More than other parts of banking law, the law of bank insolvency focuses the legal mind on the age-old ebb and flow between state power and individual freedom under the law.1 Any discussion of banking law in a market-based economic system must review the public interest served by the bank regulator as agent of the state in the light of the principle of freedom of economic activity of individual banks and their owners.
More than other parts of banking law, the law of bank insolvency focuses the legal mind on the age-old ebb and flow between state power and individual freedom under the law.1 Any discussion of banking law in a market-based economic system must review the public interest served by the bank regulator as agent of the state in the light of the principle of freedom of economic activity of individual banks and their owners.
We speak of the principle of freedom of economic activity and not of the principle of serving the public interest. In a market-based economy, the state serves the individual. Individual freedom is the norm and state intervention the exception. The differences between market economies and centrally planned socialist economies can be traced in terms of this hierarchy.
In countries with a market economy, freedom of economic activity is the rule also for banks; by implication, prudential regulation should be the exception. Consequently, every prudential regulation that infringes upon that freedom requires careful justification. This is generally accepted. What is less well understood is that the mere fact that public interests are served by a prudential regulation is not enough to justify that regulation. When a proposed regulation would infringe upon the freedom of economic activity of banks, the question is not only whether there are public interests that would be served by that regulation but also and especially whether those interests are so strong and compelling that they outweigh the proposed infringement upon the principle of freedom of economic activity. The administrative law principle of proportionality requires that the greater the infringement is expected to be, the stronger the interests served by the prudential regulation should be. If society attaches great weight to freedom of economic decision making, any restriction of that freedom will require a justification with an even greater counterweight.
These considerations apply in particular to determining the limits of regulatory power to intervene in the affairs of banks in distress, because there state intervention is often at its most forceful and intrusive. This may be illustrated by the following.
In discussing the modalities of prudential banking regulation, it is often useful to distinguish between “normal” situations where a banking system is reasonably sound, and the exceptional situation where a country suffers from an economic crisis of such magnitude as to threaten failure of the entire banking system. Crises, such as those recently encountered in Asia, commonly require exceptionally strong prudential and conservatory measures designed quickly to restore confidence in the financial markets. These measures often include the establishment of a bridge bank where nonperforming loan assets of failing banks can be parked or the appointment of a public trustee endowed with unusual powers to act decisively and expeditiously in taking over banking institutions and selling their assets without much respect for shareholder rights and without court review. An example of such a trustee would be the American Resolution Trust Company (RTC) that the U.S. Congress established in response to the savings and loan crisis of the 1980s. The exceptional force and intrusiveness of such powers are justified by the exceptional nature of the crisis for which they are granted. However, in “normal” situations, these powers are not justified and should therefore not be used, and the law should delineate the scope of their application to avoid their misuse. Accordingly, the legislation under which the RTC operated contained a sunset provision terminating the RTC when the crisis had passed.
The provisions of law that address noncompliance with banking law and other prudential requirements must distinguish between remedial measures and conservatory measures that the regulator may take or force a noncomplying bank to take. The principal purpose of remedial or corrective measures is to bring a bank back into compliance and thereby to restore the bank to financial health. In contrast, conservatory measures are designed to conserve the value of the assets of a failing bank for the benefit of its creditors.
Often, there is a logical progression from remedial to conservatory measures. As a rule, remedial treatment of a bank requires the bank’s continuing operation. This exposes the creditors of the bank to the risk that the corrective measures taken will be unsuccessful and that the continuing operation of the bank will cause further deterioration of the bank’s financial position. Sometimes, notwithstanding attempts to save the bank, the bank’s condition worsens to a point where the probability of success of remedial action has become too low to justify the risk of further erosion of the value of the bank’s assets. At that point, the bank regulator must discontinue remedial activities and give priority instead to maximizing the value of the bank’s assets for the benefit of its creditors. This paper is organized along the lines of this progression from noncompliance with prudential requirements to insolvency, and from remedial to corrective action, culminating in revocation of the bank’s operating license and liquidation of the bank.
Most banking laws empower the bank regulator to require a bank in violation of one or more prudential standards to take remedial measures designed to bring the bank back into compliance, often within a period of time specified by the regulator.
In authorizing or requiring remedial measures, banking laws follow different patterns. Many banking laws have couched the provisions authorizing the bank regulator to order remedial measures in permissive terms leaving it to the discretion of the regulator in each case to decide whether or not—and if so, which—remedial measures will be ordered. Others prescribe remedial measures in mandatory terms requiring the regulator or the noncomplying bank to take action whenever a level of noncompliance described in the law has been reached.
Discretionary Remedial Measures
Some banking laws contain a broad general provision for the regulator to order the bank to take remedial measures, without specifying in the law what these measures may be.
Thus, for instance, Article 43 of the French banking law provides:
When justified by the condition of a credit institution, the Banking Commission may issue an injunction ordering the credit institution inter alia to take, by a specified deadline, all measures necessary to restore or reinforce its financial condition or to correct its methods of operation.2
Other banking laws contain detailed lists of remedial measures.3 Thus the regulator may issue and publish written warnings, call meetings with the bank’s management and owners to agree on remedial measures, issue written orders to the bank to cease and desist from certain activities, to dispose of certain investments, to suspend dividend payments, suspend untrustworthy and unresponsive bank managers or order their resignation, order owners of the bank holding a significant interest in the bank whose influence is judged to be detrimental to dispose of their shares, or suspend their shareholder voting rights, impose fines on the bank, appoint an advisor for the bank, appoint an observer to supervise management and to report to the regulator,4 have a special external audit performed, attach conditions or restrictions to the banking license of the bank, appoint a provisional administrator, and ultimately revoke the banking license of the bank. Not all banking laws specify all these measures; however, the lists are often accompanied by a provision granting general powers to the bank regulator, which would support their interpretation as illustrative in those cases.
