A. Three Sources of Problems

At a conceptual level there are three underlying causes of problem banks: microeconomic; macroeconomic; and “system related,” or structural issues.⁴ The microeconomic causes are generally poor banking practices that lead to losses through inadequate management of credit and other risks, or fraud. While soundly managed banks can weather cyclical downturns, there can be unexpected macroeconomic shocks, such as the 1970s’ oil crisis, that threaten even the most prudent institutions.⁵ The category of “system related,” or structural causes, includes factors that are not conducive to the development of an efficient banking industry, such as market distortions from state banks, directed credits, inadequate legal framework, and inadequate supervision.⁶ A cyclical downturn or macroeconomic shock may bring to the surface the underlying microeconomic or structural weaknesses in a banking system.

In dealing with weak banks, it is important that the solution address the underlying problem. Only in the rare case of a macroeconomic shock “sideswiping” otherwise sound banks is the injection of capital or a period of time to rebuild capital likely to be sufficient to restore the health of the bank without taking other actions to address the fundamental problems. A period of time to obtain new capital can be a part of a broader plan to achieve a turn around, but failure to address the underlying microeconomic or structural causes of the problem makes it likely that capital injected will be at risk, and delay in supervisory action likely only serves to increase the ultimate loss.

B. Guiding Principles for the Resolution of Weak Banks

The need for speed, cost efficiency, avoiding market distortions and the creation of perverse incentives in the banking markets all mean that banking supervisors have to consider closing banks when depositors and creditors face imminent risk of loss due to insolvency (Box 1). The preferred resolution of a weak bank occurs long before this need would arise. In normal times well-managed banks will themselves take corrective action to deal with emerging financial problems or prudential violations, frequently before these issues come to the attention of the supervisor. However, owners and managers hoping that a general improvement in economic conditions will solve bank-specific problems, or that the bank may grow out of its problems, may have an incentive to try to conceal the true financial condition of the bank from the supervisor. The supervisor will have to take more formal action in these circumstances or in the case when the owners and managers of the bank, acting in good faith, are unable to remedy the problems.

C. Supervisory Action Prior to Closure

Specific approaches vary among jurisdictions, but there are two generic legal approaches to dealing with weak banks: (1) discretionary; and (2) rules-based. In jurisdictions with a discretionary approach, the supervisor is generally bound by broad objectives such as taking timely remedial measures,⁷ but has wide latitude regarding specific corrective actions and the timing of supervisory actions. In part to address concerns that banking supervisors may use discretionary powers to defer decisive actions, and in part to foster greater consistency in the approach to weak banks, some jurisdictions have a rules-based approach. An example of the rules-based approach is the prompt corrective action (PCA) provisions adopted in the United States and elsewhere (Table 1). PCA requires the banking supervisor to take certain minimum actions in response to specified trigger points, usually defined by capital adequacy ratios (CARs). Even with the PCA approach, the supervisor generally has wide latitude to take steps in addition to the minimum required. Thus, when the supervisor is of the opinion that the situation requires that management and shareholders be removed, there is no need to wait until capital is depleted to the level that would trigger mandatory conservatorship or receivership.

Table 1.

U.S. Prompt Corrective Action

Table 1.

U.S. Prompt Corrective Action

Early Warning Period     Increasingly Intrusive Supervision     Intervention
Adequately Capitalized CAR < 10 percent	Undercapitalized CAR < 8 percent	Significantly Undercapitalized CAR < 4 percent	Critically Undercapitalized Equity/Assets < 2 Percent
Cannot pay dividends or management fees that would lead to undercapitalization	Close monitoring Capital restoration plan required within 45 days Restrictions on growth, prior approval required for acquisitions, branching and new lines of business	Recapitalization required Restrictions on transactions with affiliates Restrictions on interest rates, growth and activities Require new directors and officers Restrictions on holding company Require divestitures	Conservatorship, receivership or other action required Appointment of receiver required if other action fails to restore capital

View Table

Table 1.

