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Legal Aspects of Regulatory Treatment of Banks in Distress   Legal Aspects of Regulatory Treatment of Banks in Distress

Tobias M.C. Asser

©2001 International Monetary Fund
April 19, 2001

Scope of the Report
Forced Liquidation and Restructuring of Banks:
  Differences Between Bank Insolvency Law and General Insolvency Law
I.    General Policy Considerations
1.    Special Treatment of Banks
2.    Institutional Framework
3.    Incidental Versus Banking System Problems
4.    The Corrective Effects of Market Forces
5.    Liquidity Support Provided by the Central Bank as Lender of Last Resort
6.    Prevention
II.    General Legal Considerations
1.    The Law Governing Banking Activities
2.    International Aspects
3.    General Protection for Banks: Principles of Administrative Law
4.    Special Protection for Banks: Provisions of Banking Law
5.    Review of Regulatory Acts
Principal Objectives To Be Pursued by Law
III.    Regulatory Intervention: Common Issues
1.    Categories and Objectives of Regulatory Intervention
2.    Discretion of Regulators Under the Law
3.    radation of Regulatory Intervention
4.    Timeliness of Regulatory Measures
5.    Reporting and Disclosure Requirements
6.    Financial Costs of Regulatory Intervention
Principal Objectives To Be Pursued by Law
IV.    Corrective Action: Common Features
1.    Authority to Take Corrective Action
2.    Grounds for Taking Corrective Action
3.    Corrective Action Plans
V.    Corrective Action: Categories
1.    Choice of Corrective Action
2.    Corrective Agreements, Warnings, and Orders
3.    Appointment of Observers and Inspectors
VI.    Exceptional Financial Support to Insolvent Banks
VII.    Special Moratorium on Debt Service by Banks Under the Banking Law
1.    General Observations
2.    Judicial Moratoria
3.    Extrajudicial Moratoria
4.    Entry into Force and Termination of Moratoria
Principal Objectives To Be Pursued by Law
VIII.    Taking Control of a Bank Under the Banking Law: Common Issues
1.    Survey of Procedures
2.    Bank Administration Procedures
3.    Issues Common to Bank Administration Procedures
4.    Regulatory Administration Versus Judicial Administration
IX.    Provisional Administration Under the Banking Law
1.    General Issues
2.    Appointment of a Provisional Administrator
3.    Legal Effects of the Appointment of a Provisional Administrator
X.    Receivership Under the Banking Law
1.    General Issues
2.    Appointment of a Receiver
3.    Legal Effects of the Appointment of a Receiver
XI.    Bank Resolution Procedures Used in a Banking Law Receivership
1.    Principal Procedures
2.    Bank Merger
3.    Purchase and Assumption Transactions
4.    Forced Bank Liquidation
XII.    Revocation of the Banking License
1.    Grounds to Revoke the Banking License
2.    Authority to Revoke the Banking License
3.    Legal Effects of Revocation of the Banking License
Principal Objectives To Be Pursued by Law
XIII.    Taking Control of a Bank Under General or Special Insolvency Law
1.    General Issues
2.    Special Bank-Related Features of the General Insolvency Law
Principal Objectives To Be Pursued by Law
XIV.    Banking System Restructuring
1.    Overview
2.    Institutional and Functional Features
3.    Legal Aspects
Principal Objectives To Be Pursued by Law

I.   Overview
During the last two decades, the deregulation of domestic and international banking transactions and the growth of national and international capital markets have had profound effects on the business of banking.

In many countries, domestic capital markets drew both borrowers and depositors away from banks, forcing banks to replace traditional forms of relationship banking with a broad array of financial services and to supplement their funding from traditional forms of deposit with funding from financial markets.   These developments required a reappraisal of bank regulation and supervision to protect domestic financial sectors from the new systemic risks that they pose.   

Banks have played a crucial international role in the unprecedented growth of cross-border capital flows, especially to emerging markets.    This has led to a continuing financial integration of national economies, which has brought many benefits, including dramatic increases in global investment and consumption that have stimulated global trade and prosperity.    However, there is a downside to this expansion of international banking activities: it has facilitated the spread of domestic financial problems throughout the international monetary system.   By intermediating international capital flows, banks have created a global web of financial interests.    This has made banks conduits for the transmission of domestic economic problems around the globe.   Consequently, it has become more difficult than in the past to contain economic problems within the borders of the countries where they originate.   Central to this transmission mechanism is the fact that many of a bank's foreign counterparties are banks.   When weaknesses in one country's banking system translate into defaults on international financial obligations, the financial condition of creditor banks in other countries may be affected.   Ultimately, this can cause a general loss of confidence on the part of investors and precipitate a steep fall in exchange rates and a national economic crisis.   In some cases (Indonesia, Russia), the collapse of domestic banking systems worsened the effects of these crises, impeded debt workouts, and postponed the resumption of international capital flows to the countries concerned.   

