Chapter

9. Guidelines for Bank Resolution

Author(s):
Charles Enoch, Dewitt Marston, and Michael Taylor
Published Date:
September 2002
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Author(s)
David S. Hoelscher

A sound banking system is composed of solvent banks, run in a safe and proper manner. Banks that become insolvent and that cannot be rehabilitated or sold should be closed and liquidated as quickly and efficiently as possible so as to minimize disruption to bank customers and to prevent contagion of banking distress to other financial institutions.

The procedures for bank liquidation must be clearly described in the national laws. Because laws differ among countries, universally applicable procedures for bank liquidation cannot be developed. But a number of issues must be addressed irrespective of the legal environment, including the treatment of shareholders, the respective responsibilities of the central bank and the supervisory agency, and the role and responsibilities of the bank liquidator. The necessary steps in the liquidation process can be described even though the legal framework will lay out specific procedures at each stage of the liquidation process. These steps include the initial control and stocktaking of the failed bank, the verification of claims and assets, the valuation and sale of assets, and the distribution of proceeds.

Since 1980, three-fourths of IMF member countries have experienced significant banking sector problems. Banking crises arise because of external factors or from excessive risk-taking by the banking sector itself. These crises jeopardize the overall economic health of a country, distorting resource allocation and impeding financial intermediation.

The supervisory authorities must be in a position to respond to the emergency. They must be authorized to require corrective measures from bank management. If unsuccessful, the authorities must have the authority to close and liquidate the bank.

Bankruptcy laws and practices differ significantly among countries. Areas of difference revolve around whether financial institutions are governed by the general bankruptcy legislation or by special statutes covering the bankruptcy and liquidation of financial entities. Similarly, a country may not have a sufficiently well-developed bankruptcy law. The law may not be precise enough or it may not address issues critical to financial institution liquidation, such as defining the role of owners or limiting the ability of the institution to continue to function after bankruptcy.1

The scope of this chapter is limited in a number of ways. First, the chapter does not seek to propose specific procedures for bank liquidation. Procedural recommendations that are appropriate in one environment may be inappropriate or unworkable in others. Rather, this chapter has two principal objectives: to outline the issues that must be considered when faced with an insolvent bank and to identify practices that are generally considered appropriate in any legal jurisdiction. Second, the chapter does not address bank resolution issues under conditions of systemic banking crises. Resolution techniques may differ in important areas when the entire banking system is facing a financial crisis. Such techniques are outside the scope of this chapter.

Overview of Bank Resolution

A bank is considered insolvent when the value of its assets is less than its liabilities.2 At that point, the agency responsible for the safe and sound conduct of the financial system (usually the supervisor) may take control of the bank to ensure the safe and sound functioning of the financial system.3 Under some circumstances (discussed below) the supervisor may wish to continue working with the existing shareowners and managers to implement a restructuring program. More often, though, the agency closes the bank, withdraws the bank’s license, and disenfranchises the bank’s shareholders.4 When the bank is closed, the shareholders lose their investments. But bank closure does not necessarily mean that bank clients lose access to banking services or that depositors and other creditors necessarily lose their investments. The impact on bank clients and bank creditors depends on a variety of factors, including the financial state of the bank and the resolution technique adopted by the supervisors. Bank closures result in losses to the shareholders but not necessarily losses to others associated with the bank.

A liquidator or receiver must then be appointed to resolve the failed institution.5 The liquidator has a number of options to resolve the now closed bank. The whole bank may be sold to qualified investors or merged with a sound financial institution to be restructured and run as a going concern. Alternatively, the liquidator may seek to split the bank into parts, selling the viable parts to sound financial institutions and liquidating the remaining parts. Failing these alternatives, the supervisors may move to pay off the secured depositors and liquidate the bank’s remaining assets.

Sometimes, the choice between rehabilitation and liquidation is relatively easy. Some banks may not engage in true banking business, may play no role in financial intermediation, or may be so deeply insolvent that rehabilitation is not a viable option. Examples are numerous and could include the “pocket banks” of the former Soviet Union, which were more like treasuries of enterprises than banks. More frequently, it is impossible to tell immediately if a bank can be rehabilitated or not. As a result, the decisions to rehabilitate or liquidate can be made sequentially. The liquidator will first attempt rehabilitation and, if that fails, will liquidate the bank. In this process, there cannot be the presumption that all banks will be rehabilitated, just as there cannot be the presumption that all banks will be liquidated.

Taking control of a bank, either for its restructuring or for its liquidation, requires the introduction of a new authority in the bank. Typically, the supervisory authorities will introduce a receiver or liquidator to evaluate the bank’s condition and decide on a resolution strategy. The functions and the responsibilities of the new authority, as well as its relations with management, shareowners, and creditors, will differ depending on whether the supervisory authorities intend to rehabilitate or liquidate the bank.

The role of the shareholders merits particular attention. The law must identify when shareholder rights are suspended and when such rights may be returned to shareholders or are terminated. In some jurisdictions, for example, shareholders retain important authority throughout the liquidation process, and as a result the liquidation process can be slow and inefficient. Under such circumstances, either the supervisor of an ongoing but failed bank or the liquidator of the failed bank may be forced to work with the shareholders. For that reason, the bank resolution techniques may be differentiated by the role and authority retained by shareholders.