In some countries, the law reinforces the authority of the regulator. For instance, the Swiss banking law contains the following provision:
Where, notwithstanding a prior warning, an enforceable decision of the Banking Commission is not observed within the deadline specified, the Banking Commission may itself, but for the account of the non-complying bank, take the measures that it had ordered.5
In Canada, the law permits the regulator to apply for a court order requiring the bank to comply with the regulator’s instructions.6
Just like others, banks must ensure that they are able to meet their liabilities as these become due. Compared with other companies, however, banks face special difficulties in meeting this requirement. Traditionally, banks use funds received by them mainly in the form of demand deposits and short-term borrowings in the financial markets to make medium- to long-term loans. The resulting mismatch between the maturities of a bank’s loan assets and its funding liabilities requires a bank to manage its resources with care so that it has sufficient liquid resources7 to meet its current payment obligations. Accordingly, prudential banking regulations usually require banks to maintain certain levels of liquid resources that are measured as a fraction of their short-term obligations or that observe certain maximum time spreads between maturity classes of assets and liabilities.8 Because of the maturity mismatch inherent in a bank’s operations and because not all a bank’s loan assets can be readily sold for a reasonable price, these liquidity requirements cannot guarantee that a bank that complies with them will always be able to meet its liabilities as they fall due. Therefore, prudential liquidity requirements are usually set so as to enable the banks to meet their current liabilities in what are considered normal conditions.
Sometimes, conditions become abnormal owing to developments over which a bank has little or no control. Examples of such developments would be a sharp deterioration in the value of a class of assets, such as real estate, or an unexpected general loss of confidence in the banking system, triggered perhaps by the failure of a large financial institution. A run on the bank by depositors may ensue that is so severe that the bank cannot meet all the demand for deposit withdrawals and is threatened with bankruptcy.
It is in such situations that the central bank would provide support to the bank in difficulties as “lender of last resort,” especially, in order to preempt or to stave off a run by depositors and other creditors on the bank.9 Generally, however, central banks provide such liquidity support only to solvent banks, i.e., banks whose assets have a value that exceeds the aggregate nominal amount of their liabilities.10
Mandatory Remedial Measures
In some countries, the banking law contains mandatory provisions and requires the bank regulator to take or impose corrective action. Thus, for example, in Switzerland, the Federal Banking Law provides:
Article 23ter. (1) When the Banking Commission discovers violations of the law or other irregularities, it must take the necessary measures to restore the rule of law and to remove such irregularities.11
A more extreme form of this mandatory approach can be found in the United States. The severe savings and loan crisis of the 1980s and the suspicion that the crisis had been worsened by lax banking supervision prompted the U.S. Congress to adopt the FDIC Improvement Act of 1991. The Act includes under the heading “prompt corrective action” a relatively long and detailed list of violations and corresponding remedial measures that the bank or the bank regulator is required to take.12 Thus, the Act defines five levels of capital adequacy for banks, ranging from “well capitalized” to “critically undercapitalized” and prescribes for each level a mandatory course of corrective action.
The question is whether such a mandatory regime produces better results than one that is discretionary. It cannot be denied that a mandatory regime creates an appearance of predictability and equality of treatment. After all, discretion can easily turn into permissiveness and lax banking supervision, especially in societies with a club culture. This is particularly so because the effects of regulatory corrective action on the name and credit rating of a bank can be devastating.
However, mandatory banking law provisions requiring the regulator to impose certain remedial measures are no panacea either. The principal weakness of a mandatory system, such as the U.S. system of “prompt corrective action” is its methodology of eliminating or restricting regulatory discretion and prescribing in its stead uniform remedial measures for all banks that have reached a certain state of noncompliance with the banking law, regardless of whether such measures are appropriate in the light of prevailing economic conditions. Theoretically, under extreme circumstances, a mandatory remedial system could produce a wholesale closure of the banking system.
The saving grace is that, in practice, mandatory systems of corrective action often turn out to be less mandatory than their appearance would suggest. One reason is that the remedial measures prescribed by the law may have a degree of flexibility built in. For example, the U.S. system of prompt corrective action consists largely of requirements for banks to submit and carry out a capital restoration plan whose content can be negotiated with the regulator.
Sometimes, the banking law requires remedial action but leaves it to the regulator to determine what specific action to take; thus Article 11(5) of the Second European Banking Directive provides:
5. The Member States shall require that, where the influence exercised by the persons referred to in paragraph 1 is likely to operate to the detriment of the prudent and sound management of the institution, the competent authorities shall take appropriate measures to put an end to that situation. Such measures may consist for example in injunctions, sanctions against directors and managers, or the suspension of the exercise of the voting rights attaching to the shares held by the shareholders or members in question.13
Another reason why mandatory systems of remedial measures against banks are often in practice less mandatory than they appear on paper is that corrective action against a bank depends invariably on a finding that the bank is in violation of the law, a finding that depends on judgments that usually are less precise than one might expect from a system that is characterized by its mandatory nature.
For example, the five levels of capital adequacy specified by the FDIC Improvement Act depend in their application on valuations of bank assets. Although marketable assets (e.g., securities and currency holdings) can be marked to market, other asset classes (e.g., loan assets and derivative claims) depend for their valuation on sometimes debatable procedures and estimates; this is particularly true for countries without fully developed markets where market values for bank assets are difficult to establish. Thus, discretion is introduced through the back door; notwithstanding its mandatory appearance, the system permits the authorities to hide behind accounting practices that fudge the facts so as to avoid a finding that would trigger remedial action. The ultimate effect of these pseudo-mandatory systems of corrective action may well be that in such a system the bank regulator is less accountable than in a remedial system that relies on the regulator’s discretion and in doing so makes the regulator responsible.
Notwithstanding the foregoing, the American system of prompt corrective action has distinct advantages. These are chiefly that it requires frequent monitoring of the bank and that, even though the determination of its trigger points may be more an art than a science, it produces periodic evidence concerning the direction in which the bank’s condition develops.
