Supervisory Early Intervention

Failure to decisively address problems at weak banks typically leads to greater losses and risk of contagion. Risk taking beyond what an institution can safely handle—such as excessive exposure to liquidity or market risks, or accumulated losses that are not prudently provisioned and actively managed—will contribute to its progressive financial deterioration. Unchecked bad practices in one entity generate moral hazard² and distortions in competition, which can reduce prudence in other institutions and erode confidence in the banking system.

The 2012 revisions to the Basel Core Principles incorporated lessons from the GFC. Changes were made to strengthen supervisory practices and bank risk management, including by increasing supervisory intensity and resources dedicated to supervising systemically important banks; applying a systemwide, macroprudential perspective in supervision; analyzing and taking preemptive action to address systemic risk; increasing the focus on effective recovery measures to reduce the probability of bank failures, and a separate core principle on banks’ corporate governance. On early intervention, a new essential criterion was added requiring the supervisor to have “a clear framework or process for handling banks in times of stress, such that any decisions to require or undertake recovery or resolution actions are made in a timely manner.”

Reducing the probability and costs of financial distress requires early action, before the financial condition of the institution is significantly impaired. In many cases, warning signs can be detected well in advance in the course of normal supervisory oversight, for example, increasing liquidity risks, deteriorating capital quality, deteriorating asset quality, inadequate pricing of risks, or chronic weaknesses in risk management and unsound governance practices. Enhanced monitoring through more frequent and detailed reporting, onsite inspections (full-scope or targeted) and stress tests should be used to identify the root causes of visible symptoms (for example, weak loan underwriting or liquidity risk management practices) and inform further supervisory actions. Staff typically recommend “a ladder of intervention” with clear but flexible triggers for corrective measures that guide the actions of supervisors. The nature and severity of enforcement actions should be proportional to the seriousness of problems, the strength of the bank’s management, and market conditions—both current and prospective. Consistent enforcement of remedial actions is important to build credibility and affect incentives in the financial sector. Supervisory actions should escalate if management and shareholders of a bank fail to comply or cannot restore the bank’s financial standing in the time given to do so. An effective resolution regime gives supervisors a credible alternative to forbearance if a systemic institution fails to take remedial action, strengthening enforcement.

A key lesson drawn from supervisory failures leading up to and during the GFC is the crucial importance of supervisors being willing and able to act. To be effective, supervision needs to be intrusive, adaptive, skeptical, proactive, comprehensive, and conclusive. To achieve this, supervisors need adequate resources, strong legal authority and protection, a clear mandate, operational independence with strong governance structures, and accountability via a transparent framework. The latter prevents supervisors from succumbing to “capture”—either by the banks they oversee or by entrenched political interests. While the Basel Committee on Banking Supervision strengthened the Core Principles in these areas in 2012, weak governance, along with inadequate staffing and budgetary resources—both of which create opportunities for outside influence and pressure—remain the greatest shortcomings in country compliance with the Core Principles (Adrian and Narain 2019; Viñals and Fiechter 2010).

Resolution Regimes

An effective resolution regime is critical to addressing the problems of weak or failing banks without undermining financial stability. Once the supervisor deems a bank to be unviable (for example, being in serious breach of, or judged to have little prospect of restoring compliance with, regulatory requirements), decisive and rapid actions are required to ensure that depositor confidence in the financial system is maintained and problems do not spill over to the broader economy. Financial stability risks are minimized by ensuring that small depositors—the bulk of bank liabilities in many countries— maintain access to their funds. Economic losses are minimized by preserving the bank’s critical functions³ and ensuring that performing assets can be managed as going concerns by acquiring or successor entities. Fulfilling these objectives requires strong powers assigned to an administrative resolution authority. These require solid legal foundations to ensure actions taken by the resolution authority (within its legal powers) cannot be undone by legal challenges. Resolution powers need to be exercisable quickly, without shareholder and creditor consent, ideally before the bank is balance sheet insolvent, which raises property rights issues. Legal safeguards (including mechanisms to ensure that creditors are made no worse off than they would have been in liquidation) are a critical component to balance financial stability objectives with private interests (Davies and Dobler 2011).

The Key Attributes codified international best practices in resolution that are consistent with, but extend beyond past IMF advice. They provide a widely applicable international standard for resolution regimes for financial institutions (Box 1). The principles embodied in the Key Attributes aim to ensure that the authorities have the powers and tools to act quickly to preserve financial stability in the case of systemic failure, while minimizing taxpayers’ exposure to loss. These aspects, as well as powers for early intervention and to appoint an administrative resolution authority with a range of resolution powers and tools set out in legislation, correspond with longstanding IMF advice. The Key Attributes additionally widened the resolution toolkit to include statutory bail-in powers (Chapter 5), established arrangements for recovery and resolution planning as well as international cooperation, and codified creditor safeguards.

Although the Key Attributes were designed for global systemically important financial institutions (G-SIFIs), staff consider most of its elements to be more widely applicable. At times of severe stress and heightened risk of contagion, even relatively small banks can present a systemic risk. A range of resolution powers enable authorities to tailor resolution to the specific challenges presented in any failure. Entering the GFC, many authorities had only the corner options depicted on the straight line in the text figure,⁴ namely liquidation, which in the case of a global systemically important bank (G-SIB) would risk financial instability, or nationalization, which gives full protection to creditors at substantial cost and risk to public resources. By providing more options, resolution regimes with effective powers can improve the trade-off between the financial stability risks associated with imposing losses on creditors, and the fiscal cost and moral hazard associated with bailing them out (shifting from the straight to the concave line in Figure 3).

Resolution Tools and Policy Trade-offs

Citation: Departmental Papers 2020, 003; 10.5089/9781513512273.087.A001

Source: IMF staff analysis.Note: AMV = asset management vehicle; KA = key attributes.

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Resolution Tools and Policy Trade-offs

Citation: Departmental Papers 2020, 003; 10.5089/9781513512273.087.A001

Source: IMF staff analysis.Note: AMV = asset management vehicle; KA = key attributes.

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Resolution Tools and Policy Trade-offs

Citation: Departmental Papers 2020, 003; 10.5089/9781513512273.087.A001

Source: IMF staff analysis.Note: AMV = asset management vehicle; KA = key attributes.

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Resolution regimes that can allocate losses effectively to bank stakeholders, while preserving financial stability, are beneficial for several reasons. First, stakeholders that could be exposed to loss in the event of failure are likely to impose greater discipline on managers, reducing excessive risk taking and, in turn, the likelihood that banks fail. Second, by recognizing the potential for loss and requiring adequate loss-absorbing capacity, these frameworks may reduce the risk of systemic spillovers. Third, by reducing the likelihood of, and direct fiscal cost associated with a crisis, they may weaken the feedback effects between sovereign and bank vulnerabilities (the “sovereign-bank nexus”). Fourth, by levelling the playing field and reducing the “too-important-to-fail” discount from which systemic banks benefit through lower funding costs compared to smaller banks.

Sound governance, independence, and resourcing of the resolution authority is critical. The resolution authority should be independent from both the government⁵ and the financial sector, and have transparent processes, sound governance, and adequate funding. This includes sufficient operating resources and resolution funds (Box 2), independent decision makers and staff with sound appointment/dismissal procedures,⁶ and legal protection. In many cases, staffing of the function is likely to entail a core cadre that undertakes day-to-day resolution responsibilities, which can be supplemented by prearranged additional expertise drawn from the public and private sector (including for asset valuation, legal due diligence, and marketing). In countries where bank failures are likely to be infrequent (for example, those with concentrated banking systems), or there are significant capacity constraints, the central bank or supervisor (if different institutions) may be best placed to assume the responsibility rather than establish a new institution. This would allow the resolution authority to leverage existing in-house capacity and resources and draw upon expertise from other areas (including from the financial stability function) at times of crisis. Adequate firewalls and governance arrangements should mitigate conflicts of interests that can arise when these responsibilities are housed within the same institution. The resolution authority should be subject to ex post evaluation and accountability to assess effectiveness in discharging its responsibilities.

Resolution and liquidation regimes for banks need to be closely aligned to ensure prompt and effective response to a bank’s failure. This can be accomplished effectively in two ways. One is a fully administrative regime whereby both resolution and liquidation of financial institutions are placed under the resolution authority.⁷ The other is a “dual regime” wherein a court-appointed liquidator liquidates an entire bank that has failed (but need not be resolved using resolution powers) or the “rump” of a bank that underwent resolution by the resolution authority. In either case, any role for the court should not hinder the prompt and effective implementation, or result in the reversal of, resolution measures taken by the resolution authority acting within its legal authority (FSB 2016). A “dual regime” also requires some alignment of the triggers and objectives of liquidation, as well as the liquidator’s mandate, for example, to require the liquidator to continue to provide critical services to an acquiring bank or bridge bank. The administrative authorities should play a significant role in a judicial liquidation framework that applies to banks in terms of initiating liquidation, appointing the liquidator, and monitoring the conduct of liquidation and issuing instruction, as necessary, to meet the public policy objectives of resolution.

Depositor Protection

Emergency Liquidity Assistance

ELA is used by central banks to provide liquidity in the event of an idiosyncratic shock affecting one or a few individual financial institutions. ELA has two principal objectives: to mitigate the risk that temporary illiquidity leads to insolvency and to avoid contagion. It may be required when one or a few individual financial institutions are unable to maintain or roll over funding (whether retail or wholesale). Demand for central bank liquidity may stem from a single institution encountering problems (such as deposit outflows triggered by a large loss), or possibly a few institutions with similar business models or geographical focus. The underlying rationale behind liquidity provision in such circumstances is to mitigate the risk of financial instability, recognizing the risk inherent in bank balance sheets arising from maturity transformation—banks borrowing at shorter maturities than at which they lend. As such, it forms a critical component of the financial safety net. Frameworks should be in place for central banks to provide ELA, at their discretion, subject to safeguards aimed at reducing moral hazard and protecting the central bank from losses that could compromise its independence or interfere with its ability to undertake monetary policy.