U.S. Prompt Corrective Action

Early Warning Period   View Expanded   Increasingly Intrusive Supervision   View Expanded   Intervention
Adequately Capitalized CAR < 10 percent	Undercapitalized CAR < 8 percent	Significantly Undercapitalized CAR < 4 percent	Critically Undercapitalized Equity/Assets < 2 Percent
Cannot pay dividends or management fees that would lead to undercapitalization	Close monitoring Capital restoration plan required within 45 days Restrictions on growth, prior approval required for acquisitions, branching and new lines of business	Recapitalization required Restrictions on transactions with affiliates Restrictions on interest rates, growth and activities Require new directors and officers Restrictions on holding company Require divestitures	Conservatorship, receivership or other action required Appointment of receiver required if other action fails to restore capital

The range of responses to a weak bank may be viewed as a continuum of increasingly intrusive actions by the banking supervisor. A break point on the continuum occurs at the moment of supervisory intervention.⁸ Up until this point, the owners and mangers of the bank retain control of the institution, notwithstanding specific directions or restrictions imposed by the supervisor. During the period preceding intervention the existing shareholders have their opportunity to try to solve the problems facing the bank, and should be strongly motivated by the potential loss of their investment. Thus, when intervention becomes necessary it is almost certain that existing owners did not have the financial resources or the willingness to inject capital or institute needed reforms, and probably also failed to find new investors or a merger partner. This can be viewed as a clear confirmation of the poor financial condition of the intervened bank, which while not precluding the possibility of a turnaround after supervisory intervention, makes a closure option more likely.⁹

D. Resolution After Intervention

Despite the best efforts of the supervisor there will be cases where it becomes evident that the bank is unable to continue it operations without jeopardizing the safety of depositors’ funds. In these cases, the supervisor must intervene. While other options may be available, as outlined above there is a strong likelihood that a closure option should result. The essential functions of a bank and confidence in the banking system can be preserved through a well-planned closure. Prompt closure can preserve any going concern value that would otherwise erode through ongoing operating losses. Decisive action can actually enhance confidence in the supervisory regime and banking system by ensuring that only sound banks are permitted to continue operating.

Following supervisory intervention it is crucial that well qualified and experienced staff take effective control of the bank and immediately assess the operations and financial condition of the bank, and undertake a review of available options (Box 2). Much of this work may have been completed prior to actual intervention if there had been an extended early-warning period, but in any event needs to be completed quickly. There is a risk of a run on the bank if uninsured depositors and other creditors fear they would have to bear some losses, and even without a run the realizable value of an intervened bank is more likely to decline than to improve. Ongoing operating losses, flight of remaining good commercial customers to higher quality banks not constrained in their ability to lend, and erosion of any remaining name and franchise value is likely to occur in banks operating for any extended period following supervisory intervention.

The review of an intervened bank may indicate that restructuring is feasible, but these conclusions need to be critically examined. A willingness to undertake more radical restructuring than was palatable to the bank’s owners and managers may be sufficient to achieve the turnaround that escaped the shareholders during the early warning period. It is more likely, however, that the failure to fix the bank prior to intervention is an indication that new capital, not just restructuring and reorganization, was required, and that the expected return was insufficient to attract new equity investors, or a purchaser or a merger partner.¹⁰

Restructuring an intervened bank may improve its attractiveness to investors, but it may be more cost efficient to sell all or parts of the bank on an as-is basis, at a discount, or possibly by providing a stop-loss or some other guarantee to the new owner.

The supervisor, or contract management or consultants retained to manage the intervened bank may be able to make improvements, but the incremental costs of restructuring may not be fully recouped in a subsequent sale. Quickly disposing of the intervened bank has the benefit of checking ongoing operating losses and permitting a more precise estimate of the costs of resolution than a longer-term restructuring plan with uncertain results.

For even the largest banks where recapitalization or restructuring has not been successful prior to intervention, possible solutions to preserve the essential functions of the bank include:

• sale of individual businesses of the bank on a going concern basis;

• liquidation and piecemeal or en bloc sales of individual assets and business lines; and

• an outright sale of the bank to another financial institution.¹¹

Particularly if the bank has a large share in certain business lines or regions, it assets should be attractive to purchasers. Another viable option may be to split the intervened bank’s assets, liabilities, staff and branch network into perhaps one or two new banks, which would be offered for sale to potential investors. If a banking system is too concentrated and dominated by a few large banks this could be a good opportunity to split it up, increasing the number of competitors.

A. Presumption Against Extraordinary Measures to Avoid Closures

It is quite often argued that large banks are too big to fail, or more accurately, too big to close and liquidate, due to the negative impact on the rest of the banking system and the real economy. Arguments used are that remaining operating banks would not have the capacity to provide banking services needed, would not be able to absorb assets and liabilities of the failed banks, or that the closure of a large bank would lead to a more wide-spread loss of public confidence. Another argument is that a bank with a dominant role in providing certain bank services (i.e., foreign exchange or payment services), or a bank that is the only provider of services in certain regions, cannot be closed without depriving the real economy of banking services. It is also suggested that disruption of borrowing relationships built up over time will be a crippling blow to a bank’s customers. Thus, it is sometimes argued that the authorities have no choice if a large bank runs into trouble but to recapitalize the bank, at any cost.

