Unlike most nonfinancial corporations, in a market-based economy, banks are subject to a special regime of licensing, regulation, and supervision (hereinafter also “prudential regulation”). In a market-based economy, the function of banks differs from that of other enterprises, calling for special treatment of banks by the state.

1. Special Treatment of Banks

Unlike most nonfinancial corporations, in a market-based economy, banks are subject to a special regime of licensing, regulation, and supervision (hereinafter also “prudential regulation”). In a market-based economy, the function of banks differs from that of other enterprises, calling for special treatment of banks by the state.

When compared with the law that governs nonfinancial enterprises, prudential regulation of banks is special in its enforcement of prudential rules and its treatment of banking problems. Unlike nonfinancial enterprises, banks are normally subject to a complex and comprehensive system of rules and procedures authorizing the bank regulator to enforce prudential regulations, to take corrective action with respect to banks not in compliance with banking law, and ultimately to take control of banks threatened with failure.

In what respect are banks so different as to justify special treatment? Because of their traditional role of intermediation between short-term demand deposits and medium- and long-term loans, banks are vulnerable to a sudden loss of confidence in their financial soundness on the part of its depositors, causing a run on the bank. If a bank is unable to meet the demand for withdrawals and becomes illiquid, the public may lose confidence in other banks as well. The failure of one bank may affect the financial health of other banks that are counterparties of the failing institution. Interbank contagion and loss of public confidence can quickly snowball into panic runs on otherwise healthy banks, which may ultimately bring down the entire banking system. It may damage the financial condition of other financial institutions and may even impair the operations of the financial markets and payment and securities transfer systems. Thus, the failure of one or more individual banks may have effects that extend well beyond the financial scope of their operations. Moreover, a national banking crisis is difficult to contain within the borders of the country where it originates: owing to growing international business connections between banks of different countries, a banking crisis in one country can trigger a banking crisis in another.

Modern market economies cannot function properly without an efficient banking system intermediating between public savings and investments and providing other essential financial services to the public. Modern market economies cannot function properly without efficient financial markets or payment and securities transfer systems that depend on banking services. A sound banking system is necessary for the conduct of monetary policy and for the operation of payment systems. Prudential licensing and supervision of banks is dictated by these considerations and by concern for the safety of public savings deposited with banks; in countries with public deposit insurance, there is a need to protect the interests of the deposit insurance agency and indirectly the state treasury that may guarantee its solvency. Therefore, banks should receive special treatment and should be submitted to prudential regulation that aims at their safety and soundness.

Banking regulation includes the institutional supervision of banks in order to ensure compliance with prudential banking standards. Although, in practice, banking supervision is meant to help maintain the safety and soundness of each bank on an individual basis, the most compelling reason for prudential banking regulation is concern for the safety and soundness of the banking system as a whole, and ultimately of the national economy. Even the objective of protecting public savings is inspired not only by social goals but also by the fear that loss of public confidence would lead to wholesale withdrawals of savings from the banking system. Therefore, as prudential banking regulation finds its justification in the need to protect the banking system, the treatment of individual banks by the bank regulator must essentially be driven by systemic considerations and not necessarily by the interests of individual banks.

The foregoing argument does not mean that banks whose failure would not pose a risk to the banking system, e.g., owing to their relatively modest size or position in the national economy, could be exempt from banking regulation. Even if it could be argued in theory that there are such banks, it would in practice be difficult to determine ex ante whether or not the failure of these banks at some future moment would trigger a banking panic. It would be even more difficult to define the objective and uniform standards that would be needed to maintain equality of treatment among banks in deciding which bank should and which bank should not be exempt from banking regulation. Furthermore, it would be improper to exempt only some banks from prudential regulation, as unregulated banks would benefit from a lower regulatory cost base than banks subject to prudential regulation. Because regulatory exemptions would expose regulated banks to unfair competition from unregulated banks, the bank regulator must instead maintain a level regulatory playing field where similar banking activities carry similar regulatory burdens for all banks alike. Finally, even if it were possible to identify in the abstract banks that would individually be too unimportant to pose a risk to the banking system, the possibility that a significant number of such banks would fail could well pose a systemic risk, as is illustrated by the small bank crisis in England in the early 1990s.

