Abstract

A supervisory authority’s bank supervision department must be proactive in identifying and responding to emerging issues and problems. Off-site analyses of individual bank and banking system data, on-site inspection activity, and frequent open communication with bank administrators are essential to effective supervision. When problems arise, the supervisory authority should tailor its response to the situation and deal with the matter in a timely manner. Strong supervision can be effective in avoiding undesirable consequences that lead to conservatorship and receivership. Box 2.1 details some of the characteristics of problem banks.

A supervisory authority’s bank supervision department must be proactive in identifying and responding to emerging issues and problems. Off-site analyses of individual bank and banking system data, on-site inspection activity, and frequent open communication with bank administrators are essential to effective supervision. When problems arise, the supervisory authority should tailor its response to the situation and deal with the matter in a timely manner. Strong supervision can be effective in avoiding undesirable consequences that lead to conservatorship and receivership. Box 2.1 details some of the characteristics of problem banks.

When a bank is identified as a problem bank (i.e., one in potential danger of failure), it must be closely monitored on a daily basis. At times individual or aggregate financial indicators, or both, resulting from on-site and off-site activities will raise supervisory concern across a broad segment of the market. Such conditions call for close monitoring of the level of classified and nonperforming loans. Authorities must remain ready to implement corrective action when and as warranted.

Figure 2.1 represents a decision tree for problem bank resolution. The content of this manual follows the flow of the decision tree, especially with regard to the more serious actions of bank intervention, conservatorship, and receivership.

Figure 2.1
Figure 2.1

Decision Tree for Problem Bank Resolution

1 In countries where banking law provides for appointment of conservator.2 In countries where a deposit insurance agency (DIA) exists.

PROBLEM BANK SUPERVISION

Corrective Measures

A bank’s managing board and owners are responsible for the troubled bank’s problems and for correcting them. If the bank fails, it is the fault of these parties for not performing their duties and responsibilities effectively and successfully.

Generally, a central bank’s bank supervision department has various informal and formal measures to deal effectively with problem banks (decision tree Boxes 2 and 3 in Figure 2.1). These tools include the following:

  • Written warnings

  • Monetary penalty assessments

  • Removal of bank personnel1

  • Restricting shareholders’ rights2

  • Other corrective action to remedy unsafe and unsound practices and conditions.

Progressive administrative or enforcement action should comprise a formal policy for dealing with problem banks. Actions should gradually become stronger based on failure to implement corrective measures. In other words, the supervisory authority should progressively build up to severe enforcement actions instead of implementing such actions initially. The best corrective measure strategy is the one that accomplishes the desired objective with the least exposure and risk to the supervisory authority. The best action is the one taken at the lowest level of authority under the law and produces corrective results in a satisfactory period of time.

Because it is in the public interest for banks to operate safely, the supervisory authority should work with the bank to get problems corrected or eliminated. The supervisory authority should also encourage and, when necessary, pressure the bank’s managing board to take the necessary actions and eliminate existing problems. These actions should be documented by appropriate written agreements between the supervisory authority and the bank. The supervisory authority should communicate to the bank and its boards that non-compliance with such an agreement may lead to more severe action.

Additionally, as mentioned earlier, it is important to involve the deposit insurance agency (DIA) early in the problem bank process so that insured deposit repayment can be prepared and the potential impact on the reserve fund analyzed. The DIA should be involved when a bank moves from informal to formal enforcement measures, at the latest.3 See Table 2.2 for examples of enforcement actions.

As mentioned above, enforcement action should be progressive, so that actions taken help build a case for stronger action if needed later. The supervisory authority should help the bank correct its problems by implementing constructive and cooperative measures. If bank officials do not take adequate recommended actions, however, the supervisory authority can progress to stronger action. For example, the supervisory authority and the bank’s management board may agree to certain corrective measures (e.g., change lending policies, increase capital, replace key officers, develop liquidity plan). If the measures are not implemented effectively and the bank continues to deteriorate, however, then stronger action is needed (e.g., a formal order or appointment of a conservator) to effect changes to protect the bank and its depositors.

