsibility to promote public understanding by developing communications plans and a formal media and public relations structure. This section covers media and public relations issues regarding bank intervention, conservatorship, and final resolution.
All safety net participants (i.e., central banks, regulatory authorities, and DIAs) should strive to develop sound media relations and communications programs to build bridges among the press, public, government, and banks. An official communications program serves two basic purposes: first, to respond to legitimate media inquiries; and second, to help carry out the agency’s mission of promoting reform while fostering a safe and sound banking system.
A supervisory authority and DIA should coordinate their efforts to promote a consistent message to the public. This is crucial in winning and maintaining public confidence in the DIA and banking system, especially in an emerging market economy.
Press releases and public appearances by senior executives can help build long-standing relationships and trust with media representatives who cover the financial sector. Learning about the needs of the media will provide an opportunity to communicate authorities’ perspective on events and issues. When this perspective is included in news reports, it will contribute to the public’s confidence in the underlying strength of the banking system and the DIA. These relationships will prove invaluable when the banking sector is experiencing problems.
Management of media and public relations is extremely important at virtually every stage of problem bank resolution. To maintain confidence in the banking system, proper handling of the media and public is critical during intervention, conservatorship, resolution, and liquidation. The goal is to deliver the message that authorities have taken a strong and serious action that will ultimately strengthen the banking sector.
Before any problem bank action is taken, communications departments from both the supervisory authority and the DIA should coordinate and provide information through one spokesperson. They should prepare and deliver a media statement immediately after taking control of a bank, providing information in a positive light to reassure the public. The information piece should stress that authorities have acted in the best interests of the depositors and the financial stability of the banking system. (See the section on media and public relations in Chapter 3 for specific guidance during a bank intervention.)
Without a communications plan, authorities will often spend much of the time on the defensive, reacting to criticism that may or may not be fair or accurate. This can be stressful and have an adverse impact on the banking system’s credibility and effectiveness.
CHAPTER SUMMARIES
Chapter 2 provides the background for problem bank resolution by discussing problem bank supervision and the various measures and procedures used by a supervisory authority to rehabilitate, restructure, or resolve a problem bank.
Chapter 3 covers bank intervention procedures. When progressive enforcement actions have failed to restore a bank to profitability or there is no chance for the bank to return to profitable operations, or both, the supervisory authority will decide to intervene the bank (with the aim to either rehabilitate it through conservatorship or liquidate it according to the law). The primary goal of a bank intervention is to control and inventory the assets of the bank, and to compensate insured depositors. A bank intervention team should be prepared to accomplish functional duties related to security, cash operations, assets, deposit operations, facilities, information technology, and legal matters. Depending on the number of branches, branch teams must be prepared to perform the same functions at each branch.
Chapter 4 reviews conservatorship operations. If the supervisory authority believes there is a chance to rehabilitate the bank, then it may appoint a conservator to accomplish this objective.15 Upon appointment, the conservator should have management control over the institution, with powers that replace those of the board of directors and senior management. The conservator should be given a specific time frame in which to thoroughly analyze the bank’s condition and prepare a resolution plan, if feasible, or liquidation. During conservatorship, the bank should remain open and maintain confidence in the banking system by allowing depositors access to their funds. Conservatorship functions should be limited (e.g., there should be no new lending) and focused on cost-saving measures and asset collection.16
Chapter 5 covers various bank resolution alternatives, along with methods for marketing a problem bank via a P&A agreement or an insured deposit transfer. If it is determined that it is not cost-effective to rehabilitate the bank, then liquidation through receivership should begin. To provide prompt repayment to insured depositors, the receiver should work with the DIA to market the bank via a P&A whereby another bank would purchase certain assets and assume certain liabilities of the bank.17 Failing that, the receiver should attempt to arrange for another bank to act as paying agent for the DIA to compensate insured depositors. In some countries, depending on the competitive environment, banks may bid for the right to assume the deposits because it is an inexpensive method of increasing market share. In other countries, the DIA or supervisory authority may have to pay a bank a fee to act as paying agent. Problem bank resolution alternatives may be limited in countries without special bank insolvency regimes. It is critical that advance preparation for both intervention and resolution be concurrent and well coordinated.
Chapter 6 looks at the operations and administrative procedures for bank liquidation or receivership and discusses liquidation office structures. Functions that relate to depositor and creditor claims, settlements, legal, management information systems, audit, and other administrative matters are covered.
Chapter 7 discusses asset management and disposition. A receiver should responsibly liquidate a failed bank’s assets with the goal of maximizing recovery to uninsured depositors and creditors of the receivership, using present value concepts in asset sales and collections. Standardized procedures are presented that deal with asset liquidation, including delegation of authority, case memorandum systems (i.e., a decision-making system), and reporting and filing systems.
Eva Hupkes, “Insolvency – Why a Special Regime for Banks?” Current Developments in Monetary and Financial Law, Vol. 3 (International Monetary Fund, Washington, 2003) pp. 2–3.
Moral hazard is the tendency to take greater risks than normally would have been taken if only the funds of bank owners were at risk. This condition is magnified in jurisdictions with an explicit deposit insurance scheme.
Note that the procedures discussed in this manual are not necessarily intended to apply in cases of systemic crises, or in large complex financial institution resolution. Although generally the principles and guidance are applicable, in such cases it may often be necessary to take action that contradicts these recommended methods; for example, not adhering to the “least-cost” restriction when providing open bank assistance.
An assisted transaction, such as a purchase and assumption (P&A) agreement, can help accomplish both these goals, with the added benefit of keeping a good deal of the failed bank’s assets in the private sector.
A country’s banking law usually defines the conservator’s powers, duties, and responsibilities.
An example of an exception to this general statement occurred during the U.S. savings and loan bailout when the Office of Thrift Supervision revoked thrift licenses and appointed the Resolution Trust Corporation as conservator.
Intervention is covered in Chapter 5. Note that, although a bank is in conservatorship, it is not necessarily a failed bank; conservators would do well to follow Chapter 5 guidelines while taking stock of the bank under their management. After all, as a substitute for bank management and the board of directors, conservators are responsible for the security and value maintenance of the bank’s assets.
Also in many countries, the commercial bankruptcy system places an emphasis on protecting shareholders.
Eva Hupkes, “Insolvency – Why a Special Regime for Banks?” Current Developments in Monetary and Financial Law, Vol. 3 (International Monetary Fund, Washington, 2003) p. 8.
Many countries’ banking laws provide for administrative bank liquidation and are not subject to commercial bankruptcy measures until after completion of administrative liquidation, if then.
Duties of the legal adviser during the various phases of bank resolution are specified in more detail in the appropriate chapters.
Other duties for a narrow-mandate DIA include managing the fund and filing a subrogated claim for insured deposit repayments. In countries where the DIA has a narrow mandate, the supervisory authority will bear virtually all the responsibility for bank resolution. Where a DIA has a more involved role in bank resolution, the responsibilities explained in this manual will need modification to reflect responsibility divergence.
As of the date of this printing, an EU revision of the directive was in process that would require insured depositor repayment to begin within 20 days.
Countries’ deposit insurance and banking laws must be harmonized so that the trigger event is defined equally in each piece of legislation to avoid any confusion or conflict.
Banking laws in some jurisdictions envision using this as a period to gain control and plan for an orderly resolution, even if there is no chance of rehabilitation.
If deposit outflow is so great that it proves untenable to continue operations, then the bank should be put into receivership even if the conservatorship period has not run its course.
If insured deposits exceed the amount of “good” assets, the DIA would be expected to fund the difference.