The conclusion that banking supervision should essentially be driven by systemic considerations has important implications for the regulatory treatment of individual banks in distress. The interests of the banking system and the interests of individual banks do not always coincide. For systemic reasons, the bank regulator will permit some banks to fail. Regulatory action taken and the costs incurred by the authorities to rescue banking enterprises whose failure could not reasonably be expected to pose a threat to the banking system could not be justified on systemic grounds.7 Actually, letting such banks fail would be in the interest of the banking system, because it would drive home to the owners and managers of other banks that unsafe or unsound banking practices have a price; this would help combat the systemic risk and moral hazard that the expectation of an official rescue would tempt banks to engage in improper banking activities.

An important legal issue to be addressed is whether the before-mentioned systemic reasons for the special treatment of banks are so strong as to justify exceptions for banks to the principle of judicial administration of the rehabilitation and winding up of insolvent institutions under general insolvency law. An extrajudicial regulatory process offers greater efficiency than a court-administered process; this is an important advantage if immediate action to close or transfer the business of a bank is required for systemic reasons. However, granting the regulator the power to act expeditiously and to avoid delays inherent in court administration has a significant cost: excluding the courts tends to deprive bank creditors and other interested parties of the procedural and substantive safeguards that they enjoy under a proper court-administered proceeding. This argument carries even greater weight in bank insolvencies where the deposit insurance agency is appointed as receiver, as the agency will usually suffer a conflict between its interests as one of the largest creditors of the bank and its role as impartial receiver. These and other aspects of the regulatory takeover of banks are discussed below.8

2. Institutional Framework

Although, in most countries, dealing with banks in distress is first and foremost the responsibility of the bank regulator, other institutions may eventually be involved, such as the deposit insurance agency, bank restructuring corporations,9 and the judiciary.

Nonbank financial institutions play an increasingly important role as custodians of public savings (brokerage houses, life insurance companies, pension funds, and mutual investment funds), and hence the effects that their failure may have on public wealth and on the financial system become increasingly significant. Therefore, in many countries, nonbank institutions are subject to prudential requirements and oversight, while some countries consolidate the prudential regulation of banks and other financial institutions under the roof of a single regulatory agency (Australia, England, Japan, Korea, Norway, Sweden).

To be effective, corrective action must be fair, swift, and decisive. This requires a bank regulator that is autonomous (i.e., financially and operationally independent from outside interference, accountable to the public, transparent and predictable in its regulatory activities of general application, and staffed with sufficient qualified and experienced personnel).

Accountability requires that the various prudential duties are assigned to a single authority for each bank or category of banks. In some countries, prudential responsibilities are divided between several agencies; typically, the issuance and revocation of banking licenses may be the responsibility of the minister of finance, while supervision of banks is entrusted to the central bank or another bank regulator such as the deposit insurance agency. Although such arrangements may be satisfactory for countries with a strong tradition of interagency cooperation (United States), in others they tend to promote negligent forbearance and to weaken accountability by giving each of the authorities an excuse for pointing the finger at the other when a bank fails.10

Transparency of policy and predictability of supervisory decision making are key characteristics of a good bank supervisory system: they help ensure equality of treatment among banks. An important contribution to transparency is made by submitting draft banking regulations to public comment before their final adoption and by rendering all regulatory decisions in rational and impartial judgment. Care should be exercised in publishing regulatory decisions affecting banks on an individual basis: if the market is unaware of a bank’s difficulties, an announcement by the authorities that corrective action is being taken with respect to that bank may cause an adverse market reaction. Essential is the prompt publication of all prudential regulations and regulatory decisions that are of general application. Predictability of regulatory decisions is achieved when generally similar regulatory issues lead to similar regulatory decisions; reducing the risk of unexpected regulatory action tends to reduce transaction costs and to enhance the efficiency of the banking industry.

Obviously, banking supervision should be conducted on the basis of technical criteria without political consideration and without outside interference from the political establishment or lobbyists. The requirement of financial independence for the regulator is designed to avoid the risk of political influence peddling in exchange for financial support. Financial independence can be assured by assigning banking supervision to an autonomous central bank. For an independent supervision agency, financial autonomy can be built on levies from the banking industry and on the assumption that banks that meet prudential requirements have a strong interest in the enforcement of banking law against banks whose noncompliance exposes them to unfair competition.