What Makes a Problem Bank?1

Management Oversight Deficiencies

Although economic conditions are a major influence on a bank’s well-being, management is the dominant factor. Decisions made today can have far-reaching implications on a bank’s future condition, and a strong manager will take steps to avoid or mitigate the severity of possible adverse economic forces. Here are some common management deficiencies:

  • Nonresponsive management

  • Passive or uninformed board of directors

  • Increasing noncompliance with laws or internal standards

  • Insufficient planning and response to risks

  • Inadequate talent and experience at the CEO level.

Significant Off-Balance-Sheet Exposure

With the increase in bank securitization activity and the proliferation of capital market products, more and more credit risk is shifting to off-balance-sheet transactions. Traditionally, off-balance-sheet credit risk has come primarily from loan commitments and letters of credit. The credit risk in these products is straightforward. The credit risk inherent in capital markets products, such as asset securitizations and derivatives, is more difficult to quantify.

Asset Quality Deterioration

Whether caused by economic factors, poor management, anxiety for earnings, insider abuse, or other factors, poor asset quality is a factor in nearly all problem banks. The following signals may indicate asset quality deterioration:

  • Increasing levels of past due and nonperforming loans as a percent of loans, either in aggregate or within loan types

  • Increasing levels of other real estate owned

  • Increasing levels of interest earned not collected as a percent of loans

  • Deterioration in local economic conditions

  • High growth rates in overall loans or individual loan types, particularly subprime or high loan-to-value products

  • Increasing proportion of long-term loans

  • Large volume of policy and underwriting exceptions

  • Large volume of loans with structural weaknesses

  • Excessive credit/collateral documentation deficiencies

  • Inadequate or inaccurate management information systems

  • Inordinately high volume of out-of-area lending

  • Large or increasing volume of unsecured lending

  • Increasing concentrations.

Rapid Growth/Aggressive Growth Strategies

Excessive growth, particularly as measured against local, regional, and national economic indicators, has been viewed as a potential precursor to credit quality problems. Such growth can strain bank underwriting and risk selection standards, as well as the capacity of management, existing internal control structures, and administrative processes. Excessive growth may also reflect fundamental changes in bank practices. Changes in bank practices evidenced by excessive growth include changes in underwriting and pricing standards, revisions to customer/product risk tolerances, increased anxiety for income, introduction of unbalanced compensation programs, and expansion of, or changes to, lending areas or sources of loans. Therefore, aggressive growth will also serve to exacerbate problems at a bank with preexisting risk management deficiencies.

Strained Liquidity

Funding constraints can be precipitated for numerous reasons, including deterioration in a bank’s financial condition, fraud, or external economic events. A bank’s liquidity situation may also become compromised if its reputation “on the street” is suspect due to either real or perceived shortfalls. In any event, the extent of a potential funding problem depends on the risk tolerance of a bank’s fund providers.

This is important because retail and wholesale fund providers have different credit and interest rate sensitivities and will react differently to changes in economic and bank conditions. Retail fund providers—generally insured public depositors—historically have not been credit- or interest rate-sensitive. In contrast, wholesale fund providers—typically other financial institutions, governmental units, large commercial and industrial corporations, or wealthy individuals—are usually placed by professionals and are generally credit-and interest rate-sensitive. The following are examples of potential liquidity strain indicators:

  • Low levels of on-hand liquidity (i.e., money market assets and net unpledged marketable investment securities)

  • Significant increases in large certificates of deposit, brokered deposits, or deposits with above-market interest rates, particularly in banks that have been heavily retail-funded

  • Significant increases in borrowing and warehouse lines (assuming no seasonality)

  • Funding mismatches (i.e., funding long-term assets with short-term liabilities)

  • Higher costs of funds relative to the market

  • Reduction in borrowing lines by correspondent banks

  • Counterparty requests for collateral to secure borrowing lines.

