David Mayes Pärnu 12/1/07 AVOIDING BANKING CRISES David G Mayes Bank of Finland and University of Auckland

David Mayes Pärnu 12/1/07

AVOIDING BANKING CRISES

David G Mayes Bank of Finland and University of Auckland


MULTIPLE SAFETY NET REGULATORS AND AGENCY PROBLEMS IN EUROPE: IS

PROMPT CORRECTIVE ACTION PARTLY THE SOLUTION?

With

María J. Nieto

Banco de España

Larry Wall

Federal Reserve Bank of Atlanta


• Motivation• Domestic implementation of PCA

– Key conceptual aspects of PCA

– Institutional preconditions

• Cross-border implementation in Europe– Integrated management of cross-border groups

– Adequately capitalized banks

– Disciplining undercapitalized but viable banks

– Bank resolution

• Conclusions


MOTIVATION

• Structured Early Intervention and Resolution (SEIR) proposed by Benston and Kaufman with a version adopted by the U.S. under the title “Prompt Corrective Action” (PCA) seems to have been an effective response to the problems in the US, which led to extensive losses from failures

• Europe has not gone so far in handling national problems and faces considerable problems for cross-border banks where the issues of intervention, conflict of interest, particularly when there are systemic issues at stake, resolution and burden sharing are hardly on the political agenda. We ask whether applying PCA could help solve the difficulties in the current framework of national home-host responsibilities


MOTIVATION: OUR CONTRIBUTIONS

• Explore the institutional changes needed in the EU if PCA is to be effective in resolving cross-border agency problems that arise in supervising and resolving cross border banking groups

– The goal of a single financial market precludes Europe from adopting a New Zealand style solution to cross-border banking

– But EU directives allow Europe to adopt multilateral cross-border arrangements that would otherwise be very difficult to adopt

• We have intentionally avoided discussing the issue of an EU level supervisor to focus on what is needed to give the existing system its best chance of success


DOMESTIC IMPLEMENTATION OF PCA• PCA adopted in response to US problems

– US supervisors had adequate institutional authority to prevent losses

– But conceptual focus was on preventing failure rather than limiting losses due to failure

– PCA made only small changes in institutional structure but made big changes in conceptual priorities

• Most non-US supervisors not only have the wrong conceptual focus but also lack some of the requisite institutions


KEY CONCEPTUAL ASPECTS: GOAL OF MINIMIZING TAX PAYERS´

LOSSES• PCA rationale is to reduce

– Losses to taxpayers– Resource misallocation by reducing the moral

hazard incentives created by mispriced deposit insurance

• In the EU: The rationale is in line with Directive 94/19/EC on deposit insurance schemes “…the cost of financing such scheme must be borne, in principle, by credit institutions themselves …” (Preamble) and the non-bail out clause and restrictions on monetary financing of the EC Treaty (arts. 101 and 103) are fully compatible.

David Mayes Pärnu 12/1/07CONCEPTUAL ASPECTS OF PCA: LIMITING PRUDENTIAL SUPERVISORS´

DISCRETION

• PCA reduces supervisory discretion to exercise forbearance by establishing a series of capital adequacy tranches with a set of mandatory supervisory actions for each of the undercapitalized tranches

• Potential problem of withdrawing charter of bank that could survive– PCA early intervention intended to reduce risk of

insolvency – PCA requires charter withdrawal at point where any

losses should be small, facilitating restructuring and return to the private sector


CONCEPTUAL ASPECTS OF PCA: BANKS´ CLOSURE AT POSITIVE

REGULATORY CAPITAL

• Rational behind timely resolution:– Reduces banks´ incentives to take excess risk– Limits DI losses

• In EU would reduce any burden to be shared• Key argument against the claim that timely

resolution involves government taking private property:– PCA provides the shareholders with an opportunity to

recapitalize the bank and to test their own assessment about the financial viability of the bank before it is forced into resolution.


CONCEPTUAL ASPECTS OF PCA: BANKS´ CLOSURE AT POSITIVE

REGULATORY CAPITAL

• Most controversial conceptual element of PCA and most difficult implementation

• In Europe, with only limited exceptions, PS have limited legal powers to intervene if a bank becomes critically undercapitalized or its net worth turns negative (Mayes, Halme and Liuksila, 2001).