Wherever bank owners and managers have powerful political connections, quick and effective corrective action by the bank regulator is the true test of its autonomy. They are also a true test of the political will to maintain an effective bank regulatory framework, because the bank regulator operates by the grace of the legislature and cannot properly fulfill its task without political respect for regulatory autonomy. In countries with a powerful body politic and a relatively short tradition of independent state agencies, the autonomy of the bank regulator may be strengthened by providing for judicial or administrative review of its decisions, as such review offers bank managers and owners a forum for grievances and politicians an excuse for staying on the sidelines.

The need to keep the political establishment out of decisions concerning individual banks sounds more obvious than it really is, especially where such banks occupy a central position in the national economy. On the one hand, it is clear that prudential bank regulation should be based on bank-technical standards. On the other hand, banking supervision is a public function that, if deficient, tends to cause great harm to the nation; it is understandable, therefore, that the body politic wishes to be involved beyond its legislative function. A balance can be struck between these interests by granting the government control over appointments to the decision-making organs of the bank regulator without impairing the regulator’s functional autonomy.11

3. Incidental Versus Banking System Problems

In discussing the modalities of banking regulation, it is useful to distinguish between “normal” situations where a banking system is reasonably sound and bank failures occur only sporadically on an incidental basis and the exceptional situation where a country suffers from an economic crisis of such magnitude as to threaten the failure of the entire banking system. Systemic banking crises, such as those recently encountered in Asia and Russia, commonly require exceptionally strong corrective measures designed to restore confidence in the financial markets quickly.

Accordingly, the book distinguishes between incidental banking problems and systemic banking crises. Although regulators may use powers granted for incidental cases also in crisis situations, systemic banking crises require additional strategies and super powers that would generally not be justified in “normal” situations. Systemic banking crises are addressed in the final section of this book.

4. The Corrective Effects of Market Forces

Because banks operating in market-based economies are exposed to the financial markets (including other banks) for their funding and other financial activities, they are subject to the vagaries of the market place. At the same time, banks are subject to prudential regulation including corrective action imposed by the banking supervisor, which in a sense interferes with the market place. This section of the book offers a brief discussion of some of the considerations that go into seeking a proper balance between the corrective effect of market forces and the corrective effect of regulatory action on banks.

In a market economy, market forces largely determine the terms and conditions on which market participants compete with each other. One of the risks of regulatory intervention is that by altering those terms and conditions it may distort or impede competition between banks and stifle banking product innovation; hence the need for a proper balance between market forces and regulation.12

Financial markets tend to correct errors in judgment and thereby impose discipline on market participants. Thus, for instance, when weak banks are permitted to succumb to market forces, the risk of bank failure provides a powerful incentive for bank owners and managers to keep their institutions safe and sound. Conversely, placing regulatory constraints on the corrective effects of market forces (e.g., by preventing banks from failing through regulatory intervention) weakens the discipline imposed by the market place.

It can be readily admitted that it is not the task of the bank regulator to try and save every bank that is threatened by demise. Bank failure should not be treated as an abnormal event and prudential bank regulation should certainly not be expected to guarantee the safety and soundness of each and every bank. As a general proposition, banks do fail and should be allowed to fail.

There are times, however, where economic conditions are so severe that they threaten the entire banking system. For instance, in the Asian crisis of 1997 such systemic threats resulted from unexpected changes in exogenous economic conditions followed by exceptionally strong reactions on the part of bank depositors and other providers of funds to what the financial markets perceive as significant weaknesses in one or more important banks or the banking system as a whole. As market economies cannot function properly without a banking system, the bank regulator must step in to protect the banking system against such threats. In doing so, the bank regulator must calibrate the extent of its regulatory intervention in banking operations so as to strike a proper balance between, on the one hand, preventing bank failures that would significantly and adversely affect the public confidence in the banking system and, on the other hand, promoting competition and innovation in the banking sector. Finding and maintaining such balance belongs to the most difficult tasks of the bank regulator.