One of the lessons learned from these disasters is that building and maintaining the confidence of domestic and foreign investors requires a credible bank regulatory system that closely supervises banks, strictly enforces banking law, helps restore ailing banking institutions to financial health, and expeditiously expels insolvent banks from the financial system.   Such regulatory pruning or weeding helps preserve and promote vigor and growth in a financial system.   It removes incentives for weak institutions not to comply with prudential regulations and helps thereby to eliminate unfair competition resulting when noncompliance with prudential requirements permits banks to benefit from a lower regulatory cost base than banks that do comply.   

Another lesson learned is that creditor banks share in the blame for economic crises in foreign debtor countries when their irresponsible lending practices contribute to the buildup of excessive external debt.    Thus, in recent years, several international currency crises found part of their origin in excessive foreign currency loans by international banks to foreign corporations ill suited to hedge inherent foreign exchange risks or to foreign banking institutions plagued by serious structural weaknesses.   Therefore, where banking supervision is intent on the avoidance of domestic financial crises and on containing the adverse effects of such crises on foreign banks, it should address not only the international borrowing but also the international lending practices of banking institutions.   

Finally, experience has taught that effective prudential regulation of banks participating in an international monetary system of growing complexity requires internationally uniform prudential standards that are strictly enforced by qualified and autonomous bank regulators in close cooperation with their foreign counterparts.   

Scope of the Report

This book discusses legal aspects of the regulatory treatment of banks1 in distress.   Banks in distress should be distinguished from banks that are merely weak.   "Banks in distress" are defined as banks that are not in compliance with prudential banking law.   

This book's main objective is to analyze and to compare the laws of selected industrial countries that may be regarded as representative for different approaches to the treatment of banks in distress.   As the book focuses on legal aspects, it addresses only those banking and economic policy issues required for a proper understanding of the banking law or the legal strategies, procedures, and practices that have evolved in the treatment of banking problems.   In doing so, the book does not intend to take positions on banking or economic policy issues, except where these are questionable in light of legal principle or law.   

To protect banks and banking systems against the risk of international financial contagion, bank regulators around the world have embarked on an extensive program of harmonizing prudential banking standards among countries and fostering closer cooperation between national bank regulators.   Particularly notable are the Core Principles for Effective Banking Supervision issued by the Basle Committee on Banking Supervision in September 1997 (hereinafter "the Basle Core Principles") and the G-22 Working Group Reports on the International Financial Architecture, issued in October 1998.   It is fair to say that, as a result, the principal licensing and prudential requirements written into national banking laws have reached a high degree of uniformity.   One of the reasons for this success is that it has been comparatively easy to identify best practices for these requirements.   

In contrast, little international uniformity of law or practice exists in the area of banking regulation governing the treatment of banks in distress.   This area of banking regulation is marked by a rich variety of regimes.   Although this book may discuss advantages and disadvantages of these regimes, it avoids rating them, mainly because each appears to reflect a distinct legal tradition defying a value judgment.   The book does identify what may be regarded as essential best practices—in the form of principal objectives at the end of book sections—but only for such general norms as rise above these differences.   

The book does not attempt to identify which of the practices described would be more or less suitable for countries in different stages of socioeconomic development.   In theory, at least, such choices could be made.   For instance, there may be practical reasons for avoiding judicial involvement in bank insolvency in countries with a weak or corrupt judiciary, in exchange for alternative procedures for the review of decisions of bank regulators, provided that such alternative procedures afford banks and bank creditors reasonable protection from regulatory abuse.

In the treatment of banks in distress, the concept of best practices is therefore perceived as a relative concept indicating that best practices differ from country to country, depend on a country's legal and other social traditions, and progress with a country's development: what is best for one country is not necessarily good for another.

The book addresses bank regulation by bank regulators.   However, in countries with a bank deposit insurance agency, the responsibility for the prudential regulation of banks is often shared with the deposit insurance agency where the law gives that agency a role in the rescue or resolution of banks in distress.   Therefore, generic references in this book to the bank regulator and to banking law are meant to include references to the deposit insurance agency and deposit insurance law.

In some countries, banks are permitted to engage in activities submitted to the prudential oversight of agencies other than the bank regulator, such as securities or insurance regulators and self-regulatory organizations.   Usually, the law provides such agencies with their own regime of prudential supervision and powers to impose corrective measures or punitive sanctions.   The book does not cover such measures and sanctions or the interaction between the bank regulator and such other agencies where it concerns laws or regulations that the other agencies are exclusively charged to enforce.

The book's conclusions and recommendations apply primarily to banks.   They may, however, be applicable to other financial institutions.   For instance, banks are not the only financial institutions to cause systemic risk that must be addressed.   There have been instances in which support, usually preserved for banks, was extended to non-bank financial institutions whose precarious financial condition posed risks to the banking system; examples are the liquidity support provided to stock exchange specialists during the stock market crash of October 1987 in the United States and the meeting of creditors held under the auspices of the New York Federal Reserve Bank in the summer of 1998 to organize supplemental funding for the Long Term Capital Management hedge fund.   For reasons of economy, this book does not address the treatment of nonbank financial institutions, even though some of the book's findings and conclusions may apply to those institutions as well.

This book begins where prudential enforcement gives way to corrective action.   It is organized as a progression from noncompliance with prudential requirements and early signs of financial distress to insolvency, from relatively simple corrective measures to receivership culminating in revocation of the bank's operating license and closure of the bank.