Insider Abuse and Fraud2

Insider abuse and fraud have been contributing factors in many bank failures. Such conduct can quickly affect a bank’s condition and undermine public confidence even in banks that are otherwise in sound condition. Financial institution fraud can occur throughout a bank’s operations and usually is accompanied by a lack of oversight and controls. Some actions that constitute financial fraud include:

  • Dishonest or fraudulent acts (especially regarding lending)

  • Forgery or alteration of documents

  • Misapplication of funds or assets

  • Impropriety in reporting financial transactions

  • Profiting from insider knowledge

  • Disclosing securities transactions to others

  • Accepting gifts from vendors.

Fraud and abuse typically are concealed from routine scrutiny; however, as with other types of problems, there usually are symptoms that can aid in detection. These can include transactions with insiders and their related interests that may indicate preferential treatment, a breach of fiduciary duty, or personal gain.

Risk Management Deficiencies

All risk management systems should identify, measure, monitor, and control risk. Although the structure of risk management systems will vary from bank to bank, areas to consider include:

  • Policies (internal standards, risk tolerance limits)

  • Processes (internal controls, audits, validation tests)

  • Personnel (management, expertise levels, training)

  • Controls (audit, management information systems).

1

This box is summarized from Comptroller of the Currency, Administrator of National Banks, Problem Bank Identification, Rehabilitation and Resolution (Washington, January 2001).

2

The term “insider” refers to a bank’s executive management, board members, and major stockholders (and their families).

TABLE 2.1

Examples of Informal and Formal Supervisory and Enforcement Actions

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Written agreements should include a warning that noncompliance may be met with stronger action. This will provide some leverage to ensure the bank’s cooperation with the written agreement. The agreement proves consistency, legitimacy, and the determination of the supervisory authority to undertake the above-mentioned actions if necessary. The supervisory authority should explain to the managing board and owners that action (e.g., memorandum of understanding, letter of agreement) is being taken owing to their cooperative action and their commitment to correct the problems. The supervisory authority should also explain the various administrative enforcement actions (including conservatorship) provided in the law to the managing board and owners. Bankers also have to understand that harsher measures can be taken if real improvements are not made and the promised corrective actions are not adequately carried out.

If the bank subsequently tries to block stronger actions, the supervisory authority would have the signed written agreement as proof that the supervisory authority cooperated with the bank to resolve the problem. Then the supervisory authority could show that the bank (i.e., owners, managing board, officials) did not effectively comply with items of the agreement, which forced the supervisory authority to use stronger measures to protect the bank’s depositors.4

Two of the most common examples of informal enforcement actions are moral suasion and letters of agreement (LOAs). Moral suasion is nonwritten communication and pressure for a bank to correct some problem. LOAs are informal written corrective measures. Using an LOA, the supervisory authority oversees and provides direction to management, requires certain corrective efforts by a bank’s managing board and officials, and requires periodic reports regarding corrective action achievements.

If informal enforcement measures are unsuccessful in bringing a problem bank to proper status, then formal action is required. When a bank’s problems become severe enough for formal action, it is important to share information with the DIA, and, ideally, involve its officials in discussions and resolution plans.

Actions, whether informal or formal, can be tailored to the needs of the bank. For example, formal action, such as a capital directive or order, requires correction of deficient capital, whereas a management directive or order addresses a deficiency in management practices or actions. The latter order could serve to restrict certain types of lending, issuance of guaranties, liquidity problems, deceptive practices, related party activities, and so on.

If the bank’s managing board does not cooperate or is careless in complying with regulations, then a supervisory authority order to cease and desist may be an appropriate action. This formidable action is designed to assure compliance with corrective measures at the risk of financial or other penalties. It is frequently used when the bank’s officials cannot be trusted and need strong messages.

