Current Legal Issues Affecting Central Banks, Volume V

Foreword to Chapters 8 and 9

Robert Effros
Published Date:
May 1998
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Dealing with Banks in Distress: Key Issues

In recent years, a broad and diverse range of countries—industrial, developing, and formerly centrally planned—have experienced significant banking difficulties. A recent survey undertaken by the Monetary and Exchange Affairs Department of the International Monetary Fund indicated that problems of this nature had arisen in nearly three-fourths of the total IMF membership (131 out of the Fund’s 182 member countries). These incidents have occurred even in economies such as those of the United States, Japan, and the Nordic countries, and, as a consequence, there has also been a growing recognition of the significance of banking system soundness for macroeconomic stability, an area in which central banks carry a major responsibility. Accordingly, increasing attention is being devoted to means of improving existing frameworks for preventing the recurrence of new banking sector difficulties as well as to the design of strategies for resolving individual and systemic bank problems when they do occur. In the IMF, the Monetary and Exchange Affairs and the Legal Departments have been heavily involved in these issues. Among other activities, the IMF has been called upon to coordinate the technical assistance of OECD countries’ central banks in this area.

Chapters 8 and 9 identify some of the most important issues that have arisen with respect to both the prevention and the resolution of banking system problems and how those frameworks can best be updated and extended to address the issues. Case histories of bank failures in the United States, the Nordic countries, and Latin America are presented and examined.

Prevention of Banking Problems

The key to preventing banking difficulties lies in the existence of proper arrangements to facilitate efficient banking and to ensure that banking activities are conducted in a sound manner. Those arrangements have several key components.

Institutional Setting

Banks must be able to operate within a comprehensive, internally consistent, and transparent legal and regulatory framework that sets out well-defined rules on how they must conduct their activities in a prudent and efficient manner. This framework must also provide banks with the instruments for their operation (for example, basic laws on contract, collateral, property, and bankruptcy) and an effective judicial system for enforcing contracts with their customers.

Internal Discipline

In order to avoid problems, banks must have good internal governance. Consequently, rules must be established on both the qualifications of owners, directors, and managers of banks, and the requirements these individuals should fulfill on an ongoing basis for operating a bank in a sound and proper fashion. These rules should apply whether banks are state owned or privately owned.

External Discipline

Private Surveillance

Market forces also are significant factors in promoting bank soundness by enforcing discipline on bank owners and managers. Effective discipline requires competition and informed bank customers. The laws and regulations underlying banking activity must ensure that these conditions are met. This is important because market discipline can serve as a powerful complement to official oversight.

Official Surveillance

Banking supervision has a key role in ensuring that banks conduct their activities in a sound manner. However, to be effective, bank supervisors must have sufficient authority and independence to establish and enforce prudential regulations, to obtain the information necessary in order to evaluate the effectiveness of governance and the financial conditions of banks, and to take corrective action against banks that are not operating in accordance with proper banking practices. Such powers must also be flexible enough to allow supervisors to adapt their criteria and instruments for monitoring diverse currently recognized risks (including market and transaction risks as well as credit risks) and new risks as they may evolve over time (for example, the new risks associated with derivatives). Supervisors must also have the power to enforce the exit of insolvent institutions.

Resolution of Banking Problems

The design of the legal and institutional infrastructures needed to underpin banking activity should give priority to the prevention of banking difficulties. However, methods also have to be provided to deal effectively and quickly with banking problems when they emerge so as to limit their effect on the proper functioning of the banking system and of the economy at large. Within the variety of those methods, it is important to distinguish between instruments for dealing with individual bank vulnerability and those for dealing with problems that may affect the entire banking system (that is, systemic problems).

In dealing with individual problem banks, supervisors must have sufficient power to enforce corrective actions to restore a bank to financial soundness. Should the scope for such actions already be exhausted, supervisors must be given the authority to force the exit of the bank in a timely fashion in order to avoid growing distortions, bad practices, and moral hazard with potentially adverse spillover effects. The relative roles of the supervisory authorities and the courts in these processes must be carefully defined in order to ensure timeliness and efficiency.

Because systemic banking problems have major macroeconomic implications, they cannot be dealt with on a case-by-case basis or through mass liquidation. In general, strategies to deal with systemic problems will entail individual bank liquidations as well as at least partial restructuring of a significant part of the banking system. Such a process involves a variety of complex decisions, including the determination of how the burden of the cost of the restructuring is to be shared, what instruments will be used for the restructuring, and what should be the role of the relevant government agencies. Thus, specific laws will be required to support the process. An important question is how much of the legal and institutional frameworks necessary to buttress systemic restructuring exercises should be put in place before those systemwide bank restructuring operations become necessary. In this particular context of the role of the central bank as lender of last resort, this question poses a delicate issue concerning the extent to which an approach of constructive ambiguity should be taken to preserve a measure of market discipline and contain moral hazard. There is, of course, no single or categorical answer on the desirability of such an approach. However, it is worth noting that ambiguous settings provide fertile grounds for politically motivated interference and for market-induced attempts to shift private risks to the public purse.

The design and implementation of a systemic bank restructuring strategy will involve various government authorities—at a minimum, the finance ministry, the supervisory authority, and the monetary authority (the latter two, of course, could be vested in the same institution). Consideration must be given to the need for legal rules to establish the respective responsibilities of these authorities and provide them with any needed special powers to carry out the systemic restructuring process. In sum, the subject of dealing with banks in distress is important, topical, and complex.

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