Current Legal Issues Affecting Central Banks, Volume V


Robert Effros
Published Date:
May 1998
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The preceding chapters present different case histories of bank failures. Together they bring out key issues for dealing with bank failures. This comment focuses on these issues and their legal implications. The IMF has done a lot of work on problem banks in recent years, and from this work it is evident that this is an area in which good banking legislation is needed the most but in reality often is the weakest.

A distinction needs to be made between individual bank problems and systemic ones. The policy response and the legal framework necessary for dealing with the two types of problems are quite different. Most countries have legislation to deal with individual bank failures, but not with systemic ones. The experience in the three Nordic countries shows that in cases of truly systemic crisis that affect most of or the entire banking system, there is a need for special legislation, which may include blanket guarantees and the formation of bank restructuring, loan recovery, or asset management agencies. Furthermore, there also is a need to define the distribution of responsibilities between such new agencies and existing ones.

What constitutes a systemic problem? When a bank is failing, especially if it is a large bank, the authorities often claim that the bank is “too big to fail” or that a failure would have “systemic” consequences. This may be true, but it is also too often an excuse for not applying the law regarding how to deal with individual banks because most banking laws leave the door open for discretionary actions in cases of systemic problems, typically without defining what constitutes such problems. Systemic problems are those problems that spread to other sound banks, affect the payments system, impair the credit channel, and have severe effects on the real economy. The case of Continental Illinois in the United States, with a market share of less than 2 percent, was not a systemic problem. (Subsequent studies have indicated that only two very small banks would have failed had the bank been closed and liquidated. In this case, however, official policy seems to have been driven more by concerns about the effects that a failure of a major U.S. money center bank would have had on foreign depositors.) Even when a bank with a much larger share of the market fails, there need be no systemic effects. In 1995, four private banks in Paraguay (with a market share of about 13 percent) failed without systemic effects. Typically, other banks know when a bank is in trouble and reduce their exposure. For example, when the Bank for Credit and Commerce International failed there were no systemic repercussions.1

When dealing with individual problem banks, the legal framework should provide for a range of gradually more severe enforcement actions, leading up to conservatorship, closure, and liquidation. Experience shows that when a bank is in difficulty and about to fail, the earlier the intervention, the less risk there is that the failure will contaminate the rest of the system. Also, the earlier the intervention takes place—when the negative net worth still is small—the more likely it is that no one, with the exception of the shareholders, will incur major losses. This calls for strict exit rules, which also will ensure that the banking system remains sound. It should be noted that governments and politicians often are reluctant to apply strict exit rules to banks. The United States is the first country to introduce a range of early corrective actions and mandatory official intervention in case of critically undercapitalized banks.2

The roles of a lender of last resort—normally (but not always) carried out by the central bank—and that of a deposit insurance scheme are important when dealing with bank failures. The cases in Ohio3 and Argentina,4 described in the previous chapters, are interesting because they show that where there were no lender-of-last-resort facilities and no credible deposit insurance scheme, solvent banks easily became exposed. In Argentina, the lender-of-last-resort facilities had been outlawed under the currency board regime (the Convertibility Law),5 and deposit insurance had been eliminated in favor of a preference for small depositors in liquidation. Both cases show the benefits of properly designed lender-of-last-resort facilities and deposit insurance scheme facilities.

Management of a lender-of-last-resort facility is difficult. The standard rule is that the lender of last resort should provide liquidity to solvent and viable banks against collateral and at a penalty rate. In order to do so, the lender of last resort needs to be guided by information from the supervisory authority as to which banks are insolvent; at the same time, it should be noted that data on banks’ solvency often are notoriously misleading. Market forces discipline weak banks by limiting their funding sources, typically by reducing their access to the interbank market. If the lender of last resort lends to insolvent banks, it prolongs their life and, in most cases, allows their losses to grow. Even if the lender of last resort lends to an insolvent bank against collateral, it may only force larger losses on unsecured creditors and thus becomes partly responsible for those losses. It is interesting to note that in the United States there are now statutory provisions that make the central bank liable to the Federal Deposit Insurance Corporation (FDIC) for the loss that the latter incurs in consequence of the advances made by the central bank to a critically under-capitalized bank that forestalled the earlier liquidation of that bank by the FDIC.6

Consequently, the lender of last resort often faces a dilemma, especially in situations where a large part of the system is fragile, that is, where several or all banks are financially weak. If it decides not to support one insolvent bank, it signals that it will not support other weak banks, and this may trigger a systemic crisis. If it continues to provide liquidity, it facilitates a further deterioration of the system. What is needed in such a situation is a comprehensive restructuring strategy in order to avoid the failure of other banks and a gradual erosion of confidence. To the extent such a strategy requires lender-of-last-resort credit, which would be financing equity rather than liquidity, the credit should be explicitly guaranteed by the government. The real dilemma, of course, would be if the government refuses to cooperate.

Deposit insurance is an important instrument for depositor confidence. However, experience seems to suggest that, in a systemic crisis, a limited deposit insurance scheme will not be adequate—only a full coverage of all bank liabilities will guarantee confidence in the system. At the same time, it is not advisable to provide full coverage in normal times because this would give rise to excessive moral hazard. It would eliminate the incentive for market forces (interbank and other large depositors and creditors) to exercise discipline. The conclusion is that depositor protection should be limited to consumer protection of small savers and that blanket guarantees should be used only on a temporary basis in cases of systemic crisis.

In dealing with bank failures and resolution issues, one of the greatest challenges appears to be how to balance the use of rules versus discretion. Experience has shown that discretion often does not result in efficient policies. In many countries, there now seems to be a trend toward better definition of the rules before problems occur. The following questions should be considered when the establishment or amendment of such rules is under consideration:

  • Is there a need for strict exit rules when banks are nearing or reaching insolvency?

  • Should different rules apply in the case of systemic problems?

  • Should systemic problems be defined in the law?

  • Should one legislate for systemic problems—or do they occur so seldom that there is no need for standing legislation?

  • Are strict rules for the lender of last resort useful, and how feasible is it to adhere to such rules?

  • How can legislation help involve the government in the case of systemic problems if it is reluctant to recognize them?

  • Should legal provisions require the government to provide explicit guarantees whenever the lender of last resort (typically the central bank) considers it necessary, or whenever that lender is instructed by the government, to lend to banks that it believes to be insolvent?

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