Resolution Options Preserving Bank Shareholders

Supervisors may be reluctant or unable to withdraw a bank’s license and disenfranchise the bank’s shareholders. Supervisors may consider that the deterioration in the bank’s financial conditions was outside the control of the shareholders and the managers, that the bank’s profitability can be quickly reestablished, and therefore that there is no need to take control of the bank. Supervisors may be faced with a systemic crisis affecting all banks in the system, and may be unable or unwilling to close all banks. Alternatively, supervisors may be unable to evaluate fully the true financial conditions of the bank and may wish to examine the bank for a period of time. Under such conditions, supervisors may (1) adopt a policy of forbearance, allowing the bank to continue operations, (2) impose restrictions on the activities of the bank, including limited operations and forced recapitalization, or (3) place a conservator in the bank to evaluate the true financial condition of the bank and determine the appropriate resolution strategy.

Forbearance

If the supervisors believe that a bank in financial distress will be able to resolve its financial difficulties in time (either because of a reversal in external conditions or because of a restructuring program), they may allow the bank’s management time to formulate and implement both financial and operational restructuring without interference by the regulators. During this period of adjustment, the enforcement of existing prudential regulations (primarily capital adequacy but maybe also provisioning and other regulations) is temporarily relaxed. Forbearance is frequently exercised in a nontransparent way, with banks allowed to function without adequate safeguards against risk taking or with time limits imposed on the exercise of forbearance.

Where forbearance has been implicit and unmonitored, success has been rare. Banks have rarely outgrown their financial distress, and the eventual costs of bank resolution have been increased. Assumptions about bank performance are frequently overoptimistic, and measures needed to achieve improvements in bank performance often are not implemented. Where successful, forbearance programs have been explicit and have included careful and continual monitoring of the bank. If the shareholders and managers are unable to fully implement agreed measures, supervisors should move quickly to close the bank and implement resolution programs. A distinction is sometimes made between forbearance and gradualism. Whereas forbearance is exercised by the supervisors without enhanced oversight of the problem banks, gradualism allows banks time to meet all prudential requirements within a program containing safeguards against risk taking. In particular, banks must agree to implement a clear and demanding timetable of reforms.

There are strong arguments against forbearance. It creates the opportunity for continued deterioration of the bank and for contagion to healthy banks, and it may result in increased resolution costs. Concerns about contagion are of particular importance as otherwise sound banks come to believe that they will not be held accountable for unsafe and unsound banking practices. One example of the costs of forbearance is the U.S. savings and loan crisis of 1980-94.6

Monitored Restructuring

Supervisors may opt to establish an explicit monitoring program with existing shareholders. The plans would be a combination of financial restructuring—including recapitalization—-and operational restructuring—including strengthening of internal risk controls and concentration of activities to core businesses. The plans agreed on with the supervisor would include a formal memorandum of understanding that lays out the restructuring measures to be adopted and a timetable for their implementation. The memorandum of understanding might also include a statement that failure to implement the restructuring program will result in the withdrawal of the banking license and the liquidation of the bank.

Under very special circumstances, the government may agree to allow the original shareholders to keep their investment in the bank and even to participate in the recapitalization program.7 This option may be more frequently used in a systemic crisis, where the deterioration in the financial conditions of the banks is generalized and is caused in large part by factors outside their control. In this case, the government may consider that participation with the private sector in the recapitalization of the banking system is less costly than taking over and running all banks in the system.

Conservator

The supervisor may consider that it does not have sufficient information to make a judgment about the true financial conditions of a bank or its future viability. Under these circumstances, the supervisor may suspend bank shareholders and take temporary control of the bank. The objective of a conservator is to preserve the bank as a going concern while reviewing the bank’s financial conditions and implementing rehabilitation measures. Under a conservator, the bank continues to operate. The conservator takes over bank management and is responsible for the day-to-day operations of the bank, as well as for the in-depth analysis of the bank’s financial conditions. Typically, though, the powers of a conservator do not exceed those of management.

Under conservatorship, the rights of the shareholders are suspended and those of the conservator prevail. The consent of shareholders is needed for any action that would normally require their concurrence. For example, conservators do not usually have the authority to restructure the bank, require additional capitalization from shareholders, or sell significant parts of the bank to other financial institutions. A key responsibility of the conservator is to evaluate the prospects of the bank and, if warranted, prepare a rehabilitation plan. This plan should analyze the current financial situation, identify the source of future earnings of the bank, and indicate the bank’s key client base. In addition, measures for operational restructuring should be described. These might include identifying and proposing appropriate reforms. This plan should be developed in conjunction with the shareholders of the bank (to ensure full agreement with the measures proposed) and approved by the supervisory authorities. The plan should have time-bound performance criteria so that the supervisory authorities can monitor progress in rehabilitating the bank.

The rehabilitation plan should include measures for the financial restructuring of the bank, including how the bank will be recapitalized and how it will remain liquid. Shareholders should be expected to invest additional funds. In recapitalizing, debt-to-equity swaps should be considered, to possibly strengthen the capital position of the bank. Not all creditors are likely to agree with recapitalization, however, raising the possibility that a small minority of creditors could prevent bank rehabilitation. Some countries therefore permit the majority of creditors (which must be defined in the law but may be two-thirds or three-fourths of the creditors) to make the recapitalization plan binding on all creditors (a cram-down provision).