International practice related to ELA has evolved in light of experience during the GFC (Committee on the Global Financial System 2017; Dobler and others (2016). The GFC triggered extensive liquidity provision, with central banks often having to expand and adapt their policy and collateral frameworks significantly to preserve financial stability. This experience challenged some of the traditional thinking on ELA, while highlighting its critical importance in helping contain financial distress. The prior view, first expounded by Walter Bagehot in the 19th century, was that central banks should lend freely to banks for a brief period, at a high interest rate against good collateral, with the assumption that a bank without such collateral was insolvent, often backed up by formal or informal central bank inspection of financial institutions’ solvency. A key lesson from the crisis (and already some central banks’ practice prior to the GFC) was that in a systemic crisis, ELA frameworks may need to temporarily replace a large part of the liquidity provided by the private financial system—not just banks, but potentially other systemically important funding markets—implying a need to accept wider collateral and counterparties beyond those accepted for monetary operations. Central banks should prepare for this possibility.

Some central banks have updated their policy frameworks for ELA to expand their facilities and, where these are public, provide greater transparency to the financial sector. Key lessons reflected in these changes include the following:

• Eligibility: All banks should be eligible for ELA, not just those predesignated as systemically important. Even smaller banks can prove systemic at times of widespread market stress, and ELA provision may prevent wider contagion. In countries where nonbank financial entities may be systemic, central banks may need discretion to be able to widen ELA eligibility to certain entities (for example, central clearing counterparties) where necessary to preserve financial stability, provided they are adequately regulated and supervised.

• Solvency test: ELA should normally only be provided at the discretion of the central bank to entities deemed by the supervisor (which may or may not be the central bank) solvent and viable. The solvency and viability assessment should be forward-looking, not merely an assessment of the given point in time when the liquidity need arises. It should also consider whether the institution has a credible funding plan to repay ELA. This will often require difficult judgements, and the assessments should be regularly reviewed.

• Collateral: ELA should always be adequately collateralized. An entity requesting ELA may have insufficient high-quality collateral, and central banks should be able and prepared to accept a wide range of unencumbered assets where a security interest can be attached and perfected (and if necessary ownership can be transferred), and the risks managed, by the central bank. Systems to value such assets, including predetermined margins (or “haircuts”) and methods for valuing different asset classes should be in place, as well as processes to settle, manage, and realize collateral in case of counterparty default.

• Duration: Central banks may need to extend ELA at longer maturities than overnight or short-term facilities, especially in cases where there are systemwide problems (for example, at times of entrenched market fragmentation). Rolling over short-term facilities may incentivize banks to reduce lending or liquidate other assets (risking asset price spirals) to manage maturity mismatches, and binding maturity limits in legislation could unduly constrain the authorities’ ability to act. As a safeguard, the counterparty should prepare detailed funding plans on the use and planned repayment of ELA, subject to intensive supervisory oversight, and with incentivizes to repay on or before the planned date. Contingency plans should be in place to address the possibility that ELA provision may be discontinued, and alternative strategies implemented. The termination of ELA may trigger nonviability and bank resolution—central banks should work with supervisors, resolution authorities, and others to prepare for and properly sequence resolution.

• Cost: It is sometimes suggested that ELA should be provided at “above market rates.” However, there is unlikely to be a genuine market rate for an illiquid bank, or if liquidity stress is systemwide. Central banks need to strike a balance between providing incentives for a distressed institution to seek alternative funding, and moral hazard if ELA were available too cheaply. The rate at which ELA is provided (typically expressed as spread over a policy rate) should be sufficient to discourage use (for example, when there are genuine market alternatives), but not so high as to accentuate the strains the ELA is seeking to alleviate.

• Governance and indemnities: Central banks should not assume substantive risks in ELA operations that, if realized, would undermine public confidence in it. If ELA has to be provided for financial stability reasons to firms whose solvency and viability are in doubt, an indemnity should be sought from the government. There should be a clear understanding between the central bank and government on what other circumstances would require ELA to be indemnified (for example, if the central bank has concerns about the duration of the support, exit strategy, quality of the collateral, or the scale of the liquidity needed).

• Disclosure: While the ELA framework should allow for the disclosure of ELA, banks facing temporary liquidity pressures should know that confidentiality will be maintained by the central bank until the stress has passed. The central bank’s transparency policies should allow for the disclosure of ELA to be delayed until financial stability would no longer be endangered, with transparency only ex post. To facilitate this, central banks should only disclose their full balance sheet with a lag (as, for example, with the US Federal Reserve and the Bank of England). If legal requirements would oblige the applicant to disclose, waivers—such as those provided under the Markets Abuse Directive in Europe—should allow for a temporary delay.

Significant challenges remain to complete these updated ex ante frameworks. They include the following:

• Stigma remains a significant challenge, as demonstrated by the unwillingness of banks to approach central bank standing facilities, including the US Federal Reserve’s discount window, during the GFC. It may not always be possible to disguise from market counterparties that a bank has accessed central bank liquidity (for example, if a bank previously known to lack liquidity suddenly has high-quality liquid assets), and this in turn may engender speculation, including in the media, about the quality of the bank’s balance sheet. Various approaches were taken to try to address stigma during the GFC, such as providing liquidity on a systemwide basis (instead of bilaterally via ELA) through widening central bank open market operations and introducing new facilities extending the eligible collateral, counterparties, and the maturity of central bank liquidity provision.¹⁰ Some central banks also used moral suasion to persuade all banks to access central bank liquidity with varying degrees of success.¹¹ These approaches were pursued in conjunction with extensive monetary policy easing and unconventional operations by central banks, and it is unclear whether they would be replicable in countries that do not issue international reserve currencies, and may not have the space to use countercyclical monetary policy and quantitative easing.

• Providing ELA in a foreign currency. The need for central banks to have the legal capacity and funding to provide ELA in a currency different from their own is critical in countries where a large fraction of deposits is denominated in a foreign currency, or where banks rely on foreign (wholesale) funding. Central banks should hold prudent international reserves. However, these may prove insufficient to meet the very large foreign currency cash calls that could arise in extended periods of distress. During the GFC, major advanced economies and some emerging market economies agreed on central bank swap lines to meet large foreign currency needs. Advance agreement could be sought internationally on the conditions for, and the possible use of swap lines for ELA; however, many countries may find them unattainable. Other aspects of the global financial safety net should also be considered, including regional financing arrangements and IMF support. Finally, the authorities should act to limit foreign exchange liquidity mismatches ex ante, for example, by imposing prudential liquidity requirements in each foreign currency.

• Liquidity in resolution. A bank in resolution is likely to need liquidity to ensure continuation of critical functions, for example, when a bridge bank is established. The central bank should be able to provide liquidity, subject to safeguards, to a bank whose current solvency may be in doubt, but which is considered systemic and viable in the context of a realistic time-bound resolution plan. The resolution and/or supervisory authority should first make a positive determination of viability. It should then be up to the central bank to decide on liquidity provision, which may need to be backed by an indemnity from the government. Many central banks are currently unable to provide liquidity in such circumstances, typically because of definitions of solvency and licensing conditions, although progress is being made in some jurisdictions.¹²

Box 3.

Different Forms of Depositor Preference

When depositor preference is established, depositors are given a more senior (or higher) claim than other unsecured creditors of the bank over the liquidation proceeds of a failed bank’s assets. This means that depositors must be paid in full before other unsecured creditors can collect on their claims. Following are three ways of broadly stipulating depositor preference (Box Tables 3.1 and 3.2):

• Insured depositor preference that gives preference to deposits covered by the deposit insurance scheme—those eligible and below the deposit insurance limit—and the scheme through subrogation (in cases where it has paid out insured depositors in a resolution or liquidation). It ranks all other ordinary, senior (non-subordinated) unsecured creditors (for example, bondholders, interbank deposits), including uninsured deposits, equally (or pari passu) thereafter.

• Tiered depositor preference (with two tiers) gives preference to insured deposits (and the scheme through subrogation) over uninsured eligible deposits (deposits eligible for insurance coverage, but above the limit), and prefers both over other senior unsecured, general creditors.

• General depositor preference gives preference to all deposit liabilities, regardless of eligibility and coverage of deposit insurance, over other senior unsecured creditors. The scheme is subrogated for insured deposits and, thus, bears losses to the same degree (pari passu) as all deposits.

Box Table 3.1.

Forms of Depositor Preference

Note: A higher position within each column and darker shading, indicates a more senior claim.

¹Or in the absence of deposit insurance, deposit claims up to a certain limit.

²Or in the absence of deposit insurance, deposit claims exceeding the limit.

Box Table 3.1.

Forms of Depositor Preference

Without	Insured (or ‘Single Tier’1)	Tiered	General
(1) All deposits (with DIS subrogation to insured deposits) rank equally with other senior unsecured claims.	(1) Insured deposits1 (with DIS subrogation). (2) Other general unsecured (including unsecured deposits and bondholders).	(1) Insured deposits1 (with DIS subrogation). (2) Eligible deposits,2 exceeding the deposit insurance limit. (3) Other general unsecured general claims (including non-eligible deposits).	(1) All deposits (with DIS subrogation). (2) Other general unsecured claims.

Note: A higher position within each column and darker shading, indicates a more senior claim.

¹Or in the absence of deposit insurance, deposit claims up to a certain limit.

²Or in the absence of deposit insurance, deposit claims exceeding the limit.

View Table

Box Table 3.1.

Forms of Depositor Preference

Without	Insured (or ‘Single Tier’1)	Tiered	General
(1) All deposits (with DIS subrogation to insured deposits) rank equally with other senior unsecured claims.	(1) Insured deposits1 (with DIS subrogation). (2) Other general unsecured (including unsecured deposits and bondholders).	(1) Insured deposits1 (with DIS subrogation). (2) Eligible deposits,2 exceeding the deposit insurance limit. (3) Other general unsecured general claims (including non-eligible deposits).	(1) All deposits (with DIS subrogation). (2) Other general unsecured claims.

Note: A higher position within each column and darker shading, indicates a more senior claim.

