Current Legal Issues Affecting Central Banks, Volume V

Foreword to Chapters 10 and 11

Robert Effros
Published Date:
May 1998
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Chapters 10 and 11 deal with banks in distress. For bank supervisors, this presents the ultimate challenge. Much regulatory law relating to solvency and the conduct of business is intended to prevent this situation from occurring. However, since the time that banking emerged as a distinct business, banks have collapsed or teetered on the edge of collapse, and no amount of good regulation will prevent this from happening in the future. Barings Bank, which recently failed, had already faced collapse in the 1890s (and had to be rescued by the Bank of England then). History tends to repeat itself.

Marked changes have occurred in international banking over the past decade. The structure of banks and the activities that they carry out have diversified, to some extent outrunning traditional regulatory techniques. Many banks are now contained within financial conglomerates, with the attendant risk of intragroup contagion. Banking business has expanded and blurred into securities, investment, and insurance-related businesses, even in countries such as the United States and Japan that have not historically recognized the concept of universal banking as it exists in some countries of the European Union. The emergence of secondary debt-trading markets, asset securitization, and credit derivatives have all provided increasing liquidity to bank balance sheets. It is hardly possible to underestimate the importance of the growth of derivatives. International banks have assumed a role in both the exchange-traded and over-the-counter (OTC) derivatives markets. They possess enormous swaps and derivatives trading portfolios and have increasingly relied on proprietary trading to supplement profits, as spreads from traditional banking activities have narrowed. Finally, advances in technology have linked financial markets on an international basis and, at the same time, facilitated an explosion in product innovation, the performance of which is sometimes untried.

As the nature of the business of banking changes, so do the risks. This introduction has three sections. First, consideration is given to the different causes of bank distress. Second, some regulatory issues are introduced. Third, the steps available to resolve specific cases, which frequently call into play national insolvency laws, are addressed.

Causes of Bank Distress

In approaching the topic of the causes of bank distress, it is important to keep in mind that the causes—and the effect—of bank distress differ widely. Viewed internationally, the causes are usually macroeconomic. There are three prominent, recent examples. The Mexican bank crisis was sparked by the 1994 peso crisis.2 The problems in Japan’s financial sector stem from the collapse of the equity and property markets. In addition, the problems in Russia’s banks are exacerbated by continuing difficulties in implementing the government’s stabilization program.

These are fundamental economic issues beyond the remit of the supervisor. Distress is not limited to particular banks, but felt across the entire sector. A worrying aspect of the Mexican crisis was the potential for a ripple effect in other emerging markets in Latin America and elsewhere, as investor confidence was affected. The crisis led to the enormous international support package that was put together in 1995.

In one sense, the headline cases over the past few years—Barings and Daiwa—were not typical because their problems were directly linked to incompetence and fraud within the individual institutions. In such cases, sound supervision can make a vital difference. The attention of the supervisors has recently been focused on banks’ derivatives activities. A combination of factors—primarily the size of potential exposures and the risk of contagion—has led to a major international effort to refine regulatory and banking techniques. Both regulators and, indeed, the banks themselves are (or should be) deeply concerned about the need to prevent derivatives activity from spiraling out of control and thereby threatening their own institutions.

To put the issues into perspective, the following is a summary of some of the potential causes (or symptoms) of bank distress, together with several contemporary examples.

Bad Loans

Banking in its traditional form is the onlending of deposits at a profit. Bad loans (or bad debt) are the classic cause of bank failure. Sometimes bad loans mount simply as a result of the incompetence of the institution concerned through a failure to make appropriate credit judgments. Sometimes, the causes are macroeconomic; for example, in the case of a severe economic downturn. Often, a combination of factors is involved. In Mexico, the effect of the peso crisis was to force interest rates sharply higher and to more than triple the amount of Mexican banks’ loans. Some institutions found that a third of their loans had turned bad. By contrast, typical banks in developed countries might find that 4 percent to 5 percent of their loans go bad. However, fraud and irregularity also seem to have played their part. In May 1994, the Mexican government took over Grupo Havre after regulators detected fraud. Furthermore, in December 1994, investigators discovered irregularities in the accounts of the financial services group Banpais-Asimex, causing the government, in March 1995, to take over the management of both the flagship bank Banpais and the group’s insurance firm Asimex.