The costs of a conservatorship can be substantial. Depositor confidence may erode in the face of a conservatorship, and interbank markets may disappear. Accordingly, conservatorship is generally imposed only for a short period of time. Once an appropriate rehabilitation strategy is agreed among the conservator, the supervisory authorities, and the shareholders, responsibility for managing the bank should be returned to the shareholders.

Resolution Options for a Closed Bank

If the existing shareholders and the managers of a bank are unable to reverse the bank’s financial deterioration, the supervisors should withdraw the bank’s license, write down or eliminate the shareholders’ equity holdings in the bank, begin resolution proceedings, and appoint a liquidator or receiver. While the closure of the bank means that the shareholders lose their investment, it does not necessarily mean that the clients of the bank or the creditors (including the depositors) lose. The liquidator has a variety of resolution techniques available. The distribution of the costs depends on the underlying condition of the bank and the resolution technique adopted by the agency responsible for the resolution of failed banks.

Role of the Liquidator

The first step in the resolution of a closed bank is the appointment of a liquidator or receiver of the failed institution. The objective of the liquidator is not to manage the bank but to ensure the greatest return to creditors, including the depositors. The liquidator has full control of the bank, with the authority to sell and transfer some assets to another institution, to sell fixed assets, and to negotiate settlement with the creditors. The law may grant the liquidator special authority to repudiate some contracts considered burdensome and to temporarily halt litigation.8

Once the liquidator takes control of the bank, the rights of the shareholders are terminated and the liquidator is given the freedom to restructure the bank and transfer the bank’s business to other financial institutions. At the same time, the shareholders often have the right to contest the actions of the supervisory authorities in courts. The issue that must be clarified in the law is whether the shareholders can reverse the actions of the supervisor. If supervisory actions can be reversed, shareholders can often severely impede the restructuring process.

The liquidator may also be given the authority to halt legal action by creditors. Creditors acting independently can jeopardize the maximization of overall return by seeking to gain immediate advantages through the exercise of their individual legal rights. Equally important, creditors may move too rapidly to allow the liquidator a chance to sell the bank as a going concern. A liquidator, therefore, must be able to place a “stay” on the exercise of creditors’ legal rights. This authority must be clarified in the law and must be time-bound. The one exception could be treatment of creditors with secured collateral. Requiring such creditors to wait until all or a large portion of bank assets are sold before they are reimbursed would nullify the benefits of being a secured creditor. That said, a short but reasonable stay of secured creditors (e.g., 30 or 60 days) may be appropriate to allow the liquidator to determine the best way to maximize the value of the bank’s assets.

In carrying out these early phases of bank liquidation, the liquidator requires extensive banking skills, such as experience in organizing bank mergers or developing purchase and assumption agreements (see next section). In the final stages of the liquidation, however, the liquidator must have relatively more expertise in the legal and accounting aspects of bank liquidation, including the disposition of both nonperforming and fixed assets. It is perhaps for this reason that, in some jurisdictions, the liquidator process is divided into several stages, the first governed by someone with banking skills and the last governed by someone with a stronger legal background.

Resolution Techniques

Broadly, three techniques for bank resolution can be identified as (1) whole bank resolution, (2) purchase and assumption agreements, and (3) liquidation and deposit payouts. The impacts on bank clients and creditors differ in each case, as do the costs of the bank resolution.

Whole bank resolution

Once the shareholders are removed, one option liquidators often consider is the sale of the bank as a going concern to a third party or the merger of the bank to another financial institution. This option preserves the bank’s franchise value and ensures that the banking services to the community are maintained. If a merger is contemplated, the acquiring institution must be sufficiently strong to absorb the failed institution. Both the sale of a whole institution and a merger may require enhancements of the balance sheet of the failed institution. This might entail the separation of the bad assets from the bank’s portfolio (see below).

In cases of large complex banks that have failed, some jurisdictions permit the establishment of a de novo institution or bridge bank as part of the resolution process. Bridge banks are temporary banking structures designed to take over the operations of the failing institution and maintain banking services for customers. Bridge banks provide the authorities with time to get control over the failed bank’s business, stabilize the situation, and determine the appropriate resolution. Operational costs of the bridge bank are often high, in part because new management may be required. In addition, if the bank’s problems are not quickly solved or, alternatively, if the bank is not quickly closed and resolved, the authorities become responsible for the bank’s subsequent deterioration.

Establishment of a good-bank—bad-bank arrangement is another resolution technique. This allows the supervisors to increase the attractiveness of a bank by transferring the bank’s nonperforming assets to a shell bank or to an asset management company and prepare a clean bank for sale to private investors or for merger with another financial institution. Under these arrangements, the good bank has greater franchise value and is able to operate more profitably than if the nonperforming loans remained on its books.

The structure of the bad bank will depend on the institutional structuring of the financial sector, the extent of the nonperforming loans in the system, and the profitability of the banking system. A bad bank can be established as a subsidiary of the parent bank, a separate bank with its own license, or part of a publicly owned asset management company.9

In marketing a failed institution, the liquidator must develop an information package including financial data on the institution, legal documents, and other requisite documents describing the assets being offered. Bidders must then be invited to participate. The liquidator has the responsibility of ensuring that the bidders have the appropriate skills and the financial capacity to manage the assets. The liquidator also must permit due diligence visits by potential bidders to assess the value of the assets. All bidders receiving information packets or conducting due diligence visits must sign confidentiality agreements stating that they will not disclose or use information obtained from the bidding process for purposes other than evaluating the assets being sold.