¹Or in the absence of deposit insurance, deposit claims up to a certain limit.

²Or in the absence of deposit insurance, deposit claims exceeding the limit.

Box Table 3.2.

Relative Advantages and Disadvantages

Box Table 3.2.

Relative Advantages and Disadvantages

	Insured	General	Tiered
Enhance depositor confidence and reduce contagion	+	+ + +	+ +
Facilitate a resolution in which all deposits are protected		+ +	+
Reduce the costs of bank failures to the DIS and/or state	+ +		+ +
Protect payment system and economic activity	+	+ + +	+ +
Maximize market discipline for wholesale creditors	+	+ +	+ +

View Table

Box Table 3.2.

Relative Advantages and Disadvantages

	Insured	General	Tiered
Enhance depositor confidence and reduce contagion	+	+ + +	+ +
Facilitate a resolution in which all deposits are protected		+ +	+
Reduce the costs of bank failures to the DIS and/or state	+ +		+ +
Protect payment system and economic activity	+	+ + +	+ +
Maximize market discipline for wholesale creditors	+	+ +	+ +

Institutional Framework

An effective financial safety net requires strong institutional foundations. While there is no one-size-fits-all approach to institutional arrangements, it is important that the supervision, resolution, and ELA functions be operationally separate, and adequate safeguards be put in place to minimize conflicts of interest. These could arise, for example, if one single agency acts as the resolution authority effecting a transfer of parts of a failed bank; as the supervisor of the purchasing bank; and as a creditor following ELA provision. Having multiple authorities with single mandates may be appropriate in some jurisdictions but not in countries with limited capacity, when the frequency of bank failures is likely to be low. In such cases, the risks in assigning the resolution function to a pre-existing authority (such as the supervisor or central bank) can be mitigated by functional separation—assigning day-to-day operations and the preparation of decisions to separate organizational units reporting to different senior executives. Crisis management expertise will need to be developed and maintained, including via the preparation of crisis and resolution manuals, undertaking table-top exercises and simulations, and so on. Financial safety net authorities and their current and former officials, staff, and agents should also be covered by effective legal protection.² This should protect against liability for actions taken and omissions made in good faith while discharging their duties in the exercise of their mandates, including actions in support of decisions by foreign authorities. Operational arrangements should be put in place to make legal protection effective, including to cover legal costs.

Recovery and Resolution Planning

The Key Attributes introduced the concept of recovery and resolution planning. Recovery and resolution plans should be updated regularly—or when there are material changes to a firm’s business or structure—and cover, at a minimum, domestically incorporated financial institutions that could be systemically significant or critical if they fail. The Key Attributes require home and key host authorities to put in place arrangements to cooperate on the preparation of these plans and facilitate the management of a cross-border failure—via crisis management groups for G-SIBs, and other cooperative processes for banks systemic in more than one jurisdiction

• Recovery plans serve to guide the recovery of a distressed financial entity. They are developed and maintained by the entity’s management, reviewed and approved by the firm’s Board of Directors, and assessed by supervisors as part of the supervisory process. They should include measures at pre-identified triggers to reduce the risk profile of a firm and conserve capital, as well as strategic options to bolster capital and liquidity, such as the divestiture of business lines and restructuring of liabilities in periods of stress (prior to resolution). Supervisors should have the power to require the implementation of recovery measures.

• Resolution plans serve to guide the resolution of a failing firm. Usually resolution authorities will develop and regularly update these plans³ and ensure that any impediments to effective resolution are removed. For example, to simplify group structures, ensure adequate LAC, including in the relevant group entities (such as overseas subsidiaries), strengthen servicing agreements and contractual arrangements for critical outsourced functions, etc. For cross-border firms, resolution strategies may follow single point of entry (SPE) and multiple point of entry (MPE) strategies—with SPE focused on resolution at the very top of the financial group by the home resolution authority with operating parts of the group preserved and with MPE focused on separate resolution of operating affiliates in different jurisdictions by the respective resolution authorities.⁴ Resolution plans and ongoing supervision need to ensure that adequate LAC is issued from the right group entities to effect the preferred resolution strategy—for example, a non-operating holding company for an SPE strategy, and material subsidiaries (or “resolution entities”) in an MPE strategy.

• The FSB monitors progress with resolution planning for G-SIBs through the so-called resolvability assessment process (or RAP). Under the RAP, home authorities report annually on progress and material issues with respect to resolvability. High-level findings from the RAP are summarized in the FSB’s annual resolution report. IMF staff do not participate in firm-specific recovery and resolution planning (including crisis management groups).

Operational Capacity in ELA Provision

Many central banks (including in advanced economies) are yet to implement the arrangements needed to accept a wide range of collateral in ELA operations. This requires prior investment in central bank risk management systems and staff to manage the significant operational and financial risks incurred in accepting lower quality collateral. Central banks manage financial risks on the collateral eligible in central bank open market operations and standing facilities through minimum credit quality requirements (for example, rating requirements), haircuts (derived primarily from observable market price volatility), concentration limits, and margin calls. The risks associated with accepting nonstandard, nontraded, illiquid bank assets with idiosyncratic characteristics (for which observable credit quality information and/or market prices are lacking) are considerably higher. The due diligence required to assess the underlying credit quality of individual loans will be challenging. There are no easy solutions but prepositioning⁵ of eligible loan pools and pre-specifying eligible debtors (corporates, private households) and minimum prudent haircuts for loans of different credit quality (for example, applying a higher haircut for nonprime retail mortgages with higher loan-to-value ratios) can significantly reduce risks and help accelerate the process of providing ELA. In countries with well-developed markets for bank securitizations, utilizing existing market expertise, conventions, and standardized contracts (including for underlying loans and their securitization) can greatly facilitate central bank risk management. In countries without such markets, and little standardization of credit contracts, risks can only be managed by applying larger haircuts to protect the central bank from greater uncertainty. Prepositioning of collateral should be undertaken for systemic entities under recovery and resolution planning. Ensuring that the central bank can make legally enforceable its security claim on nonstandard collateral, so that no other party (for example, another creditor or a bankruptcy trustee) can claim the same collateral, may also present legal challenges. Other legal obstacles that may exist in some jurisdictions—such as requirements to inform, or even receive consent from, the debtor upon the transfer of the credit claims—may limit the use of credit claims as ELA collateral and require ex ante changes to national legislation.

Domestic and Cross-Border Cooperation

Information exchange and cooperation are key to successful crisis management. Managing a failing domestic systemically important bank (D-SIB) or a systemwide crisis requires cooperation among the financial safety net authorities, including foreign agencies, if the failing firm has a material cross-border presence. This, in turn, requires legal and operational capacity to cooperate and exchange information across the relevant agencies, subject to confidentiality safeguards.

At the domestic level, formal coordination arrangements are increasingly replacing the informal or ad hoc mechanisms that were prevalent in previous financial crises. A crisis preparedness function should formally be assigned to an inter-agency committee (such as a “crisis management” or “financial stability” committee). All financial safety net authorities should be included—the financial supervisory authorities, the central bank, the resolution authority, the deposit insurance agency, and the Ministry of Finance (as applicable in different jurisdictions). It should function as a forum where the authorities work together on crisis preparedness and management, while each agency retains its own responsibility and autonomy for the exercise of relevant powers within its mandate. Such committees should have clearly specified roles, responsibilities, and operating procedures (for example, modalities for information exchange) and meet periodically in normal times to actively oversee the preparation and maintenance of national and agency-specific crisis plans. IADI Core Principle 6 prescribes that the deposit insurance agency—irrespective of its mandate—should be a member of the national crisis-management cooperative framework. Where the financial stability committee has a dual mandate for both macroprudential policies and crisis management, two standing working groups can be established with the deposit insurance authority participating in the latter.

The Key Attributes have been instrumental in enhancing expectations for cross-border cooperation on resolution. As stress builds, incentives to cooperate may diminish and relationships become strained, given potentially competing objectives in different jurisdictions (for example, whether to protect or not protect the creditors in subsidiaries or branches abroad using national funds). The Key Attributes recognize that a lack of communication could precipitate or worsen a cross-border crisis and that cooperation requires mechanisms to give effect in one jurisdiction to resolution measures taken in another. Accordingly, they call for national resolution regimes to (1) empower and strongly encourage the resolution authorities, wherever possible, to act to achieve a cooperative solution with foreign resolution authorities; (2) empower the resolution authorities to share information with their foreign counterparts, provided that arrangements are in place for the protection of confidential information; and (3) provide for transparent and expedited processes to give domestic effect to foreign resolution measures.

Regular intra- and inter-agency financial crisis simulation exercises, which should include foreign agencies, where relevant, are advisable to test and enhance operational preparedness. Authorities should conduct regular crisis simulations and table-top exercises, with participation by senior policymakers:

• Contingency planning: In addition to their operational readiness for “business as usual”—such as the failure of a non-systemic bank—authorities need to be ready for unexpected events and systemic shocks. Plans should identify the human resources, legal bases, lines of communication with other domestic and foreign agencies, and action plans for managing, for example, the failure of an SIFI or a systemwide crisis. Plans should include all systemic financial subsectors (banking, insurance, securities, etc.).

• Crisis simulations: Simulations test capacity to respond to a severe shock and should be undertaken periodically to identify gaps in preparedness. Simulations aim to test the roles and actions of all relevant authorities in a systemwide crisis scenario. They may be modeled on a previous or a hypothetical shock and apply stress test models to determine the impact on specific sectors and individual institutions. The simulation could overlay contemporaneous developments—for example, a deposit run—and be used to check the authorities’ capacities for information sharing, cooperation, and decision-making. Simulations can be undertaken on a national or a cross-border basis. The Nordic-Baltic Financial Crisis Simulation exercise in 2019, for example, entailed the participation of 31 authorities across 8 countries (Danmarks National Bank 2019).