Market Risk Through Proprietary Trading Losses

The potential for exposure in this regard has been enhanced by the development of OTC derivatives markets and through the increased use of leverage in respect of such instruments.

Difficulty in Realizing Collateral

An elementary principle of good banking is that loans should be made on the basis of the creditworthiness of the borrower, not on the strength of collateral. Nevertheless, when loans go bad banks need to be able to realize their collateral. A collapsed market in widely held collateral may exacerbate bad loan difficulties. In Japan, the collapse in the real estate market has not only produced bad loans, but has also undermined the value of real estate held as collateral. A specific aspect of Japan’s real property problems and their effect on the financial sector that has attracted international attention relates to the housing loan companies, or jusen, set up in the 1970s to offer mortgages to Japanese consumers. The funding for these non-deposit-taking institutions was provided through Japanese banks and credit unions, which are now owed enormous sums of money by the insolvent jusen. In April 1996, Japan’s House of Representatives passed a fiscal budget bill featuring the disbursement of taxpayer funds for liquidating all seven jusen, but the process remains highly controversial politically.3 The jusen affair has been compared to the savings and loan problem in the United States, both in terms of size and in the serious underlying economic and financial implications.

Since trading losses mount quickly from leveraged OTC derivatives activities, the maintenance of effective collateral is particularly important. Several recent private sector initiatives have been undertaken to minimize risk and maximize efficiency in the documentation of collateral in derivatives transactions, including plans sponsored by the Chicago Mercantile Exchange to establish the world’s first OTC swaps collateral depository.4

Apart from market problems, the value of collateral can be compromised by ineffective laws governing bankruptcy and realization. In the post-Soviet economies of Eastern Europe and elsewhere, a major focus of legal reform has been the enactment of new or revised laws governing these matters.5

Fraud and Gross Negligence

Fraud has to be particularly serious to plunge a bank into insolvency. Perhaps the most striking recent example involved Bank of Credit and Commerce International (BCCI),6 but there are other examples as well. Allegations of fraud on the part of senior executives of Banco Español de Credito (Banesto) have been the subject of judicial inquiry in Spain. Such fraud need not necessarily take place within banks to have grave effects on banks. For example, in Japan two credit unions were merged into Tokyo Kyoto Bank in order to facilitate a workout. The bank later filed criminal and civil complaints against the management of its two predecessor credit unions for fraud. It was alleged that huge amounts of money had been squandered on a poorly planned golf course and real estate projects.

Prompted by the savings and loans crisis, the U.S. Congress, in order to enhance the powers of its agencies and instrumentalities to pursue bank insiders and recover assets on behalf of these institutions, enacted certain provisions under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) to facilitate such redress.7 These provisions8 have been used extensively and successfully by banking regulators in the United States against corrupt or grossly negligent bank insiders, and current debate exists as to whether a standard of culpability less than gross negligence may be sufficient in certain cases to prevail against directors and officers.9

Mismanagement and Lack of Internal Controls

The immediate cause of the Barings collapse was proprietary trading in exchange-traded derivative contracts on the Singapore International Monetary Exchange and various Japanese futures exchanges by an unsupervised trader in an offshore subsidiary of the bank called Barings Futures (Singapore) Pte Ltd. Although the “rogue trader” managed to accumulate large unrealized trading losses over several years of trading through control over the front office (trading) and back office (settlement) functions and the use of fictitious client accounts, this alone would not have resulted in the collapse of the parent, Barings plc, if management and auditors had moved to halt these activities in time. In fact, the trader accumulated the majority of the losses (which totaled about £827 million) in less than two months (over January and February 1995) through stacked and unhedged leverage positions in exchange-traded futures and options. These positions required margin payments to the exchanges that the parent bank continued to make until less than one week prior to its being placed in administration. The subsequent reports issued by the U.K. Board of Banking Supervision10 and auditors engaged by the Singapore Ministry of Finance11 made it clear that the Barings plc collapse was caused principally by incompetence, lack of internal controls, and (according to the Singapore report) a coverup to protect the large profits purportedly made by this trader from what were supposedly low-risk interexchange arbitrage activities. Proper controls would have detected the true position much earlier and saved the bank.

