What is bank resolution?

‡ The actions taken by the competent public institutions to solve the situation of an unfeasible bank. ‡ Sometimes leads to deposits being paid-back and the withdrawal of the bank´s license, BUT not always the optimal solution«

Possible situations of a bank
Point of no Return

Risk of insolvency
Some weaknesses Normal operations

Unviable Bank

Measures

Corrective actions

Regularization Plan

Resolution

‡Failure of a single financial institution can spillover through the interbank marketing triggering a liquidity crunch and the fire sale of assets (selling at distressed prices or paying for liabilities high interest). .Why proper Bank Resolution is critical? ‡ Standard business resolution procedures (any equivalent to US chapter 11 or chapter 7) are too slow and unpredictable.

‡Signals a correct system of incentives to the rest of players (moral hazard issue). bondholders and shareholders resources (cost of resolution & assets value). .Why proper Bank Resolution is critical? ‡Banking system is critical for the economic system: 1) Processing of payments 2) Provision of credit 3) Transmission mechanism of monetary policy ‡Has consequences on the depositors.

2. the supervisor finds a single institutions in trouble.Understanding the common condition of the troubled banks: ‡Two situations are possible: 1. ‡But a common cause: An unexpected decrease of asset values (loans) which causes a sudden decline in the capital of the financial institution. Normal situation Equity Deposits Bondholders Other Debt Distressed Bank Equity Deposits Bondholders Other Debt Write-off against which liability? Write-off Loans (assets) Loans (assets) . the whole financial system is weakened.

What is critical are not the causes but the situation of the financial system: ‡Supervising institutions tend to choose the appropriated solution based in the scale and scope of the problem in the financial system. is irrelevant for choosing the resolution alternative. Bank 1 Bank 2 Bank 4 Bank 5 Bank 1 Bank 2 Bank 4 Bank 5 Bank 3 Bank 3 Scenario 1: We have a relative small problem (close the bank) Scenario 2: We have a BIG problem (we cannot close the banks. systemic resolution solution needed) . ‡What caused the problem is left for posterior analysis. ‡The focus of the supervisor is to return the financial system to the previous status quo: loans flowing and depositors trusting banks.

Basel Supervision Committee Recommendation (September 2009) Living Wills: Planning in advance for orderly resolution ‡A living will is a contingency plan for any systemically important crossborder financial institutions. ‡A living will should provide a plan to address the actions needed during a severe financial distress or financial instability. .

‡The plan goal should aim to preserve the firm as a going concern. promote the resiliency of key functions or facilitate the rapid resolution should that prove necessary. . ‡Take into account cross-border dependencies. implications of legal separateness of entities for resolution and the possible exercise of intervention and resolution powers.Basel Supervision Committee Recommendation (September 2009) ‡The living willµ plan should be proportionate to the size and complexity of the institution.

3 basic alternatives for Bank Resolution 1 Continued operations with some restrictions Bank carries high systemic risk Unfeasible Solvency YES NO 2 Forcing a merger with other institution YES YES 3 Closure of operations NO YES .

Goals: ‡ To dispose orderly troubled assets (to obtain its fair market value and not a distressed value) ‡ To generate profits from general operations to charge off losses Tools: ‡ Passive monitoring (management has autonomy to implement turn around plan) Moral Hazard.1 Forbearance and hope Dependent on: ‡ Supervisor giving high probabilities to the troubled bank to solve its problems if given enough time. monitoring it actively. . ‡ Active monitoring. central bank submits a strict plan for recovery.

‡Moral Hazard (management is not punished) . ‡Preserves bank operations.1 Forbearance and hope Remedial plan is presented Supervisor monitors developments Time allows bank to solve problems Advantages ‡No cost for taxpayers. Disadvantages ‡Situation can turn out worse (and more costly) than initially assesed.

. Tools: ‡ Capital infusion through discount window or direct loans. ‡ To provide discretionary help to the troubled bank through indirect guarantees.2 Open bank assistance Dependent on: ‡ Supervisor thinks bank´s insolvency is not management´s fault ‡ Problem can easily be solved by an accounting recognition and a capital injection. ‡ Equity or debt raising with lower interest rates using government guarantees. Goals: ‡ To maintain management as it has better information about how to solve the problem.

2 Open bank assistance Advantages ‡Avoids the costs of a bank closure. Disadvantages ‡Costly for the supervisor (fiscal and monetary impact). ‡Preserves bank operations. ‡Moral Hazard (management is not punished) .

Tools: ‡ Government technical experts take control of day to day operations. Goals: ‡ To return the bank to a healthy position attractive enough to find a merger candidate. ‡ Banking industry experts are hired to turn around the troubled bank (preferred solution) .3 Government intervention Dependent on: ‡ Supervisor thinks bank´s insolvency is management´s fault or is incapable of a turn around.

‡Moral Hazard (management is not punished) .3 Government intervention Advantages ‡Avoids the costs of a bank closure. Disadvantages ‡Costly for the supervisor (fiscal and monetary impact). ‡Preserves bank operations.