• Table-top exercises: These typically focus on the failure of one or more systemic banks, for example, a large, cross-border bank. They test policymakers’ ability to develop an agreed diagnosis and set of policy responses to the emerging problems. Table-top exercises lend themselves to testing recovery and resolution plans for individual institutions and arrangements for cross-border cooperation.⁶

Domestic and international cooperation is also important in the context of ELA provision. Although central banks should retain discretion over ELA, clear communication is essential with other authorities, both domestic and potentially foreign; for instance, with central banks in host jurisdictions that may be considering ELA provision (or not) to the same financial group.

Crisis Communications

Crisis communication planning and templates should be prepared in advance during “normal” times. Successful crisis management depends critically on the authorities’ ability to convey consistent messages on the circumstances (the facts and figures) and the policy responses to special events. A clear lesson from past and more recent crises: when official communications are lacking, unclear or inconsistent, or only identify problems without announcing credible solutions, they will likely exacerbate contagion.

Although each crisis will have varying origins and unfold differently, a few key principles apply in communicating with the public in a systemic banking crisis:

• Do not communicate problems without solutions: An effective communication strategy must be part of a comprehensive policy package, which credibly addresses the root causes and not just the symptoms of the crisis and is not an attempt to gain time or deliver platitudes. Describe what the issue is, who it affects, and what is being done about it.

• Deliver bad news in clear, definitive, but not alarmist terms: If creditors will bear losses, explain clearly which (and, most importantly, which not) and why in plain language, easily understood by the public, without a high likelihood of subsequent revision (barring clearly unexpected new shocks).

• Do not overpromise: Address the identified problems without saying or implying that there will be no more bad news. For example, saying that no more banks will fail while conditions remain turbulent may lead to a subsequent loss of credibility.

• Speak with one voice: The authorities need to communicate clearly and consistently, without contradictions or inconsistent messages. A comprehensive package of policies and consistent communication through one (or a select few) spokesperson(s) requires effective coordination as well as flexibility and capacity to respond quickly to emerging developments.

It is important to prepare in advance: While decisions will have to be made “in the moment” in any crisis, many draft decisions and materials can be prepared in advance. This would include identifying target groups for communication, such as the public, depositors, market participants, and the financial press; identifying communication channels, such as conventional media and social media; preparing draft templates for internal and external communications, such as press releases and responses to followup questions, and to preempt or neutralize false or exaggerated stories or rumors. Ongoing education and communication during “normal” times about the financial safety net will deliver a better-informed public and media, better able to interpret communications by the authorities in crisis.

Systemic Liquidity Provision

Systemwide provision of central bank liquidity to alleviate the adverse effects of market-wide shocks was a defining feature of the GFC response. This wider support—to all financial institutions of a certain type or to specific financial markets, as distinct from idiosyncratic provision of ELA targeted to individual institutions (Table 4)—was provided through central bank liquidity facilities being opened to a wider set of market participants. This provision also had a monetary policy objective as well, which was a new feature of the GFC compared to previous crises. Specifically:

• Support to financial institutions. In the case of a market-wide shock, where there may be uncertainty as to whether banks demanding support have liquidity or solvency problems, the central bank may need to provide liquidity systemwide to restore the monetary policy transmission mechanism and ensure markets can continue to function. This can be implemented through a change in the terms on which open market operations are provided (such as lengthening the tenure and expanding the collateral accepted) and facilitating the onward lending of liquidity. Proper due diligence of collateral and valuation, with appropriate haircuts, should be applied to minimize risks, protect the central bank balance sheet, and minimize moral hazard. The effectiveness of these measures hinges critically on those institutions with access to central bank liquidity being willing and able to on-lend the liquidity to institutions in need, which may not be the case at times of severe stress. In such cases, new facilities may be required to directly address the fragmentation issues.¹

• Support to financial markets. In financial systems where market-based financing is important, market-wide shocks may result in the freezing of key financial markets, increasing systemic risk (see King and others 2017). A fire sale of bank assets can precipitate solvency problems and reduce the market value of central bank collateral. The GFC showed that central banks may have to respond to freezes in individual market segments, such as the US asset-backed commercial paper market in 2008. Central banks would need to identify the particular markets that are important to financial stability, together with the relevant indicators that point to a breakdown in the functioning of those markets. Programs to restore market functioning should aim to incentivize participants to re-enter the market, while considering the costs and risks to the central bank and concerns about moral hazard.

Table 4.

Central Bank Liquidity Provision Post–Global Financial Crisis

Table 4.

Central Bank Liquidity Provision Post–Global Financial Crisis

	Idiosyncratic Provision—ELA	Systemic Provision
Domestic and Foreign Currency	To a bank or a few banks: (potentially also systemically important nonbank financial institutions)	To the banking system: Systemwide actions targeted at addressing market failures, with broad participation by banks
		To markets: Systemwide actions targeted at addressing market failures

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Table 4.

Central Bank Liquidity Provision Post–Global Financial Crisis

	Idiosyncratic Provision—ELA	Systemic Provision
Domestic and Foreign Currency	To a bank or a few banks: (potentially also systemically important nonbank financial institutions)	To the banking system: Systemwide actions targeted at addressing market failures, with broad participation by banks
		To markets: Systemwide actions targeted at addressing market failures

Liquidity provision in a systemic crisis entails heightened risks. Although the approaches proved effective in the GFC and should be considered as part of contingency planning, their advisability in practice depends more generally on market structure and on central banks’ ability to contain potentially adverse macro implications of a large expansion of liquidity, including the impact on the exchange rate in an open economy.

Government Guarantees

Asset Guarantees

Asset guarantees were widely deployed during the GFC.⁵ Government guarantees on pools of assets (for example, asset-backed securities) that remained on banks’ balance sheets provided a floor on the losses the bank could suffer, reducing uncertainty about the bank’s solvency by removing downside risks and helping stabilize market funding. Banks retained ownership of the asset, leaving the upside (if recovery values exceed the expected value) with the bank. Guarantees were usually provided for a fee and were partial—a first loss tranche (at least) was borne by the recipient. Asset guarantees provide relief only during the term of the guarantee, but, if called, they permanently remove downside risk from the bank’s balance sheet. As such, guarantees that are called have economically similar effects to government asset purchases, such as through centralized asset management companies (Chapter 6 and Table 5).

Table 5.

Comparing Asset Guarantees and Asset Management Companies

Note: AMC = asset management company.

Table 5.

Comparing Asset Guarantees and Asset Management Companies

	Advantages	Disadvantages
Asset guarante	Can be deployed quickly, for example, in response to “sudden stops” in market funding Quick/easy to exit Contingent liability, no immediate impact on government debt	Temporary only, does not permanently clean up bank balance sheet (if guarantee not called) Upside retained by shareholders/creditors of the distressed bank
Public AMC	Permanent removal of risk from balance sheet Upside value secured by the AMC/government Potential efficiencies in loan workout, for example, if pooling homogenous NPLs from different banks Improves bank liquidity if payment for transferred assets is in cash or government bonds eligible for central bank funding	Upfront cost and time required to establish and operationalize AMC Immediate impact on government debt (unless structured to avoid consolidation) Time to exit—winding up an AMC may take many years (depending on the assets)

Note: AMC = asset management company.

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Table 5.

Comparing Asset Guarantees and Asset Management Companies

	Advantages	Disadvantages
Asset guarante	Can be deployed quickly, for example, in response to “sudden stops” in market funding Quick/easy to exit Contingent liability, no immediate impact on government debt	Temporary only, does not permanently clean up bank balance sheet (if guarantee not called) Upside retained by shareholders/creditors of the distressed bank
Public AMC	Permanent removal of risk from balance sheet Upside value secured by the AMC/government Potential efficiencies in loan workout, for example, if pooling homogenous NPLs from different banks Improves bank liquidity if payment for transferred assets is in cash or government bonds eligible for central bank funding	Upfront cost and time required to establish and operationalize AMC Immediate impact on government debt (unless structured to avoid consolidation) Time to exit—winding up an AMC may take many years (depending on the assets)

Note: AMC = asset management company.

Administrative Measures

Capital controls may be needed in some circumstances, and authorities may have to impose deposit restrictions as a last resort to stop runs. In a bank run, depositors concerned over losing access to their funds swap longer duration assets for more liquid ones. They may convert deposits into physical cash or other nonbank assets, move funds away from banks perceived as weak, and convert local currency holdings into other currencies or move funds abroad, putting pressure on banks’ liquidity positions, the currency, and the balance of payments. As part of a broad policy package to support the necessary macroeconomic adjustments and financial stability, or to gain time for these policies and measures to bring results, authorities may have to resort to administrative measures in certain circumstances such as restrictions on deposit withdrawals and controls on capital outflows. Four countries used such measures during the GFC (Box 4).

Deposit restrictions should contain destabilizing outflows while aiming to minimize negative economic impacts. Although they may be needed to protect the banking system at times of severe stress, deposit restrictions interfere with payments and economic activity, and cause significant disruption, loss of depositor/investor confidence, and economic damage. They should be used only when absolutely necessary. To the extent possible, depositors should remain able to use cash and bank deposits for day-to-day transactions, with restrictions preventing the transfer of financial savings outside of the banking system or the country. Restrictions should be designed to allow households and firms to withdraw cash up to a certain amount over a certain period, calibrated to the type of depositors (for example, individuals versus firms) and currency, based on available liquidity in the banking system. The widespread use of electronic payment methods in countries that introduced cash withdrawal restrictions during the GFC facilitated domestic transactions, while maintaining funds within the domestic banking system. It also had the added benefit that the traceability of such transactions contributed to improved tax collection. For example, the deposit withdrawal restrictions adopted by Greece in 2015 contributed to significant increase in the use of debit and credit cards. This technological advance helped significantly compared, for example, to freezing all bank deposits and securitizing them to create a means of payment (as used in Ecuador in 1999 and Argentina in 2002). However, in cases where a subset of banks is perceived as weak, depositors may have the incentive to move funds to safer banks aggravating liquidity stress in parts of the financial system. In such cases, restrictions on transfers within the domestic banking system on domestic transactions may also be needed, for example, by subjecting higher transfers to an approval process, requiring adequate documentation of the purpose of the transaction (for example, Cyprus in 2013).