Regulatory Closure

Another recent case involved the closure of the Daiwa Bank’s operations in the United States by federal and state banking authorities; the ensuing criminal and civil prosecution of the bank and several of its officers for deliberately concealing and failing to report an accumulated total of nearly $1.1 billion in U.S. treasury securities trading losses over 11 years; and the consequent measures taken by the Japanese Ministry of Finance.12 The focus of the Daiwa problem, similar to that of Barings, was the bank’s failure to establish and maintain appropriate controls over the New York branch’s securities trading and custodial services, both of which were controlled by the same person. The bank initially pleaded its innocence to the criminal and civil charges filed against it.13 In February 1996, however, it pleaded guilty to 16 felony counts and agreed to pay a $340 million fine.14

Some Regulatory Issues

Proper disclosure of information is central to the regulatory process—although in itself disclosure is not a panacea. The information must be assessed and judgments (often difficult judgments) made as to the appropriate response. However, three particular areas are of concern. In each of these areas, considerable attention has recently been paid to risks posed to banks and other financial institutions by derivatives.

The Importance of Internal Controls

Ever since banking evolved from one man and a ledger, sound internal controls have been of the essence of good practice. The large exposures that proprietary trading in derivatives can generate have served to emphasize this point. In the United States, reports issued by the Commodity Futures Trading Commission (CFTC)15 and the General Accounting Office16 both emphasized the importance of internal controls as the first line of defense against the risks posed by OTC derivatives transactions.17 The failure of Barings constitutes a textbook case in this respect. In its report into the collapse of Barings, the U.K. Board of Banking Supervision emphasized five significant lessons for the management and directors of all financial institutions:

  • (a) Management teams have a duty to understand fully the businesses they manage;

  • (b) Responsibility for each business activity has to be clearly established and communicated;

  • (c) Clear segregation of duties is fundamental to any effective control system;

  • (d) Relevant internal controls, including independent risk management, have to be established for all business activities;

  • (e) Top management and the Audit Committee have to ensure that significant weaknesses, identified to them by internal audit or otherwise, are resolved quickly;18

Of these five lessons, perhaps the clearest lesson to emerge from the Barings collapse is that institutions must recognize the dangers of not separating responsibility for “front office” (that is, the trading) and “back office” (that is, the record-keeping) functions.

The events at Barings alarmed bankers around the world. The moral is that, in complex international markets where enormous losses can be suffered quickly, it is fatal to permit traders—whether or not rogue traders—to operate without firm control. The difficulties can be exacerbated where the trading activity takes place in a foreign branch subject to only periodic visitations by the head office.

Risk Management

Chapters 10A and 10B address internal controls and risk management for banks. Internal controls and risk management are interlinked concepts. These matters were raised in the investigation of the Barings collapse.19 In the derivatives context, dealer banks and end-user banks must establish risk-management guidelines and policies commensurate with the amount of derivatives activities and risk involved. The U.S. Securities and Exchange Commission (SEC) requires risk-management policies for securities firms in respect of OTC derivatives to include the establishment of independent risk-management functions, such as credit and internal audit committees, separate from the trading functions of the firm.20 Emphasis has been placed on the roles of directors and officers in this process and the expectation that the boards of directors should promulgate clearly articulated policies concerning derivatives and continuously update those policies as business and market climates change. These matters are the subject of understandings between the U.S. SEC, the U.S. CFTC, and the U.K. Securities and Investments Board (SIB).21 In addition, risk management has become a principal focus of the U.S. banking regulators. The Board of Governors of the Federal Reserve System, the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) have each initiated broad regulatory reforms with respect to the risk management of banks’ trading activities.22 For example, the OCC has issued guidelines on managing the risks of derivatives by national banks for their fiduciary accounts.23 These guidelines will supplement the OCC’s influential new “supervision by risk” program of national bank activities introduced in early 1996.24 In the case of the Federal Reserve, the agency plans to conduct risk examinations that will result in a specific grade attached to the institution’s risk-management performance; these examinations will focus not only on the risk models used by an institution, but also on its risk-management process, including the institution’s internal controls. Several industry groups in the United Kingdom have also promulgated guidelines to address principles for the effective management of derivatives risks.25