The deregulation of banking operations combined with the communications revolution and the resulting fundamental changes in banking activities have made this task even harder. For example, much of the threat to banking systems caused by market forces results from markets overreacting to negative news. With the shift in their funding from insured private individuals to uninsured sophisticated financial institutions, and the shift from traditional loan-based banking operations to trade- and service-based banking activities, banks have become more exposed to market judgments about the risks that they pose to their counterparties. In addition, the exponential growth in foreign exchange and derivatives operations of large banks with other financial institutions has made them more vulnerable to price volatility and real or perceived adverse changes in their financial condition. Uninsured financial institutions react faster and more forcefully to unexpected negative news concerning a bank counterparty than insured household depositors. By increasing the speed with which information is disseminated, financial judgments are arrived at, and investment decisions are taken, the communications revolution has added to the volatility of market sentiment.

What can be done in this environment to avoid excessive market reactions to banking problems, and thereby to mitigate their destructive effects on the banking system as a whole, without reversing the deregulation of the banking industry? The first line of defense is adequate prudential regulation of banks by a regulator enjoying public trust. The second has traditionally been deposit insurance in one form or another. The third would be the timely publication of adequate and transparent information concerning individual banks, especially where they warn the financial markets about impending problems of banks at a time when the problems are still relatively small and the markets therefore may be expected to react to them with restraint.

The more sophisticated financial market participants are, the more they will benefit from improved bank information flows. Better financial reporting will serve the interests not only of bank counterparties but also of the banks themselves. Although it might at first glance appear that greater timeliness and transparency in financial reporting by banks would make their market position more volatile, this timeliness and transparency would actually help smooth reactions of bank counterparties and help protect banks against damaging market action driven by unfounded rumor.

For household depositors with banks, the situation appears to be different. Better financial reporting by banks would affect the behavior of household depositors only if such reporting becomes more consumer friendly. For them, greater transparency in financial reporting should entail not only greater quantities of timely financial data, but also, and especially, drastic improvements in the presentation of such data. Currently, the information advantage of sophisticated investors over unsophisticated household depositors not only consists of better access to more complete information—although the internet is rapidly bridging this gap—but concerns mainly the ability to digest and use that information. Before unsophisticated household depositors can reasonably be expected to play a useful role in imposing market discipline on banks, the financial information concerning banks that is needed to make regularly informed judgments about a bank’s safety and soundness must be presented in a format that can readily be understood by the general public. This requires both changes in the presentation of financial information and education of the public in absorbing and using that information. Until such changes have been carried out, generally unsophisticated household depositors cannot be expected to make adequate or timely judgments about the soundness of the institutions where they bank, except in extreme cases.

This judgment concerning household depositors is borne out by the fact that runs on banks by depositors typically have come too late—namely, when the bank concerned was already on the brink of failure—or too early, when contagion led to panic runs on banks that were sound. Providing more information about banks may not be helpful either. In fact, negative market signals have had the perverse effect of attracting depositors instead of repelling them, such as when depositors were prompted to move their money into a bank offering relatively high deposit rates, without realizing that these attractive rates compensated for a higher risk of failure resulting from weaknesses in the bank’s financial condition.13 Therefore, household depositors should generally not yet be relied on to provide a gradual response to gradual changes in the financial condition of their banks. This may change as the financial literacy of the general public improves, and indeed, one of the objectives of banking regulation should be to promote public knowledge and understanding of the banking system and thereby to improve the ability of household depositors to form adequate judgments about the safety and soundness of their banking institutions. Meanwhile, deposit insurance may be used to protect the banking system against depositor-led banking panics.14

The corrective effects of market forces present bank regulators with a dilemma. On the one hand, the discipline that the financial marketplace imposes by penalizing a bank’s deficiencies in the form of lower credit ratings and higher interest or collateral requirements alleviates the task of the regulator. On the other hand, the increased risk of excessive market reactions makes the regulator’s task more difficult. In a market environment, corrective action taken by the bank regulator to strengthen a bank’s financial condition may be interpreted in the market as evidence of serious problems and have the unintended effect of causing an adverse market reaction that increases the bank’s cost of funding and thereby weakens the bank even further, triggering the very chain of events that corrective action is designed to forestall.15 It may even raise the specter of contagion of other banks. Although this risk should never serve as an excuse for regulatory forbearance, it does raise questions concerning the manner in which regulatory corrective action is taken. And it strongly supports the conclusion that bank regulation should be market sensitive.