Restrictions on external transfers may be needed to protect the liquidity of the banking system and contain balance-of-payment pressures in certain circumstances. Similar to restrictions on domestic transfers, limitations on cross-border flows can be designed with a combination of thresholds (below which transactions may be performed without limitations), as well as conditions for approval (or verification) of larger transactions. In designing exchange controls on current and capital account transactions, the authorities should ensure compliance with the country’s obligations under Article VIII of the IMF’s Articles of Agreement and the Institutional View on the Liberalization and Management of Capital Flows (IMF 2012).⁶ Capital flow management measures (restrictions on transactions on the financial account) on outflows can be introduced consistently with the Institutional View in crisis or near-crisis circumstances as part of a broad policy package to address the fundamental causes of the crisis. They should be rescinded once the crisis is over.

Deposit withdrawal restrictions and capital flow management measures are distortive and typically entail significant operational resources to enforce. To be effective, the compliance framework may require significant human resources, both for the authorities and banks, with staff having to be trained at short notice. Ineffective processes can lead to delays for legitimate transactions, further encouraging liquidity outflows from the financial system through loopholes, reducing the effectiveness of the measures, and exacerbating economic damage. Residents and nonresidents will “test” the limits imposed, which may result in a temporary surge of certain types of transactions (for example, depositors withdrawing cash up to the daily limit). The financial system (if necessary, with the authorities’ support) should be prepared to cope with such spikes as a shortage of physical cash at branches and automated teller machines, which otherwise would further undermine confidence.

Administrative restrictions should be removed as soon as conditions allow. Decisions on when to gradually ease administrative measures should be driven by conditions—based on a thorough assessment of the variables that the measures were designed to ameliorate their macrofinancial impact. For example, if bank deposits start to increase and reliance on central bank funding declines, this may suggest that deposit withdrawal restrictions can be eased, while capital flow measures can be lifted if exchange rate pressures ease and bonds can be issued successfully in international capital markets. Their removal should be gradual, with steps sequenced in tandem with economic recovery and the strengthening of the financial system. Country circumstances and priorities should be respected, for example, if attracting foreign direct investment is a priority, liberalization of the repatriation of dividends to nonresident shareholders should precede lowering surrender requirements for exporters.

Box 4.

Administrative Measures in Cyprus, Greece, and Iceland

Cyprus, Greece, and Iceland adopted administrative measures to arrest financial distress during and after the GFC. In Iceland, loss of market access and limited lender of last resort capacity in foreign currency caused three systemic cross-border banks to default on their foreign liabilities in 2008 and to be split into two entities—one holding domestic assets and claims, and the other (mainly) foreign assets and claims; currency depreciation caused widespread financial distress in the private sector. In Cyprus, depositors suffered losses in two systemic banks in 2013, raising the risk of a systemwide run. In Greece, a collapse in confidence and doubts over continuing access to euro funding by distressed banks prompted significant deposit outflows until deposit controls were adopted in mid-2015. Despite underlying differences, the restrictions had important similarities:

• Bank holiday. Multi-day bank holidays were declared in Cyprus and Greece (not Iceland), while the authorities decided on broader stabilization measures. Although bank branches were closed for several days, the availability of cash machines (subject to withdrawal limits), enabled individuals to access funds to cover everyday transactions, allowing the continuation of basic economic activities.

• Types of restrictions. In Cyprus and Greece, limits on domestic cash withdrawals and in Cyprus on domestic transfers mitigated the risk of deposits migrating within the banking system. Cross-border transactions (and in Cyprus domestic transfers) exceeding defined amounts per day or week had to be scrutinized by bank officials. For amounts above the limit an approval committee was established, to which transaction documentation had to be submitted. In Iceland where the deposits of the new domestic banks were guaranteed, cash withdrawals and transfers in domestic currency within the domestic banking system were not restricted but controls on capital outflows were maintained for several years.

• Calibration. The limits chosen were calibrated for everyday transactional needs and took account of the funding capacity of banks based on available data (and pressures on the balance of payments in the case of Iceland), including on precrisis payment flows. The initial limits which were subsequently raised or lifted as conditions improved, are summarized in Box Table 4.1.

Box Table 4.1.

Calibration of Selected Administrative Measures

Box Table 4.1.

Calibration of Selected Administrative Measures

Greece	€420 limit on cash withdrawals per week (any currency); no cash drawn via checks or credit cards Domestic credit card payments on goods and services unlimited €2,000 foreign cash limit per individual per foreign trip
Cyprus	€300 limit on cash withdrawals (including withdrawals via bank tellers and debit, credit or prepaid cards) per day in each credit institution; cash could not be drawn on checks Domestic card payments on goods and services limited initially but lifted two days later Domestic transfers between accounts in different banks limited to €5,000 per day, per bank account (higher with committee approval) Payments abroad by card limited to €5,000 per month per person Foreign transfers limited to €5,000 per day (higher with committee approval) €1,000 foreign cash limit per individual per foreign trip
Iceland	No limits on domestic currency withdrawals and domestic payments/transfers ISK 500,000 foreign cash limit per individual per foreign trip Credit card companies/banks introduced their own limits on payments abroad

View Table

Box Table 4.1.

Calibration of Selected Administrative Measures

Greece	€420 limit on cash withdrawals per week (any currency); no cash drawn via checks or credit cards Domestic credit card payments on goods and services unlimited €2,000 foreign cash limit per individual per foreign trip
Cyprus	€300 limit on cash withdrawals (including withdrawals via bank tellers and debit, credit or prepaid cards) per day in each credit institution; cash could not be drawn on checks Domestic card payments on goods and services limited initially but lifted two days later Domestic transfers between accounts in different banks limited to €5,000 per day, per bank account (higher with committee approval) Payments abroad by card limited to €5,000 per month per person Foreign transfers limited to €5,000 per day (higher with committee approval) €1,000 foreign cash limit per individual per foreign trip
Iceland	No limits on domestic currency withdrawals and domestic payments/transfers ISK 500,000 foreign cash limit per individual per foreign trip Credit card companies/banks introduced their own limits on payments abroad

It took some months for the framework to work effectively and some restrictions remained in place for years. Capacity to monitor compliance and process a large number of approval requests had to be developed quickly—staff had to be trained and the documentation requirements developed. After the implementation phase, the processing of approvals took one to three days. Transaction limits were thereafter gradually increased, after which certain types of deposit access were liberalized. The liberalization of cross-border transactions marked the last step, which happened three years after the imposition of restrictions in Cyprus and eight years in Iceland. The final cross-border restrictions in Greece were lifted in September 2019.

Bank Diagnostics

A comprehensive diagnostic is needed to enable effective bank restructuring and resolution in a crisis. Weaknesses in accounting and prudential rules and their enforcement are common when banking problems are widespread. In the emerging phase of a systemwide crisis, bank managers may face strong incentives to hide problems, delaying loss recognition and loan loss provisions that would adversely affect profitability and capital. These problems tend to be exacerbated by weaknesses in governance, external audit, and banking supervision. Analyzing resolution and restructuring options requires up-to-date financial statements that give an accurate point-in-time representation of a bank’s condition. Bank diagnostics typically address two fundamental needs—identifying the size and distribution of losses and identifying the viability of individual institutions.

Systemwide Restructuring and Resolution

Once the systemwide diagnostics are complete, a clear and comprehensive restructuring strategy is necessary to restore the banking system to soundness. A plan for managing the results of the diagnostic exercise is needed well in advance of the results, to allow for any legislative reforms and preparations required. The plan needs to cover a triage of viable and non-viable banks with the actions to strengthen the former through restructuring and recapitalization, and to intervene and resolve the latter (Figure 4 shows a stylized decision tree). While a common response, supervisory forbearance and delaying resolution is typically² the least advisable route, as it will usually result in higher resolution costs.³ The strategy should outline actions, timelines, responsibilities, and options for each entity examined. Communication with the banks and the broader public is key to maintaining public and investor confidence, emphasizing the objectives of the process, how deposits and financial stability will be protected, and clarifying expectations for other creditors and shareholders. The design and implementation of the strategy should involve all the members of the financial safety net.

Systemic Bank Restructuring: Decision Tree

Citation: Departmental Papers 2020, 003; 10.5089/9781513512273.087.A001

Source: IMF staff analysis.Note: LAC = loss-absorbing capacity; P&A = purchase and assumption.

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Systemic Bank Restructuring: Decision Tree

Citation: Departmental Papers 2020, 003; 10.5089/9781513512273.087.A001

Source: IMF staff analysis.Note: LAC = loss-absorbing capacity; P&A = purchase and assumption.

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Systemic Bank Restructuring: Decision Tree

Citation: Departmental Papers 2020, 003; 10.5089/9781513512273.087.A001

Source: IMF staff analysis.Note: LAC = loss-absorbing capacity; P&A = purchase and assumption.

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Banks with viable business models and recapitalization plans should be subject to intensive supervision before returning them to regular supervisory oversight. A systemic banking crisis tends to have long-lasting effects on the macroeconomic and business environment, and there will be a need for close attention to banks’ implementation of their recapitalization plans. The business plans submitted by the bank should be used as a monitoring tool to ensure that any weaknesses uncovered by the diagnostic review process are adequately and quickly addressed. When supervisory and/or resolution authorities conclude that the problems revealed by the diagnostics cannot realistically be addressed by the shareholders, the bank should be resolved.

Assessing Resolution Options

Resolution tools had been developed and used well before the GFC, but adoption across countries was uneven, and there was no credible or widely agreed approach to resolve “too big to fail” banks. The result was periods of benign neglect if a systemic institution were close to failure, followed by public solvency support to preserve financial stability. These experiences highlighted the importance of adequate resolution tools and loss absorbency to support effective resolution of systemic banks while minimizing taxpayers’ exposure to loss—as described in earlier sections. This new toolkit remains largely untested, but it offers an alternative to the unlimited use of public money in the event of failing systemic banks.