All these arguments should be questioned. First, it is important to remember that the functions performed by the bank may be essential, but the bank itself is not. It may be cheaper to hive off the important parts of the bank rather than trying to save the entire institution. This can preserve customer relationships without the costs of maintaining loss-making operations. A second important point to consider is that the alternative to intervening is to permit the continued operation of an insolvent bank. Sale of viable parts of the bank or closure and liquidation may be less costly than continued subsidization of a bank’s losses. Clearly, there is a need to take action to stem the ongoing losses to avoid diverting economic resources to an inefficient bank, and requiring other better managed banks to compete against the distortions a loss-making bank can introduce in a market.

Delay in addressing problem banks increases costs and makes ultimate resolutions more difficult. International experience has shown that bank problems can worsen rapidly if not promptly addressed, however, in many cases supervisors have tended to postpone taking timely and adequate corrective action in the hope that the problems will rectify themselves.¹⁸ The “wait and hope” strategy is seldom successful. It is rare for additional information to surface after intervention that reveals the problems to be less severe than had originally been identified, or for a delay in intervention to actually reduce resolution costs. This is the case in nonsystemic situations, where “experience has shown that unsound banks are invariably in worse condition than is indicated by their financial statements, and that the lowest cost way to keep the banking system sound is to force their exit.”¹⁹ Evidence is also found in cases of systemic crisis, where in almost 25 percent of cases repeated recapitalizations are required because the amount initially provided turns out to be insufficient to restore solvency.²⁰ However, each problem bank presents a unique situation and it is not possible to test and determine or predict with absolute certainty the results of alternative strategies. Thus, the judgment involved in estimating costs and benefits provides supervisory authorities with the scope to reach a determination that a nonclosure option is more cost effective. While sometimes true, the evidence is that more frequently the analysis and initial decision to provide open bank assistance or forbearance are subsequently proved incorrect, ultimately increasing the costs of resolution.

To offset this imbedded tendency to defer action and overestimate the likely success of open-bank resolutions, there should be a strong presumption against the use of forbearance or public funds to avoid closures. In normal times, the use of public funds²¹ for bank restructuring should only be considered in the case of systemically important banks, where the disruptive effect of the closure would result in higher costs than the cost of the extraordinary measures to deal with the problem banks. The burden of proof for use of public funds or a period of regulatory forbearance to deal with problem banks should be very high, especially when dealing with one or a small number of problem banks in normal times. This burden of proof is more readily met in a banking crisis, where there is an evident need to preserve part of an insolvent banking system to provide core functions for the real economy.

B. Costs and Benefits of Using Public Funds

Public funds or forbearance for troubled banks can create perverse incentives similar to those created by an ill-founded deposit insurance scheme. Depositors who have the expectation of being made whole exert no market discipline on banks. Owners and managers who expect public support in times of trouble are encouraged to undertake more risky activities and be less vigilant in managing the bank’s exposure. For these reasons, a well-designed deposit insurance scheme incorporates features like low coverage limits to mitigate the negative effects on market discipline.²² Similarly, the availability of LOLR support should generally be limited to solvent banks in normal times.²³ To avoid the negative consequences similar to those that can arise from the formal safety net for banks, the process of dealing with a problem bank should involve measures to ensure that it is not insulated from the effects of market discipline. In normal times these can be expected to include ensuring that shareholders lose their equity investment and depositors will not receive more than the limits of an existing deposit insurance scheme. Management found at fault need to be replaced to send a message about the negative outcomes from managing poorly.

The principal benefit of using public funds to rescue an insolvent bank is avoiding disruptive effects, the magnitude and consequences of which are difficult to predict. Fears of contagion or payment system paralysis may cause the authorities to favor extraordinary measures to avoid closure even if the probability of such widespread disruption is low. Governments may be so concerned about the costs and risks that an expensive bailout may be viewed as attractive, particularly when the costs of the bailout are uncertain and equally as difficult to quantify as the costs of disruption. The fiscal costs of government expenditures for bank restructuring or extended liquidity support can be more easily estimated, but the nonquantifiable costs outlined above may be even more significant.

