Bank Insolvency Procedures: Emerging Bank-Fund Guidelines
Effective bank insolvency procedures form an essential part of the supervisory framework and are also part of a proper financial safety net. Effective procedures help in reducing moral hazard. An analysis of the effectiveness and appropriateness of bank insolvency procedures and exit policies is an important part of BCP assessment. Experience indicates that, in many countries, those types of procedures are weak, opening the door to interference and forbearance.
The World Bank and the IMF have developed a (draft) document titled “Global Bank Insolvency Initiative,” (IMF and World Bank 2004),15 which documents practices around the world in the area of insolvency procedures. Although not a “best practices” document (given the diversity of judicial approaches around the globe, it is premature to develop best practices), this document could certainly be used to check country practices and to provide advice.
When authorities face problem banks, the general principle is that the authorities should take prompt action to restore them to health. The supervisors should have the authority to identify unsafe and unsound banking practices and then to require that those practices be halted. Supervisors should be able to apply a series of corrective measures and penalties with increasing severity. If deterioration continues, supervisors should close, merge, or otherwise resolve issues in troubled banks expeditiously before they become insolvent. Increasingly, countries are basing supervisory corrective action on a legal obligation to take specific actions (“prompt corrective action” specifically identified in the law) against a bank as capital levels fall below values established in the law. Prompt action reduces the likelihood that a failing bank will engage in risky and potentially expensive gambles for redemption.
Supervisors need good information on the condition of individual banks so they can take appropriate action. Appropriate disclosure of information to the public would support market discipline. These general issues should come out of the BCP assessment, particularly in Core Principle 22. However, the core principles do not deal specifically with insolvency proceedings other than in the preconditions. That is where the Bank – Fund document on bank insolvency (IMF and World Bank 2004) becomes useful. When making an assessment, assessors should bear in mind that legal and judiciary systems and traditions differ widely among countries. When a bank develops severe financial difficulties, it will have to be either restructured or liquidated. The legal and institutional features that should be in place to allow for orderly restructuring or liquidation are discussed in appendix G (Bank Resolution and Insolvency) and are summarized next. The broader legal environment for effective insolvency procedures is outlined in Annex 5.A.
A special bank insolvency regime, or suitable modifications of a general corporate insolvency regime, is needed to reflect the potential systemic effects of bank failures that call for prompt actions, effective protection of bank assets, and the key role of the banking authorities in bank insolvency proceedings. A typical immediate first step is to have an official authority assume direct managerial control of an insolvent bank (insolvent either in a regulatory sense or in a balance-sheet sense) with the goal of protecting its assets, assessing the true condition, and arranging or conducting either restructuring or liquidation. Official administration continues until the institution has been restored or placed in liquidation. The key principles governing official administration, bank restructuring, and bank liquidation are further discussed in appendix G. One of the key principles is that the authorities should choose the bank resolution option that costs the least. In particular, the cost of bank restructuring should be viewed in terms of net outlays on recapitalization and other assistance operations after deducting the proceeds from reprivatization and asset recoveries. When restructuring is not feasible or when it involves spinning off the viable operations of the bank and, thus, leaving behind only the nonviable part, then the bank will have to be liquidated.
In this process, the supervisory (licensing) agency should have the authority to withdraw a bank’s license on the basis of clearly defined criteria. Such criteria include (a) noncompliance with the conditions under which the license was initially granted (in particular, when management is no longer fit and proper), (b) failure to meet prudential requirements, (c) failure to make payments, (d) following of unsafe and unsound banking
practices, and (e) criminal activities by the bank. The supervisor could also be given the responsibility to establish the list of qualified liquidators.
Unless the supervisory authorities or some other government agency (such as a deposit insurance fund) is responsible for resolving the problems of insolvent banks, the liquidator will be appointed by the courts, which oversee liquidation. Any deficiency in the court process that could impede bank liquidation should be identified. The authorities should have contingency plans to deal with the emergence of systemic banking problems or large-scale bank closures. Plans should include ways to protect the payments system and to maintain basic banking services. The authorities should also have an idea of how to organize the restructuring efforts, including which institutions would be charged with guiding the restructuring efforts. In addition, the authorities should evaluate the legal framework for bank supervision and regulation to ensure that the authorities have the necessary powers to act quickly and efficiently in the face of a systemic crisis.