The tools in an effective resolution regime aim to allocate the losses of the failed bank to its shareholders and creditors. They seek to do so in a manner that ensures continuity of systemically important financial services and payment, clearing, and settlement functions, as well as avoiding unnecessary destruction of value. Having an array of resolution tools, with different properties, enables resolution authorities to tailor resolutions to the specific characteristics of any case. Figure 5 presents stylistic examples of the balance sheet effects of using different resolution tools. The examples assume that all financial entities considered have adequate LAC (that is, liabilities that can absorb losses without propagating contagion and financial instability), or that the authorities have adequate resolution funding. For example, if there were insufficient loss-absorbing liabilities to allow for a bail-in (without risking systemic disruption), there would also be inadequate liabilities left behind in liquidation incurring losses as needed to implement a partial transfer or a bridge bank.

Stylized Balance Sheet Impact of Different Resolution Powers

Citation: Departmental Papers 2020, 003; 10.5089/9781513512273.087.A001

Further details on referenced cases Banco Popular: https://srb.europa.eu/en/content/banco-popularIndyMac: https://www.fdic.gov/news/news/press/2008/pr08056.htmlNama: https://www.nama.ie/uploads/documents/NAMA-Annual-Report-and-Financial-Statments-2018-English.pdfSareb: https://www.sareb.es/file_source/web/contentinstances/documents/files/sareb.-activity-report-1h2018.pdfWashington Mutual: https://www.fdic.gov/news/news/press/2008/pr08085.html

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Stylized Balance Sheet Impact of Different Resolution Powers

Citation: Departmental Papers 2020, 003; 10.5089/9781513512273.087.A001

Further details on referenced cases Banco Popular: https://srb.europa.eu/en/content/banco-popularIndyMac: https://www.fdic.gov/news/news/press/2008/pr08056.htmlNama: https://www.nama.ie/uploads/documents/NAMA-Annual-Report-and-Financial-Statments-2018-English.pdfSareb: https://www.sareb.es/file_source/web/contentinstances/documents/files/sareb.-activity-report-1h2018.pdfWashington Mutual: https://www.fdic.gov/news/news/press/2008/pr08085.html

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Stylized Balance Sheet Impact of Different Resolution Powers

Citation: Departmental Papers 2020, 003; 10.5089/9781513512273.087.A001

Further details on referenced cases Banco Popular: https://srb.europa.eu/en/content/banco-popularIndyMac: https://www.fdic.gov/news/news/press/2008/pr08056.htmlNama: https://www.nama.ie/uploads/documents/NAMA-Annual-Report-and-Financial-Statments-2018-English.pdfSareb: https://www.sareb.es/file_source/web/contentinstances/documents/files/sareb.-activity-report-1h2018.pdfWashington Mutual: https://www.fdic.gov/news/news/press/2008/pr08085.html

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Partial asset and liability transfer

Transferring deposits to a healthy bank instead of paying out the depositors of the bank in liquidation has clear advantages. Transfer of (insured) depositors to a healthy bank with the deposit insurance fund covering any gap in the assets transferred (on a least cost basis) delivers significant benefits compared to placing the whole bank into liquidation and paying out deposit insurance. Depositors retain continuing access to their deposit accounts at the acquiring bank, minimizing disruptions. Experience from the US, where this type of resolution tool is known as a “purchase and assumption” (P&A), suggests that it can secure higher “going-concern” values for the assets of a failed bank than liquidation; and often a small premium from the purchaser for the deposit book (as banks incur costs to attract deposits). For this reason, all resolution regimes, even in relatively simple deposit funded banking systems, should have transfer powers. Deposit insurance schemes should be able to support such a resolution on a least cost basis (Chapter 2). Implementing a P&A in a short period may not always be possible; however, for instance, if the failing bank is large and complex; if the authorities are unprepared; or if no purchaser can be found (for example, in concentrated banking systems).

Bridge bank

Bridge banks allow more time to market a partial transfer (P&A). Using this tool, a resolution authority can move performing assets and some portion of liabilities (at a minimum insured deposits) from the failed bank into a temporarily government-owned “bridge bank” and liquidate the remainder of the failed bank (see Box 7). The bridge bank can be marketed to prospective private owners, and then sold to a third-party as soon as feasible—although country circumstances and the speed of economic recovery will affect investor appetite and a quick sale may be unrealistic in the midst of a systemic crisis. As a new legal entity, a bridge bank can be designed such that it does not carry contingent liabilities from the failed bank (for example, off-balance sheet obligations or litigation against the failed bank). Owing to the nature of the bridge entity, some jurisdictions do not require bridge banks to be capitalized; however, it is preferable to establish a clear ownership and governance structure from the outset. While the Key Attributes require powers to transfer assets and liabilities back from a bridge bank to the original legal entity in liquidation, these powers should be used only in strictly limited circumstances and within a short period. If financial creditors transferred to a bridge bank are subsequently transferred back into liquidation on a significant scale, this could risk undermining the bridge bank as an effective resolution tool by incentivizing creditors of the current or future bridge banks to run. This puts a high importance on getting the valuation right and not underestimating the size of the capital needs before establishing the bridge bank.

Bail-in

Bail-in powers have received considerable attention since the GFC, but practical experience to date is limited. Resolving a bank via statutory⁴ bail-in involves writing down and converting loss-absorbing liabilities of a bank in resolution into equity. The statutory bail-in powers were conceived during the GFC as a way of imposing losses on creditors, without having to liquidate the original legal entity and transfer assets and liabilities associated with its critical services to a third party. This was thought to entail fewer execution risks when resolving large and complex cross-border banks, as the legal powers would apply to fewer contracts governed by foreign law (those of the bailed-in liabilities only) than with a transfer of most assets and liabilities to a bridge bank. Since the issued securities will likely be governed by the laws of relatively few jurisdictions (for example, those of major financial centers), it may be more straightforward to achieve cross-border effect through bail-in than through transfer powers. The latter would require achieving legal effect in all of the countries with jurisdiction over the tangible and intangible property of a failing cross-border group. The entity would also retain its existing contractual arrangements with group entities and licenses and regulatory permissions, facilitating continued access to payments and settlements infrastructure (Zhou and others 2012). However, implementing bail-in has many complexities; for example, in the interaction with securities regulations on suspending, canceling, or listing shares, as well as the need to ensure compliance with fit-and-proper criteria for new owners (FSB 2018b). Countries with relatively simpler banking systems (for example, deposit funded without significant cross-border linkages) may not need a bail-in tool, as other resolution tools may achieve the same loss absorption by shareholders and creditors through simpler legal mechanisms.

Imposing losses on creditors in a systemic crisis requires that banks have adequate loss-absorbing capacity. The case of Cyprus in 2013 highlights the disruptive effects on public confidence of seeking to impose losses on depositors in the absence of adequate LAC. Reforms post-GFC have sought to enhance the total loss-absorbing capacity (TLAC)—unsecured liabilities including common equity, subordinated debt and some senior debt (excluding deposits and structured debt) with a maturity of at least one year—of G-SIBs, adding clarity on the types of claims that qualify for loss absorption, and the amounts and location within a financial group’s structure of such claims (FSB 2015). Some jurisdictions have also required D-SIBs to maintain a buffer of LAC to facilitate their resolution. It is crucial that unsecured and uninsured bank creditors understand the risks they are incurring by investing in banks and can absorb losses. In this regard, G-SIBs have been issuing TLAC-compliant debt (which excludes short-term debt claims) to mitigate potential liquidity risks and spillovers. To facilitate effective bail-in, retail investors’ exposure to bail-in-able financial instruments should be subject to strong investor protection, such as through sufficiently high minimum lot sizes (that is, the minimum value of instruments an investor can buy) to exclude retail investors, and stringent and adequately enforced requirements of suitability in marketing and selling the securities.

Recapitalizing Banks using Public Funds

Although ensuring banks have adequate capital is the responsibility of shareholders, a residual risk remains that temporary support from the government may be needed to preserve financial stability. In a large-scale financial crisis, government funds may be needed to recapitalize entities that prove systemic. At times of acute contagion risks when markets are dislocated or frozen, it will be difficult for the private sector collectively to generate new private capital for banks. If placing financial institutions into resolution would exacerbate the risk of contagion and further undermine confidence, public funds may need to be temporarily deployed (Dell’Ariccia and others 2018a). This would be the case, for example, if the LAC of some large financial entities is insufficient to cover potential losses or if doing so would trigger contagion (for example, creditors will reduce their claims on other banks).

Using public resources for bank recapitalization should be a last resort, used only when financial stability is severely threatened, and subject to strict conditions (Box 8). Resolution regimes, funding arrangements, and contingency planning should build in sufficient flexibility to allow for public support, should it be required, including scope for recovery of resources ex post from the industry. Prior conditions for government support should include all losses first being recognized (and equity capital written down) before public funds are injected, to avoid bailing out shareholders. If losses exceed equity capital, attribution of losses to other creditors will be a key decision in the resolution strategy, balancing financial stability with cost minimization and moral hazard concerns.

Ownership interests in banks following full or partial recapitalization should be the responsibility of the finance ministry (or a specialized agency). As managers of liquidity to the banking system and sometimes as supervisors, central banks have significant conflicts of interest as owners of banks. In addition, provision of capital funds to some banks can easily create conflict with the primary mandate of preserving monetary stability. Deposit insurers have a conflict of interest in owning an entity whose depositors they are insuring, and competitiveness and fairness concerns arise for the other contributors to the scheme. Such ownership also introduces scope for losses, which can undermine the credibility and balance sheets of central banks or deposit insurers.

Different recapitalization instruments have different benefits and costs. Equity participations—which trigger an immediate dilution of any remaining shareholders and afford ownership rights to the government—are advisable when losses have already accrued, capital needs are urgent, and ownership and management can be credibly separated. The provision of non-core capital (for example, contingent convertible instruments, redeemable preference shares or other subordinated instruments) may avoid the stigma associated with government ownership but are only appropriate if the bank already meets minimum core (for example, Tier 1) capital requirements and its current owners and managers are considered fit and proper. Contingent capital is best used when the authorities deem it necessary to increase bank buffers on a precautionary, temporary basis (such as due to shortfalls in a stress test adverse scenario), in realistic expectation of forthcoming private solutions.