Ideally, the bank regulator maintains a proper balance between the corrective effect of market forces and regulatory intervention, limiting regulatory constraints on market forces to situations where this is clearly justified by systemic considerations.

Deposit insurance adds a wrinkle to this line of reasoning, as it provides a disincentive for depositors to withdraw their funds from a bank when the financial health of the bank deteriorates. Consequently, bank managers are tempted to engage in unsound banking practices, in the expectation that because of deposit insurance such practices will not cause depositors to leave the bank, creating a condition known as “moral hazard.” For small banks, the moral hazard implicit in deposit insurance can be countered by the strict enforcement of explicit exit policies for failing banks. For larger banks relying on the financial markets for much of their funding and income, moral hazard implicit in deposit insurance is reduced by their exposure to the corrective effects of market forces.

Unfortunately, other factors also cause moral hazard. For banks deemed indispensable to the proper operation of the banking system, the financial markets, including the banks themselves, tend to assume that the banks will be bailed out by the monetary authorities. This judgment is generally made ex ante, long before the first signs of trouble. The possibility, or rather the probability, that such banks will be rescued because they would be “too big to fail”16 exposes society to the moral hazard that bank owners and managers may be encouraged to engage in unsound banking practices. It is difficult to measure the influence of this implicit guarantee on the cost of operations of such banks, or the effects of such thinking on the behavior of their managers and owners. There is evidence that it is conducive to a go-for-broke mentality, tempting bank managers and owners to take ever greater risks as bank capital erodes, shifting the risk of loss to the monetary authorities,17 especially in countries where the law does not threaten such reckless behavior with effective civil or criminal penalties. Meanwhile, it is not difficult to see how the assumption that such a guarantee exists can lead to complacency on the part of investors and blunt the corrective effects of market forces. But, would such investor confidence—even though misplaced—not tend to protect such a bank from adverse market action? Initially it may indeed. Ultimately, however, as the bank’s financial condition continues to deteriorate, the market will begin to question its own assumptions about the existence of a guarantee for that bank and, when it is not explicitly confirmed by the authorities, react with even greater force than before.

In England, the Financial Services and Markets Act 2000 condenses the foregoing to three statutory objectives of financial regulation that the Financial Services Authority (FSA) as regulator must so far as is reasonably possible comply with: market confidence, public awareness, and the protection of consumers.18 The Act defines these regulatory objectives as follows: the market confidence objective is maintaining confidence in the financial system (including banking activities); the public awareness objective is promoting public understanding of the financial system, including, in particular, promoting awareness of the benefits and risks associated with different kinds of investment or other financial dealing, and the provision of appropriate information and advice; and the protection of consumers objective is securing the appropriate degree of protection for consumers.19 In addition, the Act requires that the FSA, in discharging its general functions, must have regard to several principles of good regulation, which include the following (as translated for banks):

  • the principle that a burden or restriction which is imposed on a person, or on the carrying on of an activity, should be proportionate to the benefits, considered in general terms, which are expected to result from the imposition of that burden or restriction;

  • the desirability of facilitating innovation in connection with banking activities; the need to minimize the adverse effects on competition that may arise from anything done in the discharge of those functions; and the desirability of facilitating competition between banks.20

5. Liquidity Support Provided by the Central Bank as Lender of Last Resort

Just like other institutions, banks must ensure that they are able to meet their liabilities as these become due. However, compared with other companies, banks face special difficulties in meeting this requirement. Traditionally, banks use funds received by them mainly in the form of demand deposits and unsecured 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 resources21 to meet its current payment obligations. Accordingly, prudential banking regulations usually require banks to maintain certain minimum 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.22

Several sources of funds and techniques are available to banks to supplement their liquid resources. In the major industrial countries, banks have access to money markets, including the interbank market, for overnight borrowing under arrangements that may include loans secured by collateral or security repurchase agreements. In addition, banks that are account holders with their central bank usually have access to the central bank’s discount or lombard loan window or to overdraft facilities under payment, clearing, and settlement systems operated by the central bank. Often, however, central bank funding is subject to restrictions or collateral requirements. The law typically prescribes which types of assets are eligible for central bank discounting or collateral. And financial assistance by the central bank is nearly always subject to the condition that it is compatible with the central bank’s monetary policy stance, although exceptionally financial assistance may also be granted otherwise if its monetary effects are sterilized.