Timeliness of Remedial Measures
In practice, there seems to be a tendency on the part of bank regulators to postpone remedial action against wayward banks. Although there are bad reasons for such delays—political interference in the regulatory process and a club culture are among them—there is at least one proper reason for caution: a regulatory slap on the wrist, not to mention more severe sanctions, may adversely affect the bank’s reputation and standing in the financial markets, and therefore its funding costs. Remedial measures could have the unintended effect of depriving the bank of financing on which its rehabilitation depends. Prudential medicine has side effects that can kill the patient.
This risk affects in particular large modern banking institutions that depend on the markets for much of their business. The changes in the business of the banking industry over the last two decades have worsened this risk. Changes in consumer investment preferences have forced many banks to replace their traditional deposit base with money market instruments. Also, their income derives increasingly from financial services requiring transactions with other financial institutions. The financial markets are more sensitive to negative publicity concerning a bank than most depositors were in the past. Owing to the information revolution, news reaches financial market participants faster than before, and their reaction to such news is faster and more brutal than a traditional run on a bank by depositors would be. In many industrial countries, these developments in the banking sector raise questions about the continuing adequacy of the remedial instruments at the disposal of the bank regulator. In any event, the shortened reaction time of bank counterparties should cause regulators likewise to react to banking irregularities faster than before. This in turn raises questions concerning the timeliness and adequacy of information provided to the regulator.
This state of affairs points to the need for early and hopefully therefore limited remedial action that does not attract public attention. The longer remedial action is postponed, the more forceful it will have to be, increasing the risks of an adverse market reaction.
The provisions of American law requiring banks in distress and the regulator to take prompt corrective action have been written with these considerations in mind. In essence, their chief advantage is that they require an early and graduated remedial response to banking deficiencies. In contrast, the law of England seems to limit the use of most remedial measures to cases where the banking license is to be restricted or revoked by the regulator.14 Remedial measures affecting the banking license are very serious steps that can hardly be kept from the public domain, raising the specter of an undesirable market response. Unfortunately, there is scant evidence that this greater danger has produced greater compliance with prudential regulations by banks in England.
Passive Regulatory Involvement in the Management of a Bank
Some banking laws provide for the bank regulator to become involved in the management of a bank that fails to comply with the banking law or fails to carry out remedial measures ordered by the regulator.15 This category ranges from passive involvement in the management of the bank through the appointment of a supervisor or inspector, to taking active regulatory control of the bank through one or more administrators or conservators.
Where the law permits regulatory control of a bank, the law may provide that the decision to take control may be taken by the regulator.16 Otherwise, that decision must be taken by another authority, such as the Minister of Finance (Austria and Italy) or the court (Luxembourg).
Appointment of an Observer
At the least intrusive level of involvement in the affairs of a bank, the Swiss banking law authorizes the bank regulator to appoint an observer to a bank, whose task is limited to supervising and reporting to the bank regulator on the activities of the bank; the observer may not intervene in the bank’s business.17
Similarly in Germany, the bank regulator may appoint a supervisor for a noncompliant bank. The supervisor attends management and shareholder meetings and is consulted on all important business decisions of the bank. However, his consent is not required for management decisions.18
Appointment of an Inspector
In some countries, an inspector may be appointed whose prior authorization is required for all legal acts and decisions of the bank. Thus, the Belgian banking law provides that the bank regulator
… may appoint a special inspector whose general or special written authorization shall be required for any act or decision of a decision-making body of the credit institution, including the general meeting of shareholders, and of all persons with managerial responsibility ….19
Under Dutch banking law, the appointment of an inspector must be preceded by a notice of noncompliance that may order corrective action; an inspector may be appointed only if in the opinion of the regulator the bank’s response to the notice is inadequate or the bank fails to comply with the order.20
The absence of consent of the inspector for acts and decisions of the bank may not be invoked against third parties unless the inspector’s appointment was announced to the public, for instance, by entry in the public register of companies.
The control exercised by such inspectors falls short of bank management. The role of inspector or supervisor is a passive one, as he has only the right to give or to withhold his consent and may not initiate acts or decisions. The inspector does not have the power to enforce compliance by the bank with the law or the instructions of the regulator, not even where noncompliance is the principal ground for his appointment.
If the purpose of the appointment of an inspector is to restore the bank to health, more will be needed than the authority to disallow inappropriate transactions, especially if it concerns a large, modern, full-service bank. Rehabilitation of such an institution will require proactive involvement in all departments of the bank, for instance, to cut out waste, to close unprofitable undertakings or excessively risky positions, or to improve accounting, auditing, and risk management systems and procedures. It is questionable whether an inspector with no managerial authority would be legally permitted to leverage his veto powers to such an extent that he could force the bank’s management to initiate actions that he is not authorized to initiate himself. Moreover, if that were the legislative intent behind the appointment of an inspector, it would be more honest and efficient if the law were to grant direct managerial authority to the regulator or its representative.
Reasons for Provisional Administration
Remedial measures are intended and designed to rehabilitate a bank and bring it back into compliance with the banking law while the bank continues its operations.21 Their purpose can be fully realized only if these measures are fully integrated into and are carried out as an integral part of the bank’s policies and procedures by the bank’s management. Remedial measures are intended and designed to be executed by the bank concerned as part of its operations.
What to do if the bank’s own management is unwilling or unable to implement the remedial measures ordered by the bank regulator? For that event, the banking laws of several countries authorize the bank regulator to take control of the bank through administrators appointed by the regulator or the court.
For example, in Canada, when a bank with inadequate capital fails to comply with an order of the regulator to increase its capital, the regulator is authorized under the Bank Act to take control of the bank, whereupon the regulator or its representative manages the bank and the powers, duties, functions, rights, and privileges of the directors and managers of the bank are suspended.22
Article 44 of the French banking law provides that, when the operation of the institution on a normal basis can no longer be assured,
The Banking Commission may appoint a provisional administrator to whom will be transferred all powers for the administration, management and representation of the institution.23
Reasons Against Provisional Administration
There are, however, countries where the law denies the bank regulator the authority to take over the management of a bank.