Purchase and assumption agreements

If attempts to sell the whole bank or merge the bank with another financial institution are considered unfeasible or fail, a variety of tools are available. The liquidator can bundle performing assets and liabilities for sale in purchase and assumption transactions (P&As). In its most general form, a P&A is a transaction where a healthy bank purchases some or all of the assets of a failed bank; the liabilities transferred include some or all of the deposits and secured liabilities. A P&A transaction can be more attractive to the purchasing bank because the assets and liabilities are clearly defined and the purchaser runs relatively low risk of facing unexpected liabilities. As a result, the demand for such transactions can be higher than for the purchase of a whole bank or a merger with the failed institution. P&As are less disruptive than liquidating the bank and paying off the creditors because customers suffer no break in service and lose no accumulated interest.

Best practices usually require the transfer of as many of the assets as possible, thus returning assets to the market as quickly as possible. A modified form of a P&A is to package homogeneous loans in the expectation that such loans may be easier to market.10 Some categories of assets, such as claims against former directors and officers, are rarely, if ever, included in a P&A; they remain with the liquidator.

A P&A transaction must ensure that depositors are treated appropriately. There is no difficulty if all deposits can be shifted to a new institution or if full deposit insurance exists. When depositors are not fully insured, the authorities can package performing assets and sufficient government securities to match the full amount of insured deposits in the failed bank. The uninsured deposits, then, remain in the failed institution to be paid out using the proceeds from the liquidation of the bank’s assets. If the asset liquidation is insufficient to cover all uninsured creditors, proceeds are distributed on a pro rata basis.

Some P&A agreements allow the purchasing bank to sell selected assets back to the government, commonly referred to as “put-back transactions.” Under some jurisdictions, it would be possible for the bank to “put back” any number of poor or nonperforming loans, thus insuring itself against unexpected or unanticipated reductions in the value of an asset. The bank would remove the nonperforming loan from its portfolio and receive an offsetting cash injection. Such practices would have to be clearly delineated in the bankruptcy legislation and could have a variety of restrictions, including a time limit for implantation and limitations on the size of put-back transactions. Any time limit must be long enough for the acquiring bank to fully evaluate its assets, although not so long as to provide an explicit guarantee against bad management on the part of the purchaser.

Experience with put options has been mixed. The U.S. Federal Deposit Insurance Corporation (FDIC) used such options to increase the attractiveness of failed savings and loans in the late 1980s. It found, though, that significant problems developed.11 First, the acquiring banks were able to “cherry pick” the assets, choosing to keep only those with market values above book values. Second, assets tended to be neglected by the acquirer during the put period, adversely affecting their value. As a result, the full risk of managing the assets remained with the government agency responsible for the resolution rather than with the new owners. The FDIC discontinued the use of put options as a liquidation tool in 1991.

An alternative to the put option is the development of loss-sharing agreements. In these transactions, the supervisor covers the majority of the loss on certain pools of assets but receives the majority of the recovery. The acquiring bank agrees to take the loss on a smaller portion of the assets.

Liquidation and deposit payout

When no acquirer is found for a bank, the liquidator must opt for a general depositor payoff and liquidation of the bank’s assets. In this case, the supervisor closes the bank. No liabilities are assumed and no assets purchased by other banks. The supervisor or the deposit insurer then calculates the deposit balances at the end of the day of business closure. The supervisor or the deposit insurer then pays all insured deposits except those associated with illegal activities, or, if permitted by law, those retained in order to net against delinquent loans. Depositors with uninsured funds and other general creditors may be given liquidator certificates, entitling them to a share of the net proceeds from the liquidation of the failed bank’s assets.

The payout can be made either directly by the deposit insurer or through an agent bank. Paying off depositors directly has some disadvantages. Depositors must go to the authorities in charge to receive their check. Long lines and pressures on available staff may result. Reliance on an ongoing financial institution to act as the payout agent for the authorities may address these disadvantages.

Liquidation procedures can take considerable time, and the uninsured creditors may have to wait before they receive any payout. Some jurisdictions respond by making available a portion of the estimated liquidation value of the assets, allowing creditors to receive something immediately rather than after the liquidation is complete (which can take a number of years).

Options for Managing Assets

As the size and number of failed banks increase, it becomes important to develop adequate arrangements to effectively identify such institutions and then liquidate their assets. Agencies may attempt to rely on their own staff for sale of each asset case by case. As the number and value of the assets increase, though, agencies have sought to bundle the assets in a variety of ways. A question that must be addressed is whether the agency can manage to dispose of the acquired assets or whether it is wise to establish a separate asset management company, an institution that specializes in the disposition of assets, by selling them, recovering value by foreclosing on collateral, or restructuring them through negotiations with the creditors.12

Asset management has several objectives. Agencies may seek a prompt resolution of assets in the expectation that swift resolution is essential for restoring access of financial institutions to the market and for enabling the market to assess counterparty risk. Alternatively, the agency may seek to maximize the recovery of assets. A high recovery rate will benefit the creditors of the failed institution and may benefit new borrowers by lowering risk premiums. Maximum recovery may take some time, however. Selling a large portion of the assets at one time may depress market prices. The agency may prefer to wait for a recovery of economic activity before it begins asset sales. The authorities will need to determine the public policy objectives and establish the objectives of the asset disposition process accordingly.