Sometimes, however, banks are confronted with unforeseen developments that close their access to ordinary sources of funds, threatening their ability to continue meeting their liabilities as these fall due. This may be caused by unusual changes in the macroeconomic environment in which banks operate and over which they have little or no control. A typical example would be an unexpected loss of public confidence in the banking system, triggered perhaps by a currency crisis or the failure of another financial institution. Such an event may close access of the bank to the interbank market and eventually cause a depositor run on the bank. It is in such situations, where a bank experiences a catastrophic liquidity shortfall, that the question arises whether an otherwise solvent bank should be allowed to fall victim to market forces beyond its control, just as most nonbank enterprises would be allowed to fail, or whether the authorities should step in to meet the bank’s short-term liquidity needs.

As was said before, prudential regulation of banks is not designed to eliminate all bank failures. Banks engage in a risky business, and it should be expected that some will fail. The question is therefore not whether banks should be allowed to fail—many clearly should—but whether a particular bank should be allowed to fail or whether it should receive lender-of-last-resort support from the central bank. The answer to this question generally depends on a judgment whether the failure of that bank would imperil the integrity of the banking system—for instance, because its failure must be expected to cause a run on other banks or because the bank is judged an essential component of the country’s financial sector. In answering the question, a distinction should be drawn between the needs of a failing bank and the needs of the banking system as a whole.

Lender-of-last-resort support to a failing bank is traditionally understood to consist of liquidity support in the form of a collateralized loan provided in exceptional circumstances by the central bank to the failing bank if the failing bank is still solvent. Liquidity support may take other forms or be provided by another agency, however. For instance, it may be provided in the form of a central bank deposit of funds with the bank. In countries with deposit insurance, the deposit insurance agency is often authorized by law to provide liquidity support to insured banking institutions, ostensibly to reduce the risk of loss to the agency.23

Lender-of-last-resort assistance is exceptional. Therefore, it must be distinguished from liquidity support provided by the central bank to the banking system through normal channels, such as lombard and discount windows.

As lender-of-last-resort assistance, by definition, is available only to solvent banks, it must also be distinguished from exceptional financial support, or “open bank assistance” as it is sometimes called, which is provided to banks that are insolvent.24 In practice, however, the urgency of the situation may prevent the central bank from reaching a reliable judgment concerning the bank’s solvency. Lender-of-last-resort financing from the central bank is usually available only when the problems causing the liquidity shortfall are expected to be of a short duration and where the bank, notwithstanding its lack of liquidity, is still solvent, i.e., where the bank’s assets have a value that exceeds the aggregate nominal amount of the bank’s liabilities.25 If the bank is insolvent, it would usually not be eligible for central bank funding, and financial assistance must come from the government. Often, the true financial condition of an illiquid bank cannot be ascertained and the risk that the bank would prove to be insolvent cannot be properly assessed without spending time on a bank audit that the urgency of the situation does not allow. Therefore, it is suggested that the burden of proof of insolvency be turned around so that banks requesting lender-of-last-resort assistance would be presumed to be insolvent, unless they prove otherwise.26

Other practical difficulties must be perhaps overcome before lender-of-last-resort support may be made available. In a desperate attempt to obtain liquid resources, the bank may have sold most of its assets that the central bank could otherwise have accepted as collateral for credit to the bank. Or, conversely, if assets that could serve as security for central bank credit are still available, the bank may be committed under negative pledge covenants with its existing lenders not to grant any collateral to new lenders, or under pari passu covenants to ensure that existing lenders share in or are given collateral equivalent to the collateral granted to new lenders; in any event, the aggregate principal amount outstanding on the bank’s debt will often exceed the combined value of those of its assets that could serve as collateral. If negative pledge or pari passu covenants are obstacles to the provision of collateral, the central bank may be able to buy assets from the bank, if necessary through a special intermediary created for the purpose, before they are securitized and marketed.27 Another technique for circumventing the prohibition on central bank lending to the bank without adequate collateral is for the central bank to make a loan to the state for onlending by the state to the bank in distress; the central bank loan to the state may be collateralized by, or take the form of a sale to the central bank of, marketable government securities bearing interest at market rates.