One practical reason may be that the bank regulator simply lacks the staff resources to manage a bank or to supervise the management of a bank by an administrator appointed by the regulator. This argument is more serious than it may seem at first glance. Bank regulators are not in the business of managing and operating banks but of exercising prudential supervision over banks. Prudential bank supervision is not quite the same as bank management, and bank regulators do not necessarily have the qualifications, experience, or even the temperament required of a successful bank manager. The foregoing applies to both active and passive management of a bank, as an inspector to whose consent operational decisions are submitted requires the same skills as a bank manager.
A more philosophical argument for denying the bank regulator authority to take control over a bank is that bank rehabilitation does not properly belong to the scope of authority of the bank regulator. This view would have currency in countries, like England, that favor a self-regulatory regime for financial institutions.
In any event, taking regulatory control of a bank is so invasive, and the resulting violations of fundamental property rights of bank owners are so serious that they can be justified only in the extreme cases where the bank is insolvent or is threatened with imminent insolvency.24 The administrative law principle of proportionality discussed before mandates that, where such action is authorized by the law, it be taken only when other remedial measures have failed or cannot reasonably be expected to restore the bank to health within a proper time frame. A central condition appears to be that the bank’s management must be unable or unwilling to take the necessary corrective action.
The Difference Between Remedial and Conservatory Measures
There are fundamental differences between remedial measures and conservatory measures, both as to their purpose and their design. While remedial measures are meant to rehabilitate a bank, ultimately through the appointment of a provisional administrator, conservatory measures are meant to maximize the bank’s assets for its creditors.25 This difference in purpose translates into differences in bank management by or for the regulator.
Remedial management of a bank consists of operating the bank as a going concern. This means entering into new transactions, taking risk in order to make a profit, in short, engaging in banking business. The remedial management of a bank is by its nature dynamic. To be successful, the bank administrator must behave like an entrepreneur.
In contrast, the conservation of bank assets requires another attitude that is conservative and risk-adverse and aims at maintaining the value of existing assets. The task of a conservator is mainly static. Therefore, conservatory measures and conservators should normally enter a bank only after it has been decided that it is improbable that the bank can be saved as an independent institution.
Although these two categories of regulatory control of a bank are fundamentally different, they need not be mutually exclusive. In fact, there is no better method to maximize the value of a bank for its creditors than to return the bank to regulatory compliance and profitability. Also, when a bank is threatened with demise, the goal of regulatory action can still be remedial, especially if the bank is judged too big to fail. However, the closer a bank approaches insolvency, the more the interests of the regulator will tend to shift away from saving the bank towards conserving the bank’s assets for its depositors and other creditors.
Statutory Grounds for Appointment of a Conservator
Banking laws tend to cast the grounds for appointment of a conservator in fairly general terms. Thus, for instance, Spanish banking law provides:
Article 31. (1) When a credit institution is found to be in an exceptionally serious condition jeopardizing the effectiveness of its own resources or its stability, liquidity, or solvency, the credit institution may be placed under conservatorship ….
The statutory grounds for the appointment of a conservator often center on the actual or imminent insolvency of a bank. Usually, general bankruptcy law measures insolvency in terms of a bank’s inability to pay its liabilities as they come due. In banking law, however, insolvency is often also measured in terms of the adequacy of a bank’s regulatory capital, that is, the capital required to comply with prudential standards, as is illustrated by the following grounds for appointment of a conservator under the Bank Act of Canada:
the bank has failed to pay its liabilities or, in the opinion of the Superintendent, will not be able to pay its liabilities as they become due and payable;
in the opinion of the Superintendent, a practice or state of affairs exists in respect of the bank that may be materially prejudicial to the interests of the bank’s depositors or creditors;
the assets of the bank are not, in the opinion of the Superintendent, sufficient to give adequate protection to the bank’s depositors and creditors;
the regulatory capital of the bank has, in the opinion of the Superintendent, reached a level or is eroding in a manner that may detrimentally affect its depositors or creditors .…26
Tasks of the Conservator
Once the decision has been made that one or more grounds for the appointment of a conservator exist, a conservator should be appointed, without delay,27 to take immediate control of the bank’s assets and its books, to make an assessment of the bank’s financial condition for the regulator, and to recommend to the regulator a course of action. In some countries, the appointment of a conservator is reinforced by the simultaneous imposition of a moratorium on the bank’s debt service payments.28
The Bank Act of Canada authorizes the Superintendent to take control of the assets of a bank, whereupon: the Superintendent may do all things necessary or expedient to protect the rights and interests of the depositors and other creditors of the bank; the bank may no longer engage in core banking activities, such as making loans and buying or selling investment securities, without the prior approval of the Superintendent or his representative; and no director, officer, or employee of the bank has access to the bank’s cash or securities without his prior authorization.29
Although the appointment of a conservator buys the regulator some time for decision, especially if it is supported by a moratorium on debt service payments by the bank, dealing with an insolvent bank requires exceptional speed. After the regulator has taken conservatory control of the bank’s assets and its books, his first order of business is to try to realize the highest market value for the bank by selling it as a going concern. Generally speaking, if a bank cannot be sold or merged with another financial institution within a week or so after it is closed for business, its chances of being sold as a going concern will be slim, and in all likelihood it will have to be liquidated.
Ideally, an insolvent bank is closed on Friday afternoon after close of business, is sold to or merged with another bank over the weekend, and opens its doors early Monday morning under another name. Even though few bank failures have such a happy ending in such a brief time span, some can benefit from this treatment albeit sometimes after a few more days of negotiation. An instructive example of this process is the sale of the English banking house Barings to the Dutch ING Group. Unlike most companies, banks do not respond well to a drawn-out reorganization process during a moratorium of some sort.30 Once a bank has been found in need of protection from its creditors, trust in the bank and its ability to attract deposits or other funding will most often be lost.
Moratorium on Debt Service Payments
Some banking laws authorize the regulator to impose a moratorium on debt service payments by the bank.