Sovereign financing constraints may affect the choice of cash versus bond-based recapitalization. Although government bonds are frequently used to eliminate negative equity, recapitalization using cash is preferable and corresponds to the standard regulatory concept of a capital infusion. However, if a sovereign lacks market access, the only option may be to recapitalize using government bonds instead of cash, bearing in mind that if the sovereign has difficulty borrowing, the feasibility of a recapitalization strategy could be questioned and trigger adverse market reactions.⁵ The characteristics of the bonds used for this purpose are important, in particular: (1) interest rates should be high enough to allow the recipient bank to remain profitable; (2) maturities should be consistent with the expected recovery in the franchise value of the bank; and (3) the bonds should be marketable and, as such, acceptable as collateral for central bank operations (Andrews 2003).

Supervisory Policy

Sufficient loss-absorbing capacity in banks is a precondition to effective loan workout. Loans that are not adequately provisioned cannot be restructured (or liquidated) without fully recognizing the loss and charging it against income and capital. Hence, banks that are capital constrained or unprofitable—which is a common occurrence in the wake of a financial crisis—have incentives to underreport NPLs on their balance sheets, capitalize interest payments due but not received, and wait for a general improvement in economic conditions that may restore viability to the borrower. When NPLs have risen to systemic levels, such delaying tactics undermine credit conditions, business and investor confidence and, hence, economic recovery.

Table 7.

Lessons on Distressed Asset Management

Note: AMC = asset management company; NPL = nonperforming loan.

Table 7.

Lessons on Distressed Asset Management

What is Similar?	What is New?
High levels of NPLs as a crisis legacy that must be resolved
Tightening of loan classification and provisioning rules to force timely loan loss recognition	Supervisory guidance and intensified monitoring to ensure consistent and prudent application of collateral valuation and impairment provisioning Enhanced prudential oversight, including to banks’ governance, operational targets for NPLs reduction, banks’ internal NPLs management capabilities, supervisory reporting and public disclosure
Centralized, public AMCs to separate illiquid, distressed assets from bank balance sheets (although more selectively used than in the past)

Note: AMC = asset management company; NPL = nonperforming loan.

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Table 7.

Lessons on Distressed Asset Management

What is Similar?	What is New?
High levels of NPLs as a crisis legacy that must be resolved
Tightening of loan classification and provisioning rules to force timely loan loss recognition	Supervisory guidance and intensified monitoring to ensure consistent and prudent application of collateral valuation and impairment provisioning Enhanced prudential oversight, including to banks’ governance, operational targets for NPLs reduction, banks’ internal NPLs management capabilities, supervisory reporting and public disclosure
Centralized, public AMCs to separate illiquid, distressed assets from bank balance sheets (although more selectively used than in the past)

Note: AMC = asset management company; NPL = nonperforming loan.

Swift loan loss recognition and robust provisioning, income recognition, and write-offs underpin banks’ incentives to tackle high levels of NPLs. Although these aspects were equally critical in previous crises, the GFC brought into focus the role of supervisors in loan-loss provisioning within the rules set by accounting standards (Gaston and Song 2014). Supervisory regulation and guidance on collateral valuation and provisioning can help ensure a consistent and prudent application of accounting rules, for instance with regard to impairment triggers, provisioning methodologies for collectively assessed loans, and management judgment and assumptions. Supervisory policy and guidance are particularly critical on the following aspects:

• Classification and forbearance, of loans to ensure that those that are past due, unlikely to pay, or have been granted temporary payment relief in part or in full, are classified appropriately

• Loan restructuring, and conditions that would allow a restructured loan to no longer be considered impaired

• Interest accrual on NPLs, to avoid accrual of uncollectible income on loans past due, which distorts profitability

• Collateral valuation, to ensure that credit-enhancing collateral, which is used to reduce the amount of provisioning, is conservatively valued (for example, through guidance on appraisal practices)

• Write-offs, to support timely write-off for uncollectible loans (where feasible through time-bound requirements) without having to first exhaust legal remedies to collect the debt

• Disclosure, to increase market transparency and discipline.

Prudential oversight can also foster active NPL resolution by placing banks with high NPLs under enhanced monitoring, requiring them to develop internal NPL management capabilities, plans, and tools, and setting operational targets to reduce NPL levels using the tools described above, or write-off the problem loans.

Separating management of impaired loans from regular loan servicing— placing them into a different unit or legal entity—can facilitate the management of NPLs. The creation of in-house or subsidiary units can help banks manage large amounts of distressed assets by separating these functions from core operations (raising funds and making loans) and allocating scarce specialist skills (such as real estate or industrial sector experts) to recovering value from NPLs. Separating distressed portfolios also helps accountability, although it will not allow a clear break in financial terms as in-house or subsidiary workout units should consolidate accounts with the bank or financial group. Consolidated supervision and adequate provisioning remain critical in this regard, to avoid the risk of banks boosting their capital by transferring problem assets to subsidiaries at above-market values.

A targeted approach is required in cases where asset quality concerns are due to excessive related-party exposures (Karlsdóttir and others, forthcoming). Persistently high related-party transactions remain a challenge in some countries and are often associated with nontransparent bank ownership and broader governance challenges. Achieving progress with resolving these legacy problems requires a three-pronged strategy whereby legal reforms and targeted bank diagnostics allow removing unfit shareholders and unwinding related-party exposures (Box 9). As the recent experiences of Ukraine and Moldova show this process may take some years, depending on the size and nature of exposures and broader financial stability considerations.

Insolvency and Debt Enforcement for Corporates and Individuals

Effective resolution of NPLs requires a well-functioning set of legal tools for debt collection, restructuring, and disposal. These tools are important for managing NPLs in normal times and form the basis on which additional measures can build in the aftermath of a systemic crisis. NPL resolution is based on the two key pillars of enforcement and insolvency. The legal framework should enable the timely, transparent, and predictable recovery of claims while protecting value for all the concerned parties. A clear and efficient legal framework underpins both individual enforcement actions and insolvency proceedings. Clarity on the likely outcome of a legal process enables a more accurate assessment of the costs and benefits of debt workout options. This strengthens the incentives of viable but distressed debtors and all creditors to participate in meaningful out-of-court debt restructuring. In turn, distressed asset prices are heavily influenced by the duration, cost, and effectiveness of the legal tools for debt restructuring and insolvency or enforcement.

An effective legal framework for insolvency and debt enforcement requires both appropriate legislation and robust institutions (IMF 1999; UNCITRAL 2004; World Bank 2016). Legal tools should be designed to facilitate speedy in- and out-of-court solutions. An adequate institutional framework, including well-resourced courts and insolvency practitioners, should support the consistent, efficient, and predictable implementation of the laws. Reforms in both areas are often needed to address a systemic crisis. An assessment of the existing framework is the essential first step to introduce reforms. Examples of reforms addressed at specific problems in crisis countries include the following:

• Enhancing debt enforcement and foreclosure processes to achieve faster asset recoveries: for instance, ensuring clear legal title to collateral, limiting appeals, and setting short preclusive deadlines; and introducing e-auction platforms

• Strengthening the judicial system by increasing the specialization of judges, rationalizing fees, and introducing performance measures for insolvency professionals

• Augmenting out-of-court frameworks with hybrid features that generate more rapid and cost-effective results, to help address the extraordinary burden on the courts in case of a crisis²

• Facilitating the rapid exit of nonviable firms and the rehabilitation of viable firms, including via expedient in-court approval of settlements negotiated out of court, and simplified, cost-effective insolvency processes for small and medium enterprises (SMEs; Bergthaler and others 2015) and

• Facilitating, where possible, the participation of public creditors in the restructuring process by eliminating super-priorities of public claims (where they exist), introducing flexibility on the debt relief that can be offered on tax liabilities, and providing general guidance for insolvency and debt restructuring decisions.

Informational and tax obstacles to effective restructuring should be removed. Credit bureaus for banks with relevant information on debtors (for example, on tax liabilities), and publicly searchable debt and property registers are important for efficient debt workouts. From the debtor’s perspective, lack of information on options, legal advice, or counseling act as impediments to effective workout. Tax disincentives—not allowing or limiting tax deductions for write-offs or loan loss provisions, for instance—can substantially raise the financial hurdle for a viable restructuring.

If the crisis is systemic, additional steps may be needed. Where high NPLs reach proportions affecting the whole banking system or significant parts of the corporate sector, the economic effects may warrant additional public policy interventions. These can take the form of efforts to ensure creditor coordination and standardized approaches to restructuring liabilities (and sometimes operations) of similar debtors. Such measures may seek to simplify and expedite debt restructuring by committing creditors (usually banks, as in the “London” or “Istanbul” approaches) to accepting prespecified debt restructuring formulas for qualifying debtors, without additional scrutiny or negotiation.³ While such approaches can be successful, they require extensive negotiation and agreement among many stakeholders, and may only be effective as the economy recovers. Agreement, or concessions, from public creditors, may also be needed to make these approaches workable, and a public sector role may be needed to coordinate discussions toward a workable package of measures.⁴

Distressed Asset Markets

Distressed assets disposal alleviates the burden they place on bank balance sheets. The disposal of risky assets can take place via outright sales and securitizations. Distressed asset management is a specialized task where value can be created through applying specific expertise or through taking advantage of economies of scale in managing large volumes of NPLs. Typically, the distressed asset market comprises a mix of specialized nonbank participants, and joint ventures comprising specialists, banks, and investors. These entities can support an efficient market, which can raise recovery values of distressed assets, free up lending capacity at banks, and facilitate a more efficient redeployment of resources across economic activities. A reliable and efficient legal framework to enforce creditors’ rights and adequate availability of risk capital are prior conditions for a successful market in distressed assets. In many countries, these conditions are not met, and deep private markets are relatively rare, as the volume of bad assets available in the normal course of business is too low to justify development of a stand-alone industry in most countries. The legal, information, and incentive problems noted above may also hinder the development of such a market.