Tools: ‡A major capital infusion from the Government.4 Nationalization of the institution Dependent on: ‡ Balance sheet problems so severe that a partial intervention is not helpful. . ‡ Potential buyers are not willing to take the risk. Goals: ‡To maintain the bank as a going concern given its critical importance. ‡ Systemic importance for the financial network.

‡Preserves bank operations.4 Nationalization of the institution Advantages ‡Avoids the costs of a bank closure. . Disadvantages ‡Costly for the supervisor (fiscal and monetary impact). ‡Bank could be affected by a hidden agenda (ineficiency).

Tools: ‡Auction process. ‡Integrate depositors and other liabilities (different from shareholders) inside a healthier and better managed bank. .5 Merger with other banks (induced by authorities) Dependent on: ‡ Potential to improve the balance sheet before auction process. ‡Good bank-bad bank solution to isolate worse assets of the bank. ‡ Systemic importance for the financial network. Goals: ‡Retain some of the franchise value.

5 Merger with other banks (induced by authorities) Advantages ‡Preserves bank operations. Disadvantages ‡May cause problems to acquiring bank. ‡Moral Hazard .

‡Good bank-bad bank solution to isolate worse assets of the bank. Tools: ‡Auction process together with some type of guarantee from the Government to cover troubled assets losses. ‡Integrate depositors and other liabilities (different from shareholders) inside a healthier and better managed bank. Goals: ‡Retain some of the franchise value. ‡ Other private banks willing to buy the bank´s assets. .6 Purchase and assumptions Dependent on: ‡ Balance sheet with many troubled assets but some assets still can have a profitable fair value.

‡Requires skills. political will and guidelines.6 Purchase and assumptions Advantages ‡Minimizes cost of resolution (preserving asset´s fair value). Disadvantages ‡Requires voluntary participation of other banks. . ‡Minimizes moral hazard. ‡Small impact on banks operations.

‡Assumes deposits and labor claims. ‡Good-bank operates more efficiently ‡Raises capital more easily and at lower rates.6 Purchase and assumptions (good&bad bank formula) ‡Legal unity is split in two entities: a Good-bank and a Bad-bank . . ‡Funds recovered are paid back through dividends and interest payments. ‡Focuses all efforts at loan recovery and self-liquidation. ‡The key issue is funding the entity (debt can be difficult to place). ‡Assumes rest of liabilities. BAD BANK: ‡Retains non-performing assets. ‡GOOD BANK: ‡Retains well performing assets ‡Assets avoid loosing value through judicial liquidation process.

Tools: ‡Asset disposal plan. . ‡ Which are the liability holders share in the associated loss.7 Closure of the bank and payment of deposits Dependent on: ‡ Taxpayer cost of maintaining the surviving firm Vs the going concern value. ‡ Systemic importance for the financial network. Goals: ‡To use efficiently taxpayers money.

7 Closure of the bank and payment of deposits Bank is closed Deposits are paid Bank is liquidated Advantages ‡The problem is solved ‡No moral hazardmarket discipline Disadvantages ‡Asset fire sales (distressed sales due to liquidation process) ‡Bank´s services and jobs are lost. ‡Potential systemic threat .

‡Political support is needed in order to provide the necessary quantity of resources that the right solution demands. . (unlimited guarantees) ‡It is necessary to provide a clear framework for cross-border bank crisis (relationship among national supervisors. (over the weekend). funding and lenders of last resort).Conclusions on Bank Resolution: ‡ Central Bank supervision and leadership are necessary in order to implement needed actions in a short period of time.

Regulators. regulators are rarely lucky. Interventions aimed at preserving the current institutional structure generally do not achieve the expected outcome 3.Conclusions on Bank Resolution: In each case. forced P & A has the effect of liquidation with government assistance. But. 2. If they do not set off a series of counterproductive incentive effects. a change in the aggregate economy will remedy the financial imbalance. the policy will not achieve its end. or if the economy continues to deteriorate. On the edges these policy options may offer some hope to sustain the institutions· lending capacity and consumer confidence for a short period of time. in the end. all of these options are no replacement for sound bank management and a sound balance sheet. However. they may offer both the regulator and the bank manager time to shore up balance sheets and improve profitability. . as in the Scandinavian case. however. Capital inflow usually follows. Resolution options available to regulators only permit them to delay the effects of a massive asset valuation change on bank structure in the hope of a return to financial viability. often delay action in the hope of a turnaround. If the regulator is lucky. If the banking system can not correct its problems in short order. and merger talks are not far behind. they offer only a little time and often require considerable luck. or if the losses are too large. regulators attempt to limit the impact of the crisis by some form of forbearance. no matter how large. Often. The only sure resolution appears to come from confronting the insolvency directly and addressing its financial implications.. Lessons from the experience: 1. at least in recent history.Costs of intervention are generally larger than anticipated. as was the 29 case in the US Thrift Crisis. as in France. However.

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