Once the broad parameters for the asset disposal are agreed on, there are several methods for disposing of assets. The authorities themselves can take charge of the valuation and marketing process. They would then conduct some combination of negotiations with individual buyers, negotiations with a group of selected bidders, and public auctions. Each of these three alternatives has advantages and disadvantages. Negotiated sales with individual buyers may be implemented rapidly. Negotiations could even take place with the original borrower, where the liquidator forgives all obligations of a borrower in exchange for some amount of cash, perhaps substantially less than the full amount legally due. Whereas this approach may save time and may result in repayment of both performing and nonperforming loans, it entails substantial risks of fraud. The liquidator would have to ensure that it received an adequate return for any asset sold in this fashion. A requirement, for example, that the central bank board, as the oversight body for the liquidation, approve such agreements would help reduce the risks.

Competitive bidding for assets by a group of bidders selected by the liquidator reduces the risk of fraud and provides protection for the liquidator by precluding subsequent questions about the fairness of the sale process. A private competitive bidding process typically is less expensive and quicker to organize than a public bidding process, but it may not expose the loan to as wide a range of bidders, and thus it may not ensure maximum recovery. A public auction is usually the most time-consuming and costly to organize and conduct, but it attracts the maximum number of potential bidders (bidders should be screened to exclude those not “fit and proper” to own banks or those without sufficient financial resources). The choice among these sale processes depends on a variety of factors, including location and economic conditions.

Rather than deal directly with potential purchasers, the liquidator can contract a third party to liquidate the assets. Three broad types of arrangements have been used. First, the liquidator can hire a private firm to evaluate and market the assets, agreeing to pay cost plus a fixed fee or a percentage of the final sale price. A second alternative is for the liquidator to sell all assets to a third party at a deep discount. This alternative limits government involvement in the liquidation process and gets the assets off the government books quickly; however, the deep discount may well represent a substantial cost. A third alternative may be an agreement to form a joint public/private entity. The assets would be sold to this entity, but the supervisory agency would retain some influence over the process. The final arrangement depends on the structure of the market, the availability of such third parties, and the objectives of the supervisory agency.

Steps in Resolution of a Failed Bank

Intervention in a failed or failing bank requires careful planning. The specific steps must be developed in line with the laws and regulations of each country. But a generalized description of issues to be addressed can be developed.

After the supervisory authorities have decided to close a bank, they should follow certain procedures that are outlined below. A step-by-step list for the first few days of liquidating a bank is shown in the Appendix.

Preparatory Steps

When a bank is suspected of failing or being insolvent, a team of supervisors may be placed in the institution to monitor and evaluate the situation. The team should evaluate the assets and liabilities of the bank, monitor bank operations, and prepare updated financial statements. It should also monitor the use of the physical and liquid assets of the bank, because asset stripping often becomes a serious concern once a bank is suspected of insolvency. Physical assets can be removed and liquid assets can be transferred. If the inspectors identify unusual activity, especially in foreign accounts, the central bank or supervisory authority should be notified immediately so that actions to freeze the assets and to close the bank can be accelerated.

If the owners or the management of the bank are not cooperative, the supervisory authorities should be given the responsibility to appoint a conservator to take over the bank’s operations until a final disposition of the bank is decided. If efforts to resolve the bank’s financial problems are unsuccessful, the bank should be closed and its operations taken over by a liquidator. At that point, the owners should lose their equity investment in the bank.

The interveners, be they conservators or liquidators, must be accountable to the central bank or the agency that appointed them or to the court. Some estimate of the length of time required for the bank’s resolution should be established and progress in implementing the resolution monitored. Significant slippage must be addressed, either by changing the phasing envisioned in the bank intervener’s contract or by changing intervener. The intervener should be required to submit reports at least every three months to the central bank board or the supervisory agency’s board and, if also required, to a court.

First Step in Liquidation: Physical Control and Stocktaking

If these efforts fail and a decision is made to close the bank, the liquidator must immediately take physical control of the bank’s assets.13 This action involves securing the bank’s premises and equipment using security guards, police, or whatever other means are available. Physical possession must also be taken of valuable items such as cash and securities, automobiles, and artwork. Door locks to the bank premises should be changed and new guards posted so that the liquidator can control access to bank assets and records.

Once the bank is closed, ownership and control over its financial assets shift from the original shareholders, managers, and directors to the liquidator. Shareholders no longer have any control over the disposition of the bank’s assets or liabilities. No new loans can be undertaken, and all resources should be placed in a special liquidation account in the central bank clearly labeled as “Bank [X] in Liquidation.” The liquidator should have the exclusive authority to use the account; the previous shareholders of the bank should not have access to the account.