An example of this power is found in Article 74 of the Italian banking law:
(1) When exceptional circumstances so require, the commissioners may suspend the bank’s payment of any and all liabilities, in order to protect the interests of creditors. The measure shall be taken in consultation with the supervisory committee upon prior authorization of the Bank of Italy. The suspension shall be for a period not exceeding one month, extendible if necessary, subject to the same requirements, for an additional two months.
Similar powers of imposing a payment moratorium for a bank are granted to the bank regulator in Denmark 31 and Germany.32
Because the principal purpose of the appointment of a conservator for a bank is to preserve the assets of the bank for its depositors and creditors, the laws of several countries treat the appointment of a conservator as a matter of general insolvency law. This approach has two main characteristics. It moves the authority for appointing the conservator from the regulator into the courts, and it provides for an automatic moratorium. Examples are found in the laws of Austria,33 England,34 and Luxembourg.35
Treatment of Insolvent Banks
When viewed from a legal vantage point, the law of insolvency of banks is extraordinarily complex and varies significantly from country to country. There are several reasons for this. General insolvency law—including both bankruptcy law and the law of reorganization by composition—is one of the most demanding fields of the law and this extends to the treatment of insolvent banks. In addition, whereas in most countries the general insolvency law is content to balance only two sets of competing interests, namely, those of the creditors and those of the owners,36 the law of bank insolvency addresses these and one more, namely, the interests of the public represented by the bank regulator. Also, bank insolvency and the intrusiveness of protective measures imposed by the bank regulator raise difficult questions concerning the powers of bank regulators and the scope of administrative or judicial review of their actions.
In the foregoing, the case was discussed where an otherwise solvent bank was faced with such liquidity problems that it had to apply for funding to the central bank as lender of last resort. There are cases, however, where the problems of a bank are so severe that such short-term assistance from the central bank would not suffice to rescue the bank. This occurs when the bank encounters not only liquidity problems, but when also its solvency is in doubt, i.e., when there are doubts as to the adequacy of the bank’s assets to cover the bank’s liabilities under deposits, borrowings, and other financial commitments. In these situations the law often provides the central bank with several options.
The central bank may decide that it will not provide financial support to an insolvent bank. In such cases, the bank regulator may place the bank under conservatorship and take over the management of the bank in order to ensure its rehabilitation, its sale to or merger with another bank as a going concern, or its orderly liquidation; the latter will require that the bank’s banking license is revoked and may involve bankruptcy proceedings.
In some countries, such as France, the bank regulators may place pressure on the bank’s shareholders to provide additional capital to their institution or may organize a rescue operation funded by other banks.
Finally, the central bank may decide that the bank is so large that its failure would place the entire banking system at risk—in other words, the bank is too big to fail. In these cases, the central bank, usually with the consent and sometimes the active participation of the government, must mount a costly rescue operation. The possibility, or rather the probability, of such rescue operations is well known to large banks. This knowledge exposes society to the moral hazard that, in the absence of appropriate sanctions on unsound banking practices in the form of bank failure, bank owners and managers may be encouraged to engage in unsound banking practices. In the event of a rescue operation, the danger exists that owners would benefit without assuming a fair share of the operation’s cost. Such free ridership of bank owners must be avoided in order not to add to the before mentioned moral hazard.
The threat of failure of a large bank is an embarrassment to the central bank when it is responsible for the prudential supervision of the bank in difficulties. There is at least a presumption that the central bank has not done its job. As was noted before, the ability of the central bank to act as lender of last resort to failing banks and thus to cover up its own deficient prudential supervision has been used as an argument for assigning the task of banking supervision to an agency other than the central bank.
When an insolvent bank cannot be saved or sold as a going concern, its banking license should be revoked and it should be liquidated.
In Europe, the liquidation of insolvent banks is generally a judicial function, which is carried out either under the general bankruptcy or insolvency law or under special provisions of the banking law.37
In countries where the general bankruptcy law applies to banks, the law often contains provisions that give recognition to the special status of banks. For instance, the law may designate the bank regulator as one of the parties authorized to petition the courts for bankruptcy of a bank.38 Alternatively, the law may grant the regulator an exclusive right of petition for bankruptcy in order to exclude unfounded bankruptcy petitions by creditors that could threaten the bank.39 Or the law may require the bankruptcy court to afford the bank regulator an opportunity to give its views, before ruling on a petition for bankruptcy of a bank.40
One of the arguments to apply the provisions of the general bankruptcy legislation also to banks is that, in countries with efficient bankruptcy laws and courts, there appears to be little reason why a bank should be treated differently from any other bankrupt corporation, once the bank has been declared bankrupt and its banking license has been withdrawn. Special interests of household depositors can be protected through special preference rules 41 or by deposit insurance—insurance payments and subrogation make the deposit insurance agency one of the bank’s creditors.
There are countries where, often for reasons of expediency and efficiency born in crisis situations, the law makes the general bankruptcy law inapplicable to banks and provides for a special regime governing the liquidation of insolvent banks. For instance, in the United States, the law charges the Federal Deposit Insurance Corporation with the liquidation of insolvent banks.42
Discretion of Regulators Under the Law
As a rule, the scope of the powers of a public agency such as the bank regulator are limited by the statutory provisions (the banking law) granting those powers.
Some laws prescribe more or less precisely when and how a certain authority is to be exercised by the agency concerned. Examples of such a prescriptive approach can be found in provisions of U.S. banking law requiring the bank regulator to take prompt corrective action to resolve serious problems of banking institutions.43
Often, however, the law grants the public agency a measure of discretion in deciding when and how a certain power is to be exercised. Discretion in this context means that for certain administrative actions the legislature relies more or less on the judgment of the agency. There are good reasons for doing so. Usually, public agencies have unique expertise and experience in the area of their jurisdiction that justify making them solely responsible for decisions on matters that fall within their jurisdiction.