If a bank is assumed or found to be insolvent or if it cannot offer eligible collateral, it must be decided whether the bank should nevertheless receive exceptional liquidity support from the state treasury or from another official source, such as the deposit insurance agency. In addition, regardless of whether lender-of-last-resort support is provided or withheld, the central bank may add liquidity to the banking system as a whole in order to stave off depositors’ runs on other banks and thereby to contain the adverse systemic effects of a bank failure.

Although, under banking law, liquidity support is often treated independently from other regulatory measures, usually such support would be linked to a plan of bank restructuring designed to return the bank to a condition where support is no longer needed to service its obligations. It stands to reason that the rate of interest and other fees charged by the monetary authorities in exchange for such emergency assistance should be high enough to reflect the risks associated with the rescue operation and to exclude that, owing to public assistance, the stake of the bank’s owners would improve without penalty (free ridership). In practice, however, the rate of interest and other fees charged are rarely adequate—if they were, the bank could have obtained market funding on those terms. It may be preferable, therefore, to penalize bank managers by removing them (unless the bank’s difficulties are due to circumstances beyond their control) and to ensure that bank owners bear the full cost of support, including penalties where appropriate—for instance, by suspending dividend payments until the cost has been paid out of the bank’s net revenues.

In some countries, official liquidity support comes indirectly when the law authorizes the bank regulator to declare a moratorium and to suspend some or all of the debt-service payments to be made by the bank. In this manner, liquid resources are freed up—resources that the bank otherwise would have needed to meet its obligations—permitting the bank to ride out the storm or to arrange a debt workout with its creditors.28

For central banks responsible for banking supervision, lender-of-last-resort assistance may carry political costs. There may be fear that the central bank would misuse its lender-of-last-resort facility to cover up its own deficient prudential oversight. And, once financial assistance has been provided by the central bank, it will often saddle the central bank with a large loan asset of doubtful value that is collateralized by questionable assets; this may make it difficult for the central bank to support closing the bank and swallowing the resulting loss. These are among the considerations that have been advanced for assigning the task of banking supervision to an agency other than the central bank.

6. Prevention

The principal objective of prudential regulation of banks is to maintain a sound banking system. To achieve this objective, an effective system and a suitable legal framework for banking supervision will be required, meeting the standards set out in the Basle Core Principles. In this sense, enforcement of banking law and the regulatory intervention discussed in this book all aim at preventing banking problems.

However, these goals cannot be reached without a culture that fosters voluntary compliance with prudential requirements on the part of bank owners and management: it is practically impossible to place a bank regulator behind the chair of every bank manager.

In addition, several external conditions are conducive to a sound banking system. These include in particular the following:

  • a strong legal framework providing banks certainty concerning their rights and obligations under the law and permitting them to enforce their financial claims expeditiously and effectively against counterparties in default;29

  • a proper corporate framework for banks30 that is characterized by good governance, adequate internal risk management and financial control systems, market-based decision-making, and respect for shareholders’ rights;

  • proper incentives and disincentives for bank owners, managers, and directors, ranging from the effects of market forces on the bank’s financial position to personal liability for gross negligence and willful misconduct;31

  • regular publication of informative financial statements drawn up in accordance with internationally accepted accounting practices and audited by qualified and independent external auditors, promoting sound market judgments;

  • adequate payment, clearing, and settlement systems for transfers of money and securities; and

  • efficient financial markets that not only enable banks to meet their ordinary liquidity needs and to calibrate their overall risk profile by disposing of assets and hedging liabilities, but also support reasonable asset valuations for accounting and risk management purposes.

Finally, no banking system can function properly without public trust. Therefore, an important objective of the prudential regulation of banks is to build and maintain public confidence in the banking system. This objective is pursued not only by the issue and enforcement of prudential regulations but also by educating the public about the banking industry. Such education should include explaining to the public the risks of banking and the prudential standards applied to mitigate those risks, publishing important decisions of the bank regulator, and fostering reasonable expectations among the public about the continuing safety and soundness of banks. Most important is that the bank regulator has public credibility. Credibility of the bank regulator is enhanced by granting the bank regulator autonomy of decision making, by a transparent and uniform application of prudential regulations and policies, and by a proper, timely, and decisive response to banking problems.