The articles in a cease and desist order are often similar to those in an LOA. The concept, however, is more forceful (i.e., an order versus an agreement). As with the LOA, the cease and desist order focuses on the changes to be made in order of priority. The order requires the managing board to take certain action to achieve desired objectives or it requires the managing board to take certain action to stop undesired activities. These requirements must be related to an existing problem or anticipated problems, and must be reasonably achievable.

The supervisory authority may also want to consider introducing internal transaction monitoring procedures for problem banks. Such procedures should be used for banks that are troubled but not yet candidates for conservatorship or receivership and could include (but not be limited to) the following:

  • Requirement that cash shipments to the subject bank be dispatched only when there are sufficient funds in the bank’s account or arrangements have been made for a loan from the supervisory authority.

  • Prefunding of the subject bank’s electronic credit transactions.

  • Interception of electronic debit payment and settlement transactions moving through the supervisory authority’s payment network with release subject to approval of a bank supervision official. This interception should not be apparent to the recipient bank/customer.5

  • Maintenance of current branch location information for the institution.

  • Maintenance of current contact information for bank supervision staff, DIA staff, and other key supervisory authority/DIA officials.

  • Notification of supervisory authority branch office management officials as appropriate for effective coordination.

  • Notification of home or host country supervisors as necessary.

  • Daily assessment of public confidence levels.

Prompt Corrective Action

Some countries have embraced prompt corrective action (PCA) in dealing with problem banks. PCA includes provisions for discretionary and mandatory supervisory action by the supervisory authority.

The statutory and regulatory framework of PCA establishes a capital-based supervisory scheme that requires regulators to place increasingly stringent restrictions on banks as regulatory capital levels decline. PCA merely assigns banks to certain capital categories and subjects them to the respective requirements, limitations, and restrictions of those categories. Regardless of a bank’s capital level, the bank is not considered well capitalized under PCA if it is subject to a cease and desist order, a formal agreement, or a capital or PCA directive that requires it to achieve or maintain a higher level of capital.

Table 2.2 shows examples of PCA capital categories as applied in the United States.

TABLE 2.2

U.S. Prompt Corrective Action Capital Categories

(In percent)

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3 percent for 1-rated banks.

Note: RBC = risk-based capital.

PCA usually contains an important provision that authorizes examiners to reclassify a bank’s capital category to the next lower level when based on supervisory criteria. This discretionary aspect of PCA is used when examiners determine that a bank is in an unsafe or unsound condition or is engaging in an unsafe or unsound practice. For example, if the bank is well capitalized, the supervisory authority can reclassify it as adequately capitalized. Likewise, if the bank is in the adequately capitalized category, the supervisory authority can reclassify it as undercapitalized. Once reclassified, the bank may be subject to one or more limitations, requirements, and restrictions applicable to that category under PCA.6

Figure 2.2
Figure 2.2

Bank Intervention Flow Chart

PROBLEM BANK RESOLUTION

When progressive enforcement action in conjunction with private efforts by a bank’s owners and managers has failed to rehabilitate the bank, the supervisory authority can place the bank in conservatorship or receivership. Hoping that a bank will generate enough earnings to recover or that capital will inexplicably grow is not an effective approach to bank resolution. Scenarios involving the liquidation of domestic banks include cases where a bank suffers from poor management or asset quality, or both, and is slowly deteriorating, with no chance of recovery. If there is intrinsic, or franchise, value to the bank, such a case might call for conservatorship.7 In other cases, where a bank has severe financial problems as a result of taking huge risks in order to grow, or is engaging in illegal activities, it is probably best to go directly to receivership to minimize further losses.8 Either action requires bank intervention (decision tree boxes 5 and 7 in Figure 2.1; see also Figure 2.2, which is a bank intervention flow chart).