The book has a domestic focus.   There is no international bank regulator, as yet.   Bank regulation and supervision, including the response to banking problems, is still largely a national endeavor.   Even in the European Union, notwithstanding monetary union, the prudential supervision of financial institutions remains decentralized and is carried out by national agencies.   This book assumes that corrective actions concerning banks with international activities are governed by rules of the Basle Committee of Bank Supervisors assigning responsibility for banking supervision among national regulators.   It does not cover international aspects of bank insolvency.2

Forced Liquidation and Restructuring of Banks: Differences Between Bank Insolvency Law and General Insolvency Law

This book follows the report on Orderly and Effective Insolvency Procedures: Key Issues, of the Legal Department of the International Monetary Fund published in 1999 (hereinafter "the Insolvency Report").   Therefore, and because in many countries the forced liquidation of insolvent banks under receivership is subject to materially the same insolvency rules as other enterprises, this book does not cover in detail the rules and procedures governing the forced liquidation of insolvent banks.   Often, however, the law makes exceptions for banks to the general insolvency law; the most important of these are discussed.3 As in some countries insolvent banks may be submitted to a receivership including forced liquidation under the banking law, the book includes a brief discussion of this treatment.4

Although in many countries the general insolvency law includes gen-eral rehabilitation provisions that may apply to banks, the banking law of several countries also includes a special regime for the restructuring of banks, often under control of the bank regulator.   Even though, in most of these countries, the broad policy objectives served by rehabilitation provisions of general insolvency law are similar to those pursued by special bank restructuring law, there are some fundamental differences between the restructuring of banks under the banking law and the rehabilitation of nonbank enterprises (hereinafter "enterprises") under general insolvency law.5 These include the following.

The first and most obvious difference is that, as a rule, enterprise rehabilitation under general insolvency law is instituted by court order and is carried out under judicial administration.   Bank restructuring, on the other hand, is generally instituted by the bank regulator pursuant to the banking law and carried out under its control, even though in many countries the most invasive aspects of bank restructuring are subject to judicial review or administration.

Restructuring under banking law is a broader concept than rehabilitation under general insolvency law, in both time and functional scope.   Enterprise rehabilitation under general insolvency law typically commences only if the enterprise has been declared insolvent on the basis of strict statutory standards.   Restructuring a bank, however, may begin at a much earlier stage with corrective measures ordered by the bank regulator as soon as the bank shows significant signs of noncompliance with prudential requirements, even though such corrective measures may end in a court-supervised insolvency procedure including a final effort to rehabilitate the bank under general insolvency law.   In many countries, bank restructuring is part of a continuum ranging from regulatory enforcement of prudential law to receivership.

These differences between enterprise rehabilitation and bank restructuring have important consequences for the protection of rights of creditors and owners under the law.   In a general insolvency procedure, these rights are protected by procedural safeguards written into the law and by judicial administration of rehabilitation and liquidation proceedings.   In bank restructuring, however, fewer safeguards are available as most of it is carried out by the bank regulator without judicial administration.   In several countries, the law grants the bank regulator sweeping powers to take corrective action as required to protect the banking system.   And, even though the bank regulator and its agents, such as provisional administrators and receivers, are subject to principles of administrative law affording bank owners and creditors protection against regulatory abuse, the appeal afforded to bank owners and creditors of regulatory decisions is often time-consuming and does not suspend the regulatory decision under review.   Moreover, even where such agents appointed by bank regulators are experienced and licensed insolvency practitioners, they will not always be familiar with administrative law.

Difficult questions of public policy arise when the public interest in a sound banking sector and the expeditious decommissioning of failing banks that this requires are weighed against the interests of bank owners and creditors and the need to afford a reasonable degree of protection of those interests under the law.   These questions come to a head when a bank becomes insolvent and when measures designed for bank restructuring must be particularly intrusive; in several countries, the law requires the bank regulator at that point to turn the proceedings over to the courts for bank restructuring 6 and ultimately for liquidation of the bank under general insolvency law.

1For the purposes of this book, a "bank" is deemed to be an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account, following Article 1 of the First European Council Directive of 12 December 1977 concerning credit institutions (77/780/EEC) (Official Journal No. L 322/30 of 12/17/77) (hereinafter "First European Banking Directive"), reprinted in Current Legal Issues Affecting Central Banks, ed. by Robert C., Vol. 2 (Washington: International Monetary Fund), 1994, at p. 251. In addition, the meaning of the term "bank" includes any other financial institution that is regulated similarly to banks.
2See on that topic: Mario Giovanoli, and Gregor Heinrich, eds., International Bank Insolvencies: A Central Bank's Perspective (The Hague: Kluwer Law International), 1999.
3See Chapter XIII, below.
4See Chapter XI, Section 4, below.
5To avoid confusion, the term "rehabilitation" will generally not be applied to banks; instead, the term "bank restructuring" will be used throughout the book.
6 England provides an example; see Section 8 of the Insolvency Act 1986, as amended, and the Banks (Administration Proceedings) Order 1989, which makes Part II of the Insolvency Act 1986 generally applicable to banks.