1. MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION OSMAN BIN SAIF Session: TWENTY FOUR

2. Summary of last session Lender of Last Resort Classical Theory LOLR and Bank closure Policy Solvent banks and Insolvent Banks; LOLR Systemic Risk Contagion Panic of 2008 crisis Liquidity in a non functioning interbank market LOLR policy as part of the banking safety net Lessons for the LOLR’s role Case Example: The State Bank of Pakistan 2

3. Agenda of this session SECTION 6 – Systemic Banking Crisis – Indicators of Banking Crisis – Others Causes of Banking Crisis – Fundamental Factors behind most Crisis – Crisis Containment Policies – Policy responses for Resolution – Crisis Containment Tools – Policy resolution Approaches – Guiding principles for bank resolution policy – Resolution Techniques 3

4. Systemic Banking Crisis In a systemic banking crisis, a country’s corporate and financial sectors experience a large number of defaults and financial institutions and corporations face great difficulties repaying contracts on time. 4

5. Systemic Banking Crisis (Contd.) As a result, non-performing loans increase sharply and all or most of the aggregate banking system capital is exhausted. 5

6. Systemic Banking Crisis (Contd.) This situation may be accompanied by depressed asset prices (such as equity and real estate prices) on the heels of run-ups before the crisis, sharp increases in real interest rates, and a slowdown or reversal in capital flows. 6

7. Systemic Banking Crisis (Contd.) In some cases, the crisis is triggered by depositor runs on banks, though in most cases it is a general realization that systemically important financial institutions are in distress 7

8. Indicators of Banking Crisis These indicators predict banking crises relatively well. – Slower output growth, – increases in real interest rates, – declining liquidity, – faster credit growth, – explicit deposit insurance, – poor legal systems, and – a generally less-developed institutional framework 8

9. Other Causes of Banking Crisis institutional weaknesses, including the presence (or absence) of explicit deposit insurance, absence of resolution mechanisms, weak enforcement of contracts, poor regulation and supervision, and perverse links between corporations and banks. 9

10. Fundamental Factors behind most Crises Crises are typically manifestations of deeper characteristics of the financial sector, which make it prone to such events. The financial system often implicitly protects poorly performing firms by continuing to provide loans. Besides the failure of owners to discipline management of, particularly, state-owned, banks, incentives for prudential banking are typically weak. 10

11. Fundamental Factors behind most Crises (Contd.) This includes inadequately designed and weakly enforced lending limits, asset classification systems and loan loss provisioning rules which fall short of international standards, and no clear exit policy for troubled financial institutions. 11

12. Fundamental Factors behind most Crises (Contd.) Countries with systemic bank crises have often huge holes in their regulatory, supervisory, accounting, auditing and disclosure frameworks and practices. The quality and disclosure of information and financial statements is often unreliable or simply out of date. And enforcement of laws and regulations can be pitifully weak. 12

13. Crisis Containment Policies Initially, the regulator’s policy options are limited to those policies that do not rely on the formation of new institutions or complex new mechanisms. 13

14. Policy Responses for Resolution Immediate policy responses include: (a) suspension of convertibility of deposits, which prevents bank depositors from seeking repayment from banks, 14

15. Policy Responses for Resolution (Contd.) (b) regulatory capital forbearance – which allows banks to avoid the cost of regulatory compliance (for example by allowing banks to overstate their equity capital in order to avoid the costs of contractions in loan supply), 15

16. Policy Responses for Resolution (Contd.) (c) emergency liquidity support to banks, (d) a government guarantee of depositors. Each of these immediate policy actions are motivated by adverse changes in the condition of banks. 16

17. Policy Responses for Resolution (Contd.) Each of these techniques is designed to buy time, and in the case of the first two, that depositor confidence can soon be restored. The success of each technique will crucially depend on the credibility and creditworthiness of the government. 17