Legal and regulatory reforms are often necessary to support the development of a distressed asset market. Legal obstacles to the transfer of assets, such as requiring the permission of the debtor before a loan can be transferred, must be removed. Shortening foreclosure and liquidation court proceedings increases recovery values and reduces uncertainty. Other necessary reforms may include clarifying uncertainties in the priority of claims in liquidation; facilitating timely and accurate information on distressed borrowers and asset sales; ensuring collateral valuations are realistic; removing fiscal obstacles or impediments to public sector participation; and licensing (or simplifying licensing processes for) nonbanks to buy distressed assets and undertake debt restructuring.

Centralized Asset Management Companies

Centralized AMCs can be useful elements of the policy mix to address systemic crises but are no panacea.⁵ Fully or partly state-owned AMCs buying assets from several financial institutions (hence, “centralized”) formed a key facet of public support in past crises (for example, the Nordic and Asian crises), and were used in a few cases during the GFC (for example, Sareb in Spain, NAMA in Ireland, Maiden Lane in the US). AMCs can reap economies of scale and scope by consolidating creditor claims and scarce expertise. Efficiency gains are most likely where problems are widespread, and NPLs are large, syndicated, and relatively homogenous (such as corporate or commercial real estate loans). AMCs may also encourage the development of distressed asset markets through setting benchmark prices and adopting standard procedures for workouts and asset sales. But AMCs’ operations entail fiscal costs and risks, as well as governance challenges. The costs and benefits of establishing an AMC need, therefore, to be carefully weighed on a case-by-case basis (Table 8).

Table 8.

Advantages and Risks of Public Asset Management Companies

Table 8.

Advantages and Risks of Public Asset Management Companies

Advantages	Operational Risks
Economies of scale and scope—consolidating assets from many banks can address multi-creditor issues Bargaining power—due to their size, especially with large borrowers and syndicated loans Specialized skills—concentrating scarce expertise in financial and operational restructuring Uniform valuation criteria—can help price discovery and credit discipline	Political and stakeholder interference/pressures Unclear objectives, weak organization and skills, or a weak legal framework Accountability, transparency, and media pressures Inappropriate financial structure, given cash flow Inflated acquisition prices Inadequate documentation

View Table

Table 8.

Advantages and Risks of Public Asset Management Companies

Advantages	Operational Risks
Economies of scale and scope—consolidating assets from many banks can address multi-creditor issues Bargaining power—due to their size, especially with large borrowers and syndicated loans Specialized skills—concentrating scarce expertise in financial and operational restructuring Uniform valuation criteria—can help price discovery and credit discipline	Political and stakeholder interference/pressures Unclear objectives, weak organization and skills, or a weak legal framework Accountability, transparency, and media pressures Inappropriate financial structure, given cash flow Inflated acquisition prices Inadequate documentation

Establishing AMCs may entail significant upfront costs to the government as well as fiscal risks. Cases where centralized AMCs contributed to recovery without incurring substantial costs to the government are rare. Centralized AMCs are typically fully or partly state owned and publicly funded (directly or by issuing bonds with public guarantees). AMCs need liquidity to cover negative cash flows in their first years of operations, as recoveries take time to be realized, even in favorable conditions. Adequate capital to absorb initial losses will be necessary, as will good practice governance frameworks (Box 10). Central bank ownership or funding of AMCs is not advisable, as it exacerbates conflicts of interest.

Centralized AMCs raise complex governance challenges. The large-scale transfer of risk from banks to the public sector creates the conditions for political interference, overpaying for assets, or corruption. Without tightly defined mandates or “sunset clauses,” AMCs have on occasion become permanent bureaucracies and generated moral hazard. To be successful, centralized AMCs should have robust governance frameworks, clear mandates and incentives focused on value recovery, operational and budgetary independence, and strong transparency and accountability rules.

The price at which assets are transferred to AMCs is critical. The financial objective of any AMC should be to recover the amount paid for the assets over its fixed-term life, that is, to break even. AMCs should not enable the transfer of losses from banks to taxpayers by acquiring assets at prices that are above market—this would be equivalent to a bail-out of shareholders and creditors. If public resources are necessary, their amount and beneficiaries should be clear, and the resources should be given only after the asset losses are recognized and accrued on the balance sheets of banks. To ensure effectiveness of the policy approach, the supervisor should engage with participating banks to ensure valuation practices are appropriate, including collateral valuations. An effective technique can be to introduce time-bound collateral haircuts that consider the type of collateral and the time an NPL has been past due.⁶ The experience during the GFC was that “going concern” banks were less willing to sell to an AMC if the transaction crystallized substantial losses on their balance sheet. For this reason, many centralized AMCs during the GFC acquired assets from institutions that had already been intervened, recapitalized by the state, or resolved. While profit-and-loss sharing agreements, so-called claw-backs, can help minimize the ultimate impact on bank capital, they will not avoid the upfront loss. They also imply that financial risks (both up and downside) remain with the bank, which will prevent asset derecognition (that is, the removal of an asset from the balance sheet) or risk transfer for capital purposes and could undermine the gains to investor confidence from a clean sale.⁷

Granting special powers to AMCs to accelerate recoveries should be avoided. Centralized AMCs have on occasion been granted fast-track legal and administrative powers for loan recovery, restructuring, or foreclosure to compensate for shortcomings in the legal system. These special powers introduce an element of unfair competition (particularly if the AMC has some private equity) and can result in an unfair or unequal treatment of debtors. It is preferable therefore to focus on reforms to introduce a more efficient insolvency and foreclosure regime for all market participants.

Box 9.

Dealing with Excessive Related-Party Exposures

Excessive related-party exposures present a major risk to financial stability. Related-party loans that go unreported conceal credit and concentration risk and may be on preferred terms, reducing bank profitability and solvency. Persistently high related-party exposures also hold down economic growth by tying up capital that could otherwise be used to provide lending to legitimate, creditworthy businesses on an arms-length basis. Related-party exposures complicate bank resolution, as shareholders whose rights have been suspended have an incentive to default on their loans to the bank.

Opaque bank ownership greatly facilitates the hiding of related-party exposures and transactions. Opaque ownership is associated with poor governance, AML/CFT violations, and fraudulent activities. Banks without clear ultimate beneficial owners cannot count on shareholder support in times of crisis, and the quality of their capital cannot be verified. Moreover, unknown owners cannot be held accountable for criminal actions leading to a bank’s failure.

Resolving these problems requires a three-pillar approach. Legal reforms are needed to lay the foundation for targeted bank diagnostics and effective enforcement actions:

• Legal reforms to introduce international standards for transparent disclosure and monitoring of bank owners and related parties—including prudent limits, strict conflict of interest rules on the processes and procedures for dealing with related parties, and escalating enforcement measures. Non-transparent ownership should be made a legal ground for license revocation or resolution, and the supervisor authorized to presume a related party under certain circumstances. This shifts from supervisors to banks the “burden of proof “—to demonstrate that a suspicious transaction is not with a related party.

• Bank diagnostics are targeted at identifying ultimate beneficial owners and related-party exposures and transactions and assessing compliance with prudential lending limits for related-party and large exposures. The criteria for identification include control, economic dependency, and acting in concert. Identification of related-party transactions should also consider their risk-related features, such as the existence of preferential terms, the quality of documentation, and internal controls over the transactions.

• Enforcement actions are taken to (1) remove unsuitable bank shareholders—that is, shareholders whose ultimate beneficial owner is not identified, or are otherwise found to be unsuitable; and (2) unwind excessive related-party exposures through repayment or disposal of the exposure, or resolution of the relationship (change in ownership of the bank or the borrower).

The three-pillar approach is best implemented in the context of a comprehensive financial sector strategy. There may not be enough time to implement legal reforms during early intervention or the resolution of systemic banks. In such situations, suspected related-party exposures and liabilities must be swiftly identified and ringfenced. Once the system is stabilized, however, the three-pillar approach should be implemented for all banks (including those in liquidation).

Source: Karlsdóttir and others (forthcoming).

Box 10.

Design Features of Successful Public Asset Management Companies

• Mandate: The stated objective of the asset management company (AMC) should be to maximize the recovery value of transferred assets and reduce public contingent liabilities over a fixed lifespan, with a clear commercial focus.

• Governance: AMCs may be subject to strong political or market pressures from borrowers or investors seeking preferential treatment. For that reason, the Board and senior management of an AMC should be composed of individuals independent of government or active market players, with relevant expertise and market credibility.

• Independence: AMCs should be established as autonomous entities, with flexibility over pay and staffing (that is, to set incentives for staff on market terms, not constrained by public sector employment norms), the ability to hire advisory firms and to set and execute operational and valuation policies, and with adequate protection from litigation for staff to facilitate resolution, foreclosure and liquidation of assets.

• “Sunset” clauses: Centralized AMCs should have limited lifespans to avoid the risk of creating a permanent bureaucracy and to establish the right incentives to realize assets values expeditiously.

• Valuation of assets: To avoid distorting incentives and for fair accountability, the AMC’s performance in maximizing value should be measured against a realistic benchmark. A review of asset values should be undertaken once the AMC has established its valuation models and current values should be compared to the starting balance sheet to measure performance. The starting balance sheet should show values below the transfer price if assets were transferred at above market prices.

• Transparency and accountability: AMCs should publish operational and financial plans and prepare audited financial statements based on current market valuations of assets, with oversight by appropriate governance bodies (for example, a parliamentary committee).

• Funding: The AMC’s operating budget should be separated from the funding allocated for asset purchases and be sufficient to cover start-up costs. Government bonds used to fund asset purchases should be remunerated at market rates and accepted

as collateral for central bank liquidity. Tenors should be long enough to allow for realization of the value of the assets through sale, restructuring, or foreclosure and sale of collateral. Seeking some market funding (with no guarantees) can help minimize competitive distortions and maintain clear incentives for the AMC by giving a market-based cost of funding to facilitate operational financial decisions.