Special care must be taken with the bank’s correspondent accounts, especially with accounts held in foreign banks, because of their size, liquidity, and vulnerability to unauthorized access. It is therefore critical to notify immediately all financial institutions, domestic and foreign, holding funds in the bank that those funds have been placed in the liquidation account and that withdrawals or transfers can be authorized only by the liquidator. This notification should be made by the most expeditious means possible, such as by fax, telex, or hand-delivery by representatives of the liquidator. It may also be appropriate initially to communicate through a telephone call, notifying that the written communication is forthcoming. If accounts are held in correspondent banks, or if balances are held in foreign accounts, ownership of the assets should be transferred to the central bank. Foreign currency—denominated balances should be held in separate liquidation accounts for foreign currencies.

An additional immediate step in liquidation should be the announcement to the press of the closure of the bank. Generally, a banking crisis is a matter of considerable concern and media attention. Either the central bank or the supervisory agency should take the initiative in such circumstances, announcing the closure and explaining the implications for the banking system. The objective of the announcement should be to create an atmosphere of calm professionalism and to minimize any systemic effect by maintaining confidence in the banking system.

Second Step: Verification of Claims and Assets

Because the liquidator may not be able to rely on existing records, or available information may be out of date, a bank’s creditors should be invited to confirm their claims on the bank. The liquidator must validate these claims, clarifying any inconsistencies. The liquidator should revise the balance sheet, verifying and reconciling correspondent account statements, currency holdings, and equipment lists. Notes receivable must also be verified against balance sheet and subsidiary records.

A bank in liquidation must halt activities, so must not accept any new deposits. All work in the bank, including unprocessed deposits and incoming loan payments, should be posted to the general ledger and subsidiary accounts. A final statement and balance sheets should be prepared. Loan payments received after the bank closure should be recorded in the loan documentation and the payments deposited in the liquidation account in the central bank. At the same time, the liquidator should recognize that the clients of the bank must continue to operate. For example, a small business loan may be secured by furniture and plant equipment, and the business itself may be making its loan repayments on schedule from ongoing business activity. Under such circumstances, it would be imprudent to recall the loan or foreclose on the furniture and equipment because this action would put the firm out of business and eliminate further sources of loan repayment. As a result, there may be value in not calling in performing loans while the liquidator seeks to sell the bank’s loans to another financial institution.

One issue that must be clarified is the continued accrual of interest on deposits held by the bank. Such interest payments may be justified, particularly under conditions of high inflation, which reduces the deposit value. Interest paid, however, would increase the cost of the bank’s resolution. The liquidator, perhaps subject to central bank approval, should have the right to determine an appropriate interest rate under such circumstances.

A clear distinction must be made among branches, affiliates, and subsidiaries. There is no legal distinction between ownership of the assets by the head offices and branches. All branches of a failed bank are part of the bank itself, and the assets of all branches (including the main branch or the head office) should be consolidated in the liquidation account opening statement. The liquidator’s responsibilities are the same for the branch and head office assets. Affiliates are separate legal entities such as companies or banks that are related in some way (normally through share ownership) but that, in legal terms, are not directly affected by the liquidation of a bank.14 If the affiliates are banks, however, they could be indirectly affected by the liquidation of the bank, particularly if the creditors and the depositors are aware of the relationship between the affiliate and the failed bank. In such an instance, affiliated banks could be confronted with large withdrawals and could become illiquid.15 Conversely, if an affiliated bank is closed or encounters difficulties, the parent bank may feel strong pressure to provide financial support.

Subsidiaries are companies in which the bank owns a majority of shares. In this case, the bank’s asset is the stock in the subsidiary company, not that company’s underlying assets. Generally, a liquidator will maximize recovery by allowing the subsidiary to continue as a going concern and to sell its stock.

Third Step: Valuation and Sale of Assets

Valuation of liquid financial assets poses few problems. Notes, coins, and correspondent bank accounts denominated in domestic and foreign currencies have set values. Similarly, items such as stocks and bonds for which there is an established and active market can be rapidly disposed of for a fair value. The liquidator must be aware, though, that if the market for those instruments is thin, the market price of those assets can fall sharply as liquidation begins. Under these circumstances, there may be a trade-off between the speed of liquidation and the resources generated from the asset sale. The mix chosen will depend on a variety of factors, including the state of the banking system, the risks of contagion, the number of unsecured creditors, and the general economic environment.

The most time-consuming and difficult category of financial assets to liquidate is the loan portfolio. Often it is not profitable to spend the time and the effort to identify, assess, and sell every loan. Accordingly, the liquidator may undertake a statistical sampling of the portfolio. Loans can be divided into categories such as real estate or commercial loans. Each loan in each category can then be classified as either performing or nonperforming. To estimate the liquidation value of the portfolio, a sample of loans is then selected from each category for in-depth analysis and evaluation. The estimate of the value for the sample is then applied to the broad subcategory of loans.

If the loan is not classified, it is highly probable that the value of the loan should approximate its principal balance plus interest due (at the time the loan is sold). For these loans, a liquidator can usually find potential buyers (banks or other financial companies) and sell the loans without significant difficulties. Problem credits typically pose significant difficulties, in which case the liquidator may resort to negotiated sales with potential buyers.