18. Bank Holiday Deposit withdrawals can be addressed by emergency liquidity loans, usually from the central bank when market sources are insufficient, by an extension of government guarantees of depositors and other bank creditors, or by a temporary suspension of depositor rights in what is often called a “bank holiday”. 18

19. Crisis Containment Tools Preventing looting of an insolvent or near insolvent bank requires a different set of containment tools, which may include: – administrative intervention including the temporary assumption of management powers by a regulatory official, 19

20. Crisis Containment Tools (Contd.) – Closure, which may for example include the subsidized compulsory sale of a bank’s good assets to a sound bank, – Together with the assumption by that bank of all or most of the failed entity’s banking liabilities; or more simply an assisted merger. 20

21. Crisis Containment Tools (Contd.) Here the prior availability of the necessary legal powers is critical, given the incentive for bank insiders to hang on, as well as the customary cognitive gaps causing insiders to deny the failure of their bank. 21

22. Crisis Containment Tools (Contd.) Adopting the correct approach to an emerging financial crisis calls for a clear understanding of what the underlying cause of the crisis is, as well as a quick judgment as to the likely effectiveness of the alternative tools that are available. 22

23. Crisis Containment Tools (Contd.) The actions taken at this time will have a possibly irreversible impact on the ultimate allocation of losses in the system. In addition, the longer term implications in the form of moral hazard for the future also need to be taken into account. 23

24. Policy resolution Approaches The main policy approaches employed in the resolution phase of crises include: (a) conditional government-subsidized, but decentralized, workouts of distressed loans; 24

25. Policy resolution Approaches (Contd.) (b) debt forgiveness; (c) the establishment of a government-owned asset management company to buy and resolve distressed loans; 25

26. Policy resolution Approaches (Contd.) (d) government-assisted sales of financial institutions to new owners, typically foreign; and (e) government-assisted recapitalization of financial institutions through injection of funds 26

27. Guiding principles for banks resolution policy It may take the deposit insurer some time to determine who are the insured depositors, to close their accounts and pay them off. 27

28. Guiding principles for banks resolution policy (Contd.) In the absence of a deposit insurer, the delay to depositors – if they are entitled to receive any monies back - will be even longer as liquidation procedures can be protracted. In any case, the choice of resolution measures, and the choice between resolution and closure, should be made with the aim of minimising market disruption. 28

29. Resolution techniques The distinction between a legal closure and economic closure of the bank is important. In a legal closure, the licence of the bank is withdrawn and the legal entity ceases to exist. In an economic closure, there is interruption or cessation of the operations of the bank which may often lead to severe disruption and possibly losses for the bank’s customers. 29

30. Resolution techniques (Contd.) The art of resolving bank problems often entails achieving a “legal closure” while avoiding an “economic closure”. 30

31. Resolution techniques (Contd.) Following are the fundamental resolution techniques: 1.Restructuring plans 2.Mergers and acquisitions 3.Purchase-and-assumption transactions 4.Bridge bank 5.Use of public sector monies in a resolution 6.Closure of the bank: Depositors pay-off 7.Management of impaired assets 8.Public disclosure of problems 31

32. Restructuring plans While a weak bank may be required to reorganise its operations as a corrective action, if insolvency is imminent, the bank may be required to carry out a radical restructuring. Such a strategy is only worth adopting if there is a real chance of getting the business back on a sound footing in the short term. 32

33. Mergers and acquisitions When a bank cannot on its own resolve its weaknesses, it should consider a merger with, or acquisition by, a healthy bank. This is a private sector resolution technique. 33

34. Mergers and acquisitions (Contd.) Banks (even those that fail) are attractive targets to investors, especially financial institutions, because of their intrinsic franchise value. 34

35. Mergers and acquisitions (Contd.) The advantages of an M&A type solution is that it: Maintains the failing bank as a going concern and preserves the value of the assets (thereby reducing the cost to the government or deposit insurer); Minimizes the impact on markets as there are no disruptions in banking services to customers of the failing bank; and All assets are transferred in an M&A and all depositors and creditors are fully protected. 35