Sharing of Information Between Supervisory Authorities

Sharing of information between supervisory authorities is the subject of Chapter 11. The world’s financial sector is inextricably interlinked. This interconnection is only increased with the emergence of universal banking carried out by financial conglomerates, even in countries such as the United States and Japan, which for many years separated banking and securities businesses. However, regulatory structures often do not reflect the underlying unity of the financial sector. Again, the Barings collapse provides important insights, which are summarized by the following commentary:

The problem arose because a Barings group company, supervised by a securities/derivatives regulator, was trading in derivatives on exchanges located in two countries [that is, Japan and Singapore]. These exchanges were each supervised by a different self-regulatory organisation, which in turn reported to different futures regulators. Finally, the company was funded by a related banking entity in the UK, supervised by both banking and securities regulators, via another related securities firm, supervised by a securities regulator.

Barings clearly raises the question of gaps in international regulatory co-ordination, not just between different securities regulators, but also between securities and banking regulators. The question that Barings really raises is how to treat multinational hybrid securities/banking financial conglomerates. This is a matter that is becoming all the more important with financial deregulation, such as the impending repeal of the Glass-Steagall Act in the USA.

The issue is how to reconcile the differing treatment of bank and securities regulators in taking into account, or ignoring, the financial effect of the activities of a foreign subsidiary on a domestic parent firm. In particular, Barings raised this issue in the context of the allocation of responsibilities between home and host country regulators. It is this crucial issue that will have to be addressed in the light of the demise of Barings.26

In the wake of Barings, there have been a number of efforts internationally to address these issues. Specifically, there is the influential “Windsor Declaration”27 issued after a conference on the supervision of futures exchanges in May 1995, hosted by the U.S. CFTC and the U.K. SIB.28 Among other matters, the regulators agreed to support mechanisms to improve the prompt communication of information relevant to material exposures and other regulatory concerns. The Windsor Declaration was endorsed by all 72 members of the International Organization of Securities Commissions (IOSCO) in July 1995.29 Mention should also be made of the joint report of the Basle Committee and IOSCO entitled Public Disclosure of the Trading and Derivatives Activities of Banks and Securities Firms (November 1995). In March 1996, futures regulators from 14 jurisdictions signed an information-sharing accord to foster better supervision of the world’s futures markets.30 The Declaration on Cooperation and Supervision of International Futures Exchanges and Clearing Organizations provides a multilateral mechanism to share information on a bilateral basis, consistent with the respective parties’ legal and contractual obligations.31 The regulators’ declaration complements the memorandum of understanding signed by 62 international futures exchanges and clearing organizations.32

International Joint Supervisory Initiatives

The Basle Committee on Banking Supervision and IOSCO have undertaken several joint projects with a view to: (i) the establishment of a common framework of principles for regulation and supervision of the derivatives activities of banks and securities firms, (ii) the supervision of international financial conglomerates, and (iii) the disclosure of trading activities of banks and securities firms. The intention is to promote better international standards of transparency and disclosure.

Summary of Recent Regulatory Moves

To summarize these regulatory moves, the aims have been basically threefold. The first aim is to strengthen individual banks so that they can withstand shocks. The traditional approach, reflected in capital adequacy requirements based on the Basle Accord, has had to be modified in light of off-balance-sheet derivatives.33 A significant development of this modification is a new approach to market risk, subject to strict qualitative and quantitative standards. International banks are now permitted to choose between using the standardized method contained in the adopted principles or their own in-house value-at-risk models to calculate their particular market risks.34

The second aim is to strengthen risk management within banks. The Institute of International Finance has expressed the rationale that banks publicly disclosing their internal estimates of market risks will foster market discipline and ensure that firms know their conterparties.35 Legally, strengthening risk management ranges from reviewing standard form documentation to vetting particular counterparties (for example, in respect of the adequacy of collateral, whether the counterparty has proper authority, and other issues).