The valuation of nonfinancial assets can be more difficult than the valuation of financial assets. Efforts to establish a market value may be complicated, particularly in turbulent or thin markets, and the use of professional appraisers may serve to protect the liquidator in case the sale decisions are questioned. Following the evaluation of nonfinancial assets, the liquidator should make the proposed sale of the assets known to potential buyers. If an asset is sold for substantially less than the estimated value after consideration of all relevant factors, it is recommended that the reasons for such a decision be documented in writing, because the liquidator could later be held accountable.

Fourth Step: Distribution of Proceeds

All creditors, including foreign banks, should be informed when a bank enters liquidation. Creditors could be asked to submit evidence of their claims against the failed bank, or the liquidator could notify them of the amount in the bank’s records. In either case, a cutoff date for the identification and presentation of claims should be established, with claims submitted after that date not honored.

Netting of claims

There must be rules for the netting of the claims of a creditor on a liquidated bank against the claims of the liquidated bank on that creditor. While civil law on netting differs from country to country, some basic elements are as follows: Netting is normally allowed only between claims that have fallen due. Otherwise, proceeds from asset sales may be reduced, thus limiting the ability of the liquidator to repay creditors. The netting of unmatured claims at full value could result in unequal treatment of other creditors, because netted claims are settled in full, while other claims may be settled only on a pro rata basis with resources from the asset liquidation. Also, the claims should be uncontested. Netting of claims does not automatically take place; a declaration of one of the parties addressed to the other is required. Both parties should be authorized to collect and pay the claim.

The claims do not have to be of equal size. The remainder of the larger of the two claims after netting continues to exist as a claim. Netting of bearer claims is also possible. In such cases the bearer paper could, for instance, be signed by the creditor as “paid” and returned to the issuer of the paper. When netting claims are in different currencies, the exchange rate of the day of netting can be used.

Interbank contracts may contain so-called cross-default clauses, implying that default on a loan to one party leads automatically to a repayment obligation with regard to a loan from another party. This could lead to a situation where a loan that would not have been “nettable” becomes subject to netting. Under such conditions, the loan is repaid earlier than originally intended because of the cross-default effect.

The relationship between a bank in liquidation and parties that are closely connected to the bank—such as managers, directors, and shareholders—can be complicated. In general, the deposits of, and loans to, managers, directors, shareholders, and their relatives should not be treated differently from deposits or loans to other parties. If any loan to managers, directors, shareholders, or their relatives is delinquent, the normal collection policies applied to other loans should be followed. But shareholders should not be allowed to net any claims for repayment of their capital contributions with claims of the bank on themselves resulting from a loan agreement or other claim. Repayments of capital contributions are to be considered only if the liquidation shows a surplus (i.e., after all creditors’ claims have been satisfied). It is also conceivable that the bank may still have a claim on the shareholder. This claim should not be netted against capital contributions already paid in or any other claim of the shareholder the bank.

Ranking of creditors

If resources generated by asset liquidation are insufficient to reimburse all creditors, creditors must be ranked in order of priority. The establishment of creditor priorities, in principle, is a matter for national legislation. All fully secured claims are paid first, up to their full value or the value of the security, whichever is lower. Then all liquidation costs are paid. For that reason, the liquidator must have a reasonably accurate estimate of total costs and must ensure that sufficient resources from the proceeds of the sales of remaining assets are preserved. In principle, all unsecured creditors are reimbursed last. If the proceeds from the sales of the bank’s assets do not cover all unsecured creditors (including uninsured depositors), such creditors should be reimbursed on a pro rata basis, and creditors would each receive a percentage of their total claim. The liquidator must be certain to ensure that the claims of each class of creditor are fully met before proceeding to the next category of creditor.

Notwithstanding the above, legislation in some countries provides for preferential treatment of all depositors, or of certain categories of depositors such as households or small depositors, over other unsecured creditors. Under these schemes, depositors are reimbursed up to a certain amount before other unsecured creditors such as holders of bearer instruments or interbank credits. One benefit of such preferential treatment of depositors is that the potential for runs on the banking system is reduced. The decision on deposit preferences is a public policy choice to be reflected specifically in legislation.

If a deposit insurance scheme exists, eligible qualified depositors will be reimbursed immediately upon closure of the bank from the resources of the insurance fund. As the bank is liquidated, the insurance fund may be given preferential treatment and reimbursed up to the amount it paid to depositors. This treatment would help prevent decapitalization of the fund. Under these conditions, other uninsured creditors will be reimbursed next. As noted, shareholders should be reimbursed for their capital investment only after all other creditors have been satisfied.

Bank liquidations can take considerable time.16 Because of this possibility, the central bank may ensure that unsecured creditors periodically receive partial payment, rather than having to wait until the entire liquidation process is completed. Partial payments should be based on the estimated recovery value of the assets under liquidation. In most cases, for example, a significant portion of the assets of the bank can be liquidated and distributed to creditors within the first year following the bank’s closure.

The role of the central bank must be carefully considered. One option is to treat the central bank like any other creditor. If its claims are collateralized, it would be immediately reimbursed. For noncollateralized claims, it would stand with all other nonsecured creditors. Alternatively, the central bank could hold a privileged position, receiving full reimbursement before other unsecured creditors. Although the second alternative may strengthen the financial position of the central bank, this procedure increases the costs to other creditors and could be viewed as unfair by other nonsecured creditors.