Intervention

The primary goal of a bank intervention is to control and inventory the assets of a bank, prepare a final balance sheet and, as applicable, compensate insured depositors. The supervisory authority and the DIA must work closely to accomplish these goals. Supervisory authority personnel are responsible for the inventory and control of assets, while the DIA is responsible for making repayment to insured deposi-tors.9 A bank intervention team should be prepared to accomplish functional duties related to security, cash operations, asset control, deposit operations, facilities, information technology, and legal matters. Depending on the size of the bank, some of these functions may be combined. Depending on the number of branches, branch teams must be prepared to perform the same functions at each branch (see Chapter 3 for more details).

Conservatorship

If the supervisory authority believes that there is a chance to rehabilitate the bank (decision tree box 4 in Figure 2.1), then conservatorship (decision tree box 5) may be a good option. When a conservator is appointed, that person should be granted management control over the institution, with powers that replace those of the board of directors and senior management. The conservator should be given a specific time frame (usually 60 days, but could be longer depending on size and complexity) in which to thoroughly analyze the bank’s condition and prepare a feasible rehabilitation plan. During conservatorship, the bank should remain open to maintain confidence in the banking system by allowing depositors access to their funds. The conservatorship should perform limited functions (e.g., there should be no new lending) and focus on cost-saving measures and asset collection. If deposit outflow is overwhelming, causing operations to halt, then the bank should be put into receivership even if the conservatorship period has not run its course (see Chapter 4 for more details).

Final Resolution

To provide prompt repayment to insured depositors, the DIA should work with the supervisory authority’s bank supervision department or the conservator, or both, to market the bank via a purchase and assumption (P&A) agreement (decision tree boxes 3 and 6 in Figure 2.1). A P&A agreement provides for another bank to take certain assets and assume the first bank’s insured deposits, acting as paying agent for the DIA to compensate insured depositors. In some instances, depending on the competitive environment, banks may bid for the right to assume the deposits because it is an inexpensive method to increase market share. In other instances, the DIA or supervisory authority may have to pay a bank a fee to act as paying agent (see Chapter 5 for more details).

Receivership

If it is determined that it is not cost-effective to rehabilitate a bank, then liquidation through receivership should begin (decision tree boxes 7 and 8 in Figure 2.1). The DIA is responsible for insured deposit repayment, whether directly or via a paying agent bank. The receiver should responsibly liquidate the failed bank’s assets with the goal of maximizing recovery to uninsured depositors and creditors of the receivership, using present value concepts in asset sales and collections (see Chapters 6 and 7 for more details).

1

When persons are removed by such an order, they should also be permanently barred from ever working for any other bank.

2

This can include barring shareholders from voting their ownership at a general shareholders’ meeting and can also provide for the forced divestiture of shares by an owner that is a company and not an individual.

3

Some supervisory authorities contend that it is inappropriate to involve a DIA because of the confidential nature of the information involved. DIA employees should be “fit and proper” professionals and be privy to necessary information to fulfill their mandate. If banking laws preclude such involvement, then the banking law should be amended to allow such information sharing.

4

Good banking laws set forth clear appeals procedures for any corrective measure, including any deadlines, and how and where to file. Such appeal procedures allow the supervisory authority greater control of the process, while protecting management and shareholders’ rights. Providing an appeals process can strengthen the supervisory authority’s position if the bank deteriorates further and bank owners try to implement stronger actions later on.

5

At times, rejecting a transaction may cause greater harm or a systemic problem. In such cases, a supervisory authority official must take a decision regarding disposition alternatives. The supervisory authority’s lending powers may be needed; hence, all prerequisites for lending should be in place.

6

Summarized from Comptroller of the Currency, Administrator of National Banks, Problem Bank Identification, Rehabilitation and Resolution (Washington, January 2001).

7

On the other hand, as noted earlier, some jurisdictions envision using the conservatorship period to gain control and plan for an orderly resolution, even if there is no chance of rehabilitation.

8

After any significant action, such as intervening a bank, it is important to monitor deposits throughout the banking system for contagion.

9

In some jurisdictions, where the DIA has a broad mandate that includes bank resolution responsibilities, the DIA will take a greater role in staffing intervention procedures, and the supervisory authority will have a lesser role.