A. Statement of Principles

In a systemic crisis or if a number of banks have been intervened, a clear strategy is required to avoid magnifying problems through ad hoc reactions. No decision on the use of public funds or a policy of forbearance should be taken until a strategy, which can be made public in a statement of principles, has been developed. This should lay out the process for dealing with the banking problems, including clear decision rules as to which banks will be eligible for extraordinary assistance and which banks should be closed. To be eligible for public funds, at a minimum a bank should:

• have fit and proper owners and managers;

• recognize the full extent of losses based on realistic asset valuations;

• have a business plan to achieve full capital adequacy within a realistic time frame;

• commit to necessary operational restructuring to assure future profitability; and

• involve private sector owners with sufficient capital at risk to provide a strong incentive for them to work for the survival and success of the institution.

In addition, the terms of provision of public funds should provide safeguards for the funds invested and incentives for the bank to be returned to full private ownership as quickly as possible. Such measures usually include intensive supervision and reporting requirements, restrictions on dividends, and could also involve provisions for automatic intervention or changes in management if agreed restructuring and performance targets are not met. Also, the provision of some or all of the public funds in the form of equity or convertible debt enables government to realize some of the benefits of a successful turnaround as well as providing the private shareholders with an incentive to repay the investment of public funds at the earliest opportunity.

It is important that the initial announcement of bank closures should be part of a coordinated package of actions and announcements including details of how the closures will be affected, plans to ensure smooth deposit transfer and payment, and details on the treatment of the staff of the banks to be closed. Failure to position bank closures as part of a coordinated process to deal with the crisis and to ensure minimal depositor disruption risks a continuation rather than stabilization of the crisis (Box 3). A clear communications strategy ensuring that only predetermined individuals speak publicly and deal with the press is important to ensure that the public is not confused by erroneous or speculative statements by individual politicians or officials.

B. Evaluating Banks’ Financial Condition

An immediate review of the banking sector will likely identify some clearly unviable banks that should be closed immediately. An additional period of evaluation will be required to determine which other banks should be eligible for public assistance, and which should be subsequently closed or exit the market through merger (Box 4). The triage process is complicated by likely uncertainty about the veracity of reported financial data, the absence of market prices for most distressed bank assets, and general uncertainty arising from volatile macroeconomic conditions.

A review of the quality of banking supervision as part of this triage process serves two purposes. First, it establishes the extent to which supervisory data and bank reports provide reliable information on which to base assessments of banks’ viability. Second, a review of prudential regulations and their enforcement, with a focus on asset quality, including loan classification and provisioning requirements; accounting standards; profitability; liquidity; and solvency will identify areas that require strengthening as part of the institutional reform that is a necessary part of a longer term recovery plan.

C. Minimizing the Fiscal Burden

The authorities should always pursue options that minimize the fiscal burden once the decision has been taken to use public funds to assist in the restructuring of banks. This may mean having to limit the number of banks eligible for public assistance, perhaps by requiring that banks raise new private capital in order to be eligible for public assistance. In evaluating options it is important to consider that in the aftermath of a systemic crisis recovery rates from the assets of closed banks may be quite similar to recovery rates for the assets of restructured banks. In both cases, an asset management company would likely undertake much of the collection on loan assets. In a closure there is the possibility of recoveries from other assets and deposits sold to other operating banks. The cost for closing and liquidating a bank would roughly equal the estimated net value (likely to be negative) of the bank plus liquidation costs such as severance payments for staff, and lease and contract termination costs. These costs may not vary greatly from the costs of a financially assisted merger or restructuring, as all options are likely to entail significant rationalization of both staff and facilities.²⁸

D. Save Only the Viable Banking Franchises

Hard decisions will be required to minimize the number of banks to be saved at public expense, both to minimize the fiscal cost and in an effort to ensure that the post-crisis landscape is not populated with a large number of “banks” that only warehouse recapitalization bonds. As a general principle a bank should be closed and liquidated if there is not a very high probability that recapitalization and a short period of restructuring would result in a bank that could be easily sold to private investors. Making this determination for individual banks in the midst of a crisis will be difficult, but it is important to keep in mind that injection of enough capital could make any bank financially viable, but it will only be attractive to investors if it has a valuable banking franchise. Thus, a bank with a largely nonperforming asset portfolio, or one that loses most of its customer base through the transfer of nonperforming loans to an asset management company, will most likely not be a good candidate for restructuring. Building a new customer base on the asset side is a risky and lengthy exercise, and if built up too quickly could involve assuming a high degree of credit risk. This suggests that recapitalization and restructuring efforts should focus on those banks that retain the largest portion of unimpaired loans. For banks without a strong franchise, faster and lower cost resolutions may be achieved through the en bloc or piecemeal sale of any attractive businesses and a deposit transfer and payout.