The third aim is to strengthen the financial infrastructure to prevent individual shocks from spreading. Netting is a key to this, because the credit exposure of a bank trading in derivatives is mitigated if netting with counterparties is firmly in place. Of the Lamfalussy Report minimum standards36 to be met to ensure an effective system of netting, one is particularly noteworthy: “Netting schemes should have a well-founded legal basis under all relevant jurisdictions.”37 Two initiatives should be mentioned. In April 1995, the Basle Committee on Banking Supervision issued a report addressing the question of bilateral netting in the context of off-balance-sheet items, such as OTC derivatives.38 In addition, in April 1996 it issued a report dealing with multilateral netting arrangements on the forward foreign exchange markets.39

Resolving Distress

If a bank gets into distress, how should the matter be addressed? There are a number of rescue techniques, some of which require public funding, and others that do not. These include bailout, nationalization, reconstruction, recapitalization, sale, takeover, and merger. Sometimes a “resolution trust corporation” is set up to recover bad debt on behalf of the rescuing authority. Whatever method used, there are likely to be implications for the national deposit insurance scheme, if there is one. In the United States, the FDIC can acquire a problem bank and operate it as a “bridge bank” for two years.40 Experience in particular countries will show which forms of rescue are best suited to local circumstances.

Central bank laws often contain provisions enabling the central bank to use bankruptcy procedures in respect of commercial banks. There are two basic forms of bankruptcy procedure. One is intended to preserve the institution as a going concern and facilitate its eventual rehabilitation.41 The other is intended to achieve the liquidation of the institution and the realization of its assets. As to rehabilitation:

legal control over the bank’s assets may be vested in a conservator (usually the bank supervisory agency, such as the FDIC in the United States, or the central bank in Argentina). The conditions that prompt the appointment of a conservator can include technical insolvency, actions by management that violate the bank’s charter, inability to cover maturing obligations, or the presumption of fraud or mismanagement on the part of bank officials or directors. The conservator is charged with operating the bank as a going concern and with investigating its financial condition. Once the investigation is complete, the conservator evaluates the various options for recapitalization and decides which one to pursue. In this role, the conservator makes an offer to each class of creditor and typically has discretion to issue new equity and deposits or to initiate liquidation procedures.42

Sometimes a combination of techniques is necessary. In the case of Barings, the Bank of England placed the bank in the U.K. equivalent of conservatorship (administration) and, in a successful conclusion to the affair, sold the banking business to the Dutch group ING a week after-wards. Liquidation is the last resort. In many countries, bank liquidations are subject to ordinary insolvency law principles. In others, such as Austria, the Netherlands, and the United States, bank bankruptcies are covered by separate legal regimes.43


Is banking becoming more risky? One problem in answering this question is that it is hard to define what “banking” is anymore. There is a notable difference between the business of a small institution providing traditional deposit taking, loan, and money transmission services, and that of an international financial conglomerate active in a host of markets. The one need not be riskier than the other. For example, the small institution may be vulnerable to a slump in property values, which the large international bank can shrug off.

Nevertheless, risks need to be taken seriously. The sheer complexity of the contemporary international financial system can be bewildering. If the management of a bank like Barings did not understand their own business, how were depositors expected to make reasoned judgments?

All this puts an increased onus on regulators. Development of international standards is undoubtedly one way forward. At the same time, there is a need to avoid regulatory overload. An unfortunate side effect of more visible regulation is that public expectation may have been raised to unrealistic levels. Sound regulation is important. However, it cannot avoid disasters completely. In the end, now, as in the past, prudent management remains the essence of good banking.

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