36. Purchase-and-assumption transactions If a private sector M&A is not forthcoming or cannot be arranged, a purchase and assumption (P&A) transaction may be considered. A P&A transaction is one where a healthy institution or private investor(s) purchases some or all of the assets and assumes some or all of the liabilities of a failed bank. 36

37. Purchase-and-assumption transactions (Contd.) P&A transactions in most countries require withdrawal of the bank licence and the commencement of resolution proceedings by the liquidator. The acquiring bank purchases assets of the failed bank but not its charter. 37

38. Purchase-and-assumption transactions (Contd.) The P&A type solution has the following benefits: saves the value of the assets of the failed bank (thereby reducing the resolution cost); minimises the impact on the market by returning assets and deposits to normal banking operations with the acquiring bank quickly. It can typically be completed over a weekend; and 38

39. Purchase-and-assumption transactions (Contd.) customers with insured deposits suffer no loss in service and have immediate access to their funds at the acquiring bank if the P&A transaction can be completed over the weekend. 39

40. Bridge bank A bridge bank is a resolution technique that allows a bank to continue its operations until a permanent solution can be found. The weak bank is closed by the licensing authority and placed under liquidation. 40

41. Bridge bank (Contd.) A new bank, referred to as a bridge bank, is licensed and controlled by the liquidator. The liquidator has discretion in determining which assets and liabilities are transferred to the bridge bank. Those assets and liabilities that are not transferred to the bridge bank remain with the liquidator. 41

42. Bridge bank (Contd.) A bridge bank is designed to “bridge” the gap between the failure of a bank and the time when the liquidator can evaluate and market the bank in such a manner that allows for a satisfactory acquisition by a third party. It also allows potential purchasers the time necessary to assess the bank’s condition in order to submit their offers while at the same time permitting uninterrupted service to bank customers. 42

43. Use of public sector monies in a resolution Public funds are only for exceptional circumstances. Public funds for the resolution of weak banks may be considered in potentially systemic situations, including the risk of loss or disruption of credit and payment services to a large number of customers. Government support may take the form of financial inducements to facilitate a resolution measure. 43

44. Closure of the bank: Depositors pay- off If no investor is willing to step in to rescue the bank, the repayment of depositors and the liquidation of the bank’s assets are unavoidable. In countries with a deposit insurance scheme, closure of the bank and depositor pay-off is also the right decision where a depositor pay- off is less costly than other resolution measures. 44

45. Management of impaired assets In all resolution techniques, unless all of the assets of a weak bank are acquired by another institution, there will be a large amount of impaired loans and other bad assets that needs to be managed. 45

46. Management of impaired assets (Contd.) Asset recovery should aim to be economic, fair and expeditious, with a view to maximising the recoveries on a net present value basis. 46

47. Management of impaired assets (Contd.) Recovery of impaired assets can be done through direct collection (foreclosure of assets of debtors, especially from large debtors) or sales of assets to third parties, or by handling the assets (e.g. through debt work-outs) to prepare them for later sales. 47

48. Public disclosure of problems An important issue is whether, and at what point, the bank, the supervisor, central bank or perhaps the government, should comment publicly on problems faced by a weak bank. As a general rule, disclosure should be favoured to the extent legally permissible and required. 48

49. Public disclosure of problems (Contd.) The overriding consideration in the choice of timing and content of the disclosure must be how they contribute to resolving the weak bank, while maintaining overall confidence and systemic stability. 49

50. Summary of this session SECTION 6 – Systemic Banking Crisis – Indicators of Banking Crisis – Others Causes of Banking Crisis – Fundamental Factors behind most Crisis – Crisis Containment Policies – Policy responses for Resolution – Crisis Containment Tools – Policy resolution Approaches – Guiding principles for bank resolution policy – Resolution Techniques 50

51. THANK YOU 51