The degree of discretion granted can vary considerably. Take, for example, the quite common power of the bank regulator to appoint for a bank that has become insolvent a provisional administrator in order to secure the bank’s assets for its creditors. In the Netherlands and the United Kingdom, the banking law grants no discretion at all to the bank regulator: administrators must be appointed by the court at the regulator’s request.44 In contrast, French and U.S. banking law provide for the appointment of a provisional administrator by the bank regulator on broad statutory grounds leaving the regulator a fair amount of discretion. Thus, in France, a provisional administrator may be appointed “… when the operation of the bank on a normal basis can no longer be assured.”45 U.S. banking law provides for a long list of grounds for appointing a conservator, including the bank’s assets are less than the bank’s obligations, an unsafe or unsound condition to transact business exists, and any violation of any law or regulation has occurred that is likely to cause insolvency.46 The decision whether one of these grounds applies is left to the judgment—the discretion—of the bank regulator.
In determining the scope of discretion to be granted to bank regulators, a balance must be struck between protecting the banking system from regulatory abuse and the need to avoid provisions that are so tightly written that they would unduly impair the ability of the regulator to address unforeseen financial conditions or unexpected innovations in banking services or financial products. Indeed, the unprecedented rate of change in the financial markets and the banking industry experienced during the last decades has made it necessary to grant bank regulators greater regulatory discretion than was deemed desirable before. This development has shifted much of the burden of providing safeguards against abuse of discretion to administrative law.
Bank regulators are agencies of the state, and, as such, their regulatory activities are generally governed by administrative law. Administrative law provides protection against regulatory abuse at several levels. It requires that public agencies such as the bank regulator do not exceed their statutory powers and that they use those powers only in accordance with the law. These requirements include that the regulator may not unduly stretch the scope of its discretion and may not abuse the measure of freedom granted by the law.
To protect the public, administrative law often prescribes the manner in which regulatory discretion must be exercised by mandating procedures for the issuance of regulations, such as including in regulations an introductory statement of the statutory authority for their issue and of the objectives pursued by them, to promote transparency, affording the public a reasonable opportunity for commenting on draft regulations, publication of regulations, guidelines, and decisions of general application, and observance of an appropriate notice period before regulations become effective. For regulatory decisions, the law may require the regulator to hear interested parties, to support the decisions with adequate reasoning, and to cause the decisions to be published or forwarded to all interested parties.
Apart from such procedural requirements, administrative law includes important principles of substantive law that aim at the content of discretionary decisions, such as impartiality and equal treatment, the duty for the regulator to weigh competing interests, proportionality between a regulatory measure and its objective, also called “the principle of least pain,” and the duty to promote transparency of administrative policy and legal certainty in its execution. In some countries, several of these standards are brought together under the rule that administrative decisions may not be arbitrary or capricious.
Review of Regulatory Decisions
In order to protect the public from abuse, and apart from the possibility to sue for damages in civil court, most countries permit or expressly provide for some form of administrative or judicial review and revision of administrative decisions. Administrative review may be performed by a higher administrative authority or by a higher organ of the decision-making agency. Judicial review may be performed by either administrative or civil courts.
In discussing the permissible scope of review of administrative decisions, a distinction must be drawn between a review of the legality of the decision and a review of the merits of the decision. Whereas the review of administrative decisions as to their legality—statutory authority and compliance with procedural and substantive rules of law—is not controversial, the review of administrative decisions as to their merits is. To be proper, a review of the merits of a decision requires a degree of expertise that is at least equal to that of the agency that took the decision. Generally, administrative and civil courts lack such expertise and therefore abstain from reviewing the merits of administrative decisions, respecting the discretion granted by the legislature to the agency concerned. Usually, administrative decisions are reviewable as to their merits only when the law grants specific authority for such review to a higher administrative authority such as a minister or a council of state, or to a special review panel composed of specialists.
In reviewing the authority and powers of the bank regulator, the authority doing the review must consult not only the banking law but also general provisions of administrative law setting standards that apply to the issuance and enforcement of prudential regulations and other decisions of the bank regulator.
Principles of administrative law apply both at the legislative or rule giving level and at the level of application and enforcement of banking law and regulations. Thus, for example, the principle of proportionality would require regulators to ensure that their regulatory activities are proportional to the systemic risks against which they afford protection, while the principle of equal treatment under the law would require that prudential regulations apply uniformly and are enforced uniformly throughout the country with respect to all banks.
Some of these principles are supported not only by norms of good governance but also by economic considerations. A good example is the need for uniformity of regulatory burden.
Lack of uniformity produces unfair competitive advantages for banks that are being treated more favorably than others. Bank regulators must maintain what has come to be called a “level playing field” where similar financial institutions are subject to similar regulatory costs, and where regulations and enforcement actions are avoided if they would establish or support competitive advantages for some institutions over others. A level playing field for banks requires not only equality of regulatory burden but also equality of other governmental charges (taxation) and subsidies. Thus, bank regulators may deny banking licenses to banks from foreign countries where prudential banking standards are low, not only because the entry of weakly supervised foreign banks would present risks to the local banking system, but also and especially because the entry of foreign banks enjoying an improper regulatory cost advantage would expose local banks to unfair competition.47
Although it is generally accepted that, in principle, measures taken by state agencies, including the bank regulator, are subject to review by a higher administrative authority or in the administrative or civil courts, the possibility of a revision of remedial measures taken by the bank regulator raises difficult questions of balance between the fundamental right of interested parties to a judicial review of governmental decisions by which they are affected and the equally fundamental interest of society in effective supervision of the national banking system, including the prompt and definitive closure of insolvent banks.
The principle of judicial review has been enshrined in Article 13 of the First European Banking Directive:
Member States shall ensure that decisions taken in respect of a credit institution in pursuant to laws, regulations and administrative provisions adopted in accordance with this Directive may be subject to the right to apply to the courts. The same shall apply where no decision is taken within six months of its submission in respect of an application for authorization which contains all the information required under the provisions in force.
Article 6 of the European Convention on Human Rights provides that
in the determination of his civil rights and obligations … everyone is entitled to a fair and public hearing within a reasonable time by an independent and impartial tribunal established by law.