The use of reserves held in the central bank as collateral raises similar issues. Typically, there is no contractual or legal basis for treating reserves as loan collateral. Reserve requirements are not generally imposed to serve as a source for collateral, but rather as a monetary or prudential tool. Moreover, reserves are not related to a particular central bank loan, but are related to the deposit base of the bank. Beyond this, the prudential function of reserves would be illusory if reserves cannot be used to meet the needs of the creditors of the bank in case of liquidation. Because the use of reserves to offset central bank claims on the liquidated bank reduces proceeds for other creditors, it breaches the principle of “equality of creditors.” For these reasons, central banks should not net reserves against claims of a failed bank, but rather should require other forms of collateral when lending to commercial banks.

Finally, the law should state that the central bank will not assume any responsibility in case the proceeds from the sale of assets are insufficient to meet the claims of some or all creditors. The law should also make clear whether the government will assume any such responsibility. The lowest-cost option is for the government not to be involved and to return to the creditors only the realized value of a bank’s assets.

These procedures for bank liquidation—the initial stocktaking, the verification of claims and assets, asset sales, and the distribution of proceeds—must be fully supported by the legal status of the country. The status covering such steps is often found in several laws, including the law on banks, the law on the central bank, the civil code, and the bankruptcy laws. Not only must the individual laws be clear and unambiguous, they must be consistent among themselves. While the specifics of the bank resolution may differ among countries, the issues covered above need to be addressed if the resolution process is to be efficient and complete.

Appendix: Initial Steps upon Closing a Bank

The first hours of a bank closure are of particular importance. Steps must be taken immediately to secure the bank, prevent employees or shareholders from gaining unsupervised access to bank assets, and protect credit interests. The following checklist provides a guide for activities in the first day of bank liquidation:

  • Take physical control over bank premises.

  • Pick up keys from all employees.

  • Ensure that all doors are locked.

  • Count cash and cash items and then seal.

  • Count travelers’ checks and any liquid securities and seal.

  • Seal the bank’s insurance policies, board minutes, and audit accounts.

  • Do not allow employees to put the vault under a time lock.

  • Seal collateral, trust accounts, credit files, notes, and charged-off loans.

  • Keep one person controlling access to the vault until security guards are in place or until locks and combinations have been changed.

  • Call a locksmith and security guards.

  • Notify the post office and change combinations and address.

  • Notify utility companies.

  • Notify correspondent bank accounts and follow up with a fax or telegram.

  • Notify courier services.

  • Check on bank property not on the premises, including cars and credit cards.

  • Notify the bank’s attorney. If the attorney has any documents or notes belonging to the bank, these should be returned.

  • Post notices of closure on the entrance door.

References

    EnochCharlesGillianGarcia andV.Sundararajan2001“Recapitalizing Banks with Public Funds: Selected Issues,”IMF Staff PapersVol. 48No. 1 pp. 58110.

    Federal Deposit Insurance Corporation1998Managing the Crisis: The FDIC and RTC Experience 1980-1994 (Washington: FDIC).

    FrécautOlivierKennethSullivan andJ.W.van der Vossenforthcoming“Bank Equity and Its Measurement,”IMF Working Paper (Washington: International Monetary Fund).

    SchiffmanHenry1997“Legal Measures to Manage Bank Insolvency in Economies in Transition,”paper presented at the EBRD conference on Bank Failures and Bank Insolvency in Economies in TransitionLondonOctober.

    WooDavid2000Two Approaches to Resolving Nonperforming Assets During Financial Crises IMF Working Paper No. 00/33 (Washington: International Monetary Fund).

The author is grateful for helpful comments and assistance from Warren Coats, Carl-johan Lindgren, Greta Mitchell, Jan Willem van der Vossen, and Henry Schiffman.

For a discussion of these issues, see Schiffman (1997).

For a detailed discussion, see Frécaut, Sullivan, and van der Vossen, “Bank Equity and Its Measurement,” forthcoming Working Paper.

The agency responsible for intervention varies among countries and may include the bank supervisor, the deposit insurer, or some other agency that has adequate legal authority.

In civil law countries, the shareholders frequently cannot be disenfranchised. Accordingly, the supervisors must have the authority to write down the value of the original shareholders’ equity to a nominal sum (such as US$1).

The terminology used in bank rehabilitation varies among jurisdictions. Liquidators may he referred to as hank receivers.

FDIC (1998, p. 25).

Such authority must he specified in the laws governing the liquidator because the liquidator may be liable for damages.

The good-bank-bad-bank split may also be used by open banks, either as part of their own restructuring efforts or as part of the public sector’s efforts to deal with a systemic crisis.

P&A transactions can become quite specific. Distinctions can be made among total P&As, small loan P&As, P&As involving only guaranteed deposits, and other arrangements. The objective is to design a package that maximizes the probability of sale.

FDIC (1998, p. 15).

For recent discussion of asset management companies, see Woo (2000).

If the bank is already under the control of a conservator, the liquidator will take over responsibility for the bank from the conservator.

Of course the closed bank’s assets held by the affiliate must normally be liquidated.

When confronting the closure of a bank with one or more affiliates, it is wise in the preparation phase to plan for the contingency that affiliated banks also may fail.

Some bank liquidations have taken in excess of 10 years because of complex legal issues involved with the closure of a bank.

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