Similar rights of review are granted by American and Canadian law. For instance, in the United States, a bank may challenge the appointment of a conservator by the Comptroller of the Currency by bringing an action in Federal Court; the law directs the court “upon the merits” either to dismiss the action or to direct the termination of the appointment; and it specifies that the Comptroller’s decision
… shall be set aside only if the court finds that such decision was arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law.48
Meanwhile, it is equally accepted that the bank regulator must have the power to act swiftly and decisively in taking remedial measures required to protect the banking system or the interests of depositors and other creditors from the consequences of the failure of a bank to comply with prudential standards. In some countries, therefore, the law provides that decisions of the bank regulator ordering remedial or conservatory measures are enforceable immediately, notwithstanding their review.49
Review of regulatory decisions is often offered at two levels: at the administrative level and before the civil courts.
The law may provide for administrative review either in the form of a general administrative law statute or by special provisions of law. An example of the first technique is found in the Netherlands where decisions of the bank regulator are governed by the General Administrative Law Act, even though the banking law provides also for a special appeal to the appeals organ of an industry group.50 Examples of special provisions for administrative review of decisions of the bank regulator can be found in many countries. The laws differ, though, as to the authority having jurisdiction to hear the review.
In Belgium,51 Canada,52 and Spain,53 for instance, the Minister of Finance is the authority to review decisions of the bank regulator. In Italy, jurisdiction for review of decisions of the bank regulator is given to the Interministerial Committee of Credit and Savings, consisting of several cabinet members, including the Minister of Finance. As these authorities are not politically independent, the risk of partiality exists. Yet, that risk is inherent in most administrative review at higher levels of government. In any event, these quasi-judicial tribunals would probably not qualify as courts under Article 13 of the First European Banking Directive or as independent and impartial tribunals under Article 6 of the European Convention for Human Rights.
In Denmark, decisions of the bank regulator are subject to review by a more or less independent Companies Appeals Board established by the Ministry of Industry.54
In England, reviews of decisions of the bank regulator are heard by a specially constituted ad hoc administrative tribunal, the Banking Appeal Tribunal.55 Whenever a request for a review is lodged with the secretary of the Tribunal, the Lord Chancellor and the Chancellor of the Exchequer must appoint the three members of the Tribunal who are to carry out the review. The composition of the Tribunal—an experienced lawyer appointed by the Lord Chancellor as chairman and two members, one an accountant and one a banker—is designed to ensure a professional judgment. The proceedings of the Tribunal are held in camera so as to preserve confidentiality and to help avoid leaks of sensitive information to the financial markets. Finally, the review by the Banking Appeal Tribunal is passive and may not redo the decision of the bank regulator; the scope of review is limited by law to the following:
… whether, for the reasons adduced by the appellant, the decision was unlawful or not justified by the evidence on which it was based.56
The English Banking Appeal Tribunal can serve as a model for other countries, and not only because it meets the criteria of the First European Banking Directive and the European Human Rights Convention. By its limited scope of review and by bringing a measure of independence and professionalism to the administrative review process, it provides safeguards that are missing in other countries. In view of the seriousness of banking regulation, the question must be whether an administrative review of decisions of the bank regulator is at all justified in the absence of such safeguards. Normally, an administrative review includes a review of the merits of the decision under review and permits the decision under review to be overturned. In banking matters, the authority carrying out the review takes the seat of the bank regulator and must therefore have qualifications worthy of his task. Because of the often highly technical nature of bank regulatory decisions, it cannot be readily assumed that a review panel that is not composed of experts like those serving on an English Banking Appeal Tribunal will be able to review decisions of the bank regulator with the degree of expertise that such decisions demand.
These requirements of expertise do not apply to the judicial review of regulatory decisions in the civil courts, because, unlike administrative review, the scope of civil review normally excludes a review of the merits.
On the European continent, the law accords significant freedom of decision making to technical administrative agencies such as the bank regulator. The administrative law principle of discretion generally prevents the civil courts from reviewing administrative decisions as to their merits. The review of administrative decisions in the civil courts is normally limited to the application of several fairly narrow legal standards, such as whether the agency taking the decision stayed within its statutory authority, the legality of the decision as to form and procedure, manifest error, and misuse or abuse of power, while a substantive review of the decision usually does not go beyond compliance with standards of good administration and general principles of administrative law, such as equality of treatment and proportionality between the administrative action approved or adopted by the decision and the interests served thereby.
In North America, the principle of discretion of administrative authorities is not well developed as such. Generally, the standards applied by common law courts to review administrative decisions include the doctrine of ultra vires, including the formal and material legal validity of the decision, the requirement that the decision may not be arbitrary or capricious or an abuse of discretion, and principles of natural justice and equity.
In England, the review on appeal by the High Court of a decision of an English Banking Appeal Tribunal is limited by law to determining if the decision of the Tribunal “was erroneous in point of law.”57
Hazards Associated with the Review of Regulatory Decisions
The review of regulatory decisions, whether administrative or judicial, is hazardous for the regulator. The reviews of regulatory decisions should remain the exception and may not become the rule, albeit only for fear that an avalanche of litigation would divert staff away from prudential supervision.
This is especially a problem in countries with economies in transition, where for understandable historical reasons there is a deep distrust of state power including the authority of bank regulators, where a long-repressed public has discovered the joys of litigation, and where the judiciary has often not yet fully understood the need to constrain its newly found independence from the state or to resist the undue influence of politicians and other interested parties. The result has been that decisions of the bank regulator to take control of banks have been ignored, that conservators that were appointed were dismissed by the courts or stripped of their authority, and even that some banks that had been placed in liquidation after their licenses had been revoked rose like a phoenix from their ashes to reopen their doors to a stunned public, all on the strength of a court order.
In such conditions, the temptation is great to protect at least the most critical decisions of the bank regulator—such as the appointment of a conservator or the revocation of a banking license—by statutory immunity from administrative or judicial review. Whether attempts to do so will stand up in court remains to be seen.
Although the very concept of immunity from review may seem heretical as it runs counter to the fundamental right that affords each person a day in court, there is a good case to be made for according it to at least some critical decisions of the bank regulator. It must be admitted that the speed and secrecy with which such decisions often must be made by the regulator prevent the use of procedural techniques that in other situations would provide safeguards against errors and abuse. By their nature, conservatory measures do not lend themselves to consultative processes or democratic forms of decision making involving interested parties. Bank regulation is in essence an autocratic affair. Moreover, in extreme cases, damages could be awarded to bank owners by the civil courts.
Some protection against undesirable court intervention may be granted by the legislature in the form of prescriptive statutory provisions that by excluding regulatory discretion in effect preempt judicial review. To that end, the provisions must carefully delineate the content and scope of the authority of the bank regulator and precisely define the circumstances in which such authority may be exercised. Additional protection can be found in making the provisions mandatory, requiring the regulator to take or to order the measures concerned if certain conditions occur. Owing to the essentially discretionary nature of prudential supervision, this technique should be used only in countries where reasonable constraints on judicial review have not yet been established and then only for those remedial and conservatory measures whose immunity from judicial review is required by compelling systemic considerations.
For the purposes of this paper, a “bank” is deemed to be an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account, following Article 1 of the First European Council Directive of 12 December 1977 concerning credit institutions (77/780/EEC)(Official Journal No. L 322/30 of 12/17/77), reprinted in 2 Current Legal Issues Affecting Central Banks 251 (Robert C. Effros ed., 1994).
Art. 43 of Law No.84-46 of January 24, 1984, regarding the Activities and Supervision of Credit Institutions. See also Belgium, Art. 57 (1) of the Law on the Legal Status and Supervision of Credit Institutions; Italy, Art. 53(3)(d) of Legislative Decree No. 385 establishing a Unified Banking and Credit Act; Netherlands, Art. 28 (2) of the Law on Supervision of the Credit System.
See, e.g., Canada, Sections 480, 485, 535, and 537 of the Bank Act; England, Section 12 of the Banking Act of 1987; France, Art. 45 of Law No. 84-46 regarding the Activities and Supervision of Credit Institutions; and Germany, Sections 45 and 46 of the Law on the Credit System KWG.
The lender-of-last-resort rescue action mounted by the U.S. federal authorities in 1984 to save Continental Illinois is instructive; see Federal Deposit Insurance Corporation (FDIC), History of the Eighties—Lessons for the Future, 1997, Volume I, Chapter 7.
Conversely, a bank is generally deemed insolvent when the value of its assets is less than the aggregate nominal amount of its liabilities. Often, the bank supervisor uses the concept of regulatory insolvency, which measures solvency in terms of the adequacy of a bank’s capital to meet prudential standards.
12 United States Code (hereinafter “U.S.C.”) § 1831o (1994); the unusually detailed conditions and remedial measures specified in the law are supplemented by equally detailed regulations in 12 Code of Federal Regulations (hereinafter “C.F.R.”) 325 (1998).
Second European Council Directive of 15 December 1989 concerning credit institutions (89/646/EEC)(Official Journal No. L 386/1 of 12/30/89), reprinted in 2 Current Legal Issues Affecting Central Banks, supra note 1 at 264. The persons referred to in para. 1 are persons having a direct or indirect holding in the credit institution that represents 10 percent or more of the capital or of the voting rights or that makes it possible to exercise a significant influence over the management of the institution.
Conservator is the American term. In Europe, the term “administrator” or “commissioner” is used instead. The American term is preferred to distinguish the conservator’s objective of conserving the value of the bank’s assets from the remedial objective of provisional administration.
Systemic banking crises may present an exception to this norm. In the United States, conservatorship was first introduced by Title II of the Emergency Banking Act of March 9, 1933, in response to a banking crisis. It permitted the bank regulators to take and to retain control of individual insolvent banks, until the damage to the banking system as a whole was assessed and a systemic battle plan was prepared.
In England, failing banks are placed under an administration order pursuant to Section 8 of the Insolvency Act of 1986. Part II of the Insolvency Act is applicable to banks pursuant to the Banks (Administration Proceedings) Order 1989. See Sections 10 and 11 of the Insolvency Act for a stay on payments by the bank.
France is a notable exception, requiring the courts, in deciding on a petition for bankruptcy, to review the chances of a successful reorganization in light of the loss of employment that liquidation would entail; see Articles 1, 18, and 61 of Law No. 85-98 of January 25, 1985 concerning the judicial rehabilitation and liquidation of enterprises.
For instance, in Italy and the Netherlands, even though the general bankruptcy law applies to banks, the banking law makes special provision for forced liquidation of insolvent banks upon the request of the bank regulator—Articles 80 ff. of the Italian Legislative Decree No. 385 establishing a Unified Banking and Credit Act; and Articles 71 ff. of the Netherlands Law on Supervision of the Credit System.
In the absence of a formal deposit insurance system, Switzerland grants a special preference for household savings and alimony and pension deposits up to SwF 30,000—Article 37a of the Swiss Federal Law on Banks and Savings Banks. See also Article 49 of Law 21526 of Argentina.
Netherlands, Article 71 (7) of the Law on the Supervision of the Credit System; United Kingdom, Section 8 of the Insolvency Act of 1986, applicable to banks pursuant to the Banks (Administration Proceedings) Order 1989.
Unfortunately, not all countries are equally strict in pursuing equality of treatment for their banks. In some countries, public-sector banks owned or controlled by the state are given favorable treatment in the form of cheap capital and state guarantees, creating for such banks an unfair competitive advantage over private-sector banks. An example are the German Landesbanken that are owned by the German states and benefit from state guarantees that enable them to borrow and therefore to lend funds at lower rates of interest than private banks. This has helped, e.g., the Westdeutsche Landesbank Girozentrale to become one of Germany’s largest banks.
See, e.g., Belgium, Article 57(2)(2) of the Law on the Legal Status and Supervision of Credit Institutions; Luxembourg, Article 60 of the Law on the Financial Sector; and Germany, Section 49 of the Law on the Credit System.