INSTITUTIONAL PRECONDITIONS FOR PCA SUCCESSFUL IMPLEMENTATION:

INDEPENDENCE AND ACCOUNTABILITY• PCA is an acronym for Prompt Corrective Action

– A requirement for prior judicial or political approval at best results in rubber stamp approval

– Worse, weakens prompt element– Worst, undercuts idea of mandatory intervention

• Key is short-term operational independence combined with long-term oversight– By judiciary of good faith execution of the laws– By the political authorities of appropriateness of actions

given existing law• No EU equivalent to FDIC with clear task

David Mayes Pärnu 12/1/07INSTITUTIONAL PRECONDITIONS FOR PCA SUCCESSFUL

IMPLEMENTATION: INDEPENDENCE AND ACCOUNTABILITY

• European countries generally comply with need for political independence, albeit a few minor issues remain

• Independence from the judiciary varies.– Some countries put the burden of the proof on

the supervisors before they can take remedial action

– Some countries also provide inadequate protection to supervisors for actions taken in good faith


INSTITUTIONAL PRECONDITIONS FOR PCA SUCCESSFUL IMPLEMENTATION: ADEQUATE SUPERVISORY MEASURES

• US supervisors had extensive authority• This difference is crucial to the extent that

political authorities may not follow supervisors´ recommendations.

• Adequacy in EU varies by country (Table 1 of Nieto and Wall)


INSTITUTIONAL PRECONDITIONS FOR PCA SUCCESSFUL IMPLEMENTATION: ADEQUATE RESOLUTION PROCEDURES• Confidence in the resolution procedure is critical if

PS are to enforce timely resolution • Without such confidence, bank supervisors are likely

to resist forcing a bank into resolution because: – Closure would impose costs on society– Political consequences of bank closure particularly if it

severely disrupts the economy • US had well developed techniques that allowed the

continue operation of the bank under new private owners or temporary government control


INSTITUTIONAL PRECONDITIONS FOR PCA SUCCESSFUL IMPLEMENTATION: ADEQUATE RESOLUTION PROCEDURES

• The existing legal framework offers European prudential supervisors two suboptimal options for addressing an insolvent bank: (1) limited provisional administration, which may not

be sufficient to bring about efficient resolution especially if losses exceed owners funds, or

(2) turning the problem over to a bankruptcy court.

• In a cross-border context the problem is multiplied



ACCURATE AND TIMELY FINANCIAL INFORMATION

• Banks threatened by PCA likely to report inflated estimates of the value of their portfolios

• The extent of bank’s ability to overestimate their capital under PCA depends on:

– The accounting rules

– The enforcement of the rules by private auditors and the PS

– If auditors are not strict then PCA depends on the effectiveness of bank examinations by PS

– Yet relying on the supervisors to enforce honest accounting creates a contradiction in PCA



ACCURATE AND TIMELY FINANCIAL INFORMATION

• European accounting rules superior to US rules because they require adjusting valuations to reflect interest rate changes

• Most, but not all, EU supervisors also supplement bank auditing with on-site examinations to verify banks’ reported financial condition.


CROSS-BORDER IMPLEMENTATION IN EUROPE

• US has multiple supervisors acting as agents but a single principal in the form of the US Congress

• EU can have multiple supervisors for cross-border groups but it also has multiple principals– Multiple agents/principals for groups operating

banking subsidiaries/branches across borders– Supervisors should be expected to follow the

interests of their home country


CROSS-BORDER IMPLEMENTATION IN EUROPE

Prudential Supervisor

Deposit Insurance Regulators

Reorganization and Winding-Up

Authority Banks locally incorporated

Parent banks authorized in

home country

Home country authorizing parent bank

(consolidated supervision - solvency)

Home country

Home country

Subsidiaries of parent banks

headquartered and authorized in another EU

country

Home country

authorizing parent bank (consolidated

supervision - solvency) Host country

authorizing the subsidiary

("solo" basis)

Host country

Host country

Branches

Branches of banks headquartered and

authorized in other EU country

Home country of head office (consolidated

supervision - solvency) Host country (liquidity)

Home country (possibility of

supplementing the guarantee by host

country )

Home country

The EU safety net

Source: Garcia and Nieto (2005)


INTEGRATED MANAGEMENT OF CROSS BORDER GROUPS

• Cross-border groups increasingly operate as integrated entities: – Risk management and liquidity management, data processing,

and loan evaluation each centralized in one part of the group– Not all services are necessarily centralized in the same country – No neat structure of a parent and free-standing locally

incorporated subsidiaries but a complex interweaving of branches and subsidiaries that cannot survive on their own

Bank supervision must also be structured for efficient cross-border supervision:

– It implies someone has to be responsible and accountable for a clear objective

– They need the tools and powers to undertake the tasks efficiently and effectively.


CROSS-BORDER IMPLEMENTATION IN EUROPE: ADEQUATELY

CAPITALIZED BANKS• Information sharing is critical for cross-border groups

– US gathers and makes publicly available common quarterly financial statements for all banks and top level BHCs

– EU should do the same (ECB vs CEBS)• Market prices (benefit from the enhanced information

requirements of Pillar 3) could help PCA– Directly as triggers for PCA, at least, for critically

undercapitalized organizations – Indirectly as triggers for increased supervisory scrutiny

including possible consultations with the home supervisor or a meeting of the bank’s college of supervisors


CROSS-BORDER IMPLEMENTATION IN EUROPE: DISCIPLINING UNDER-

CAPITALIZED BUT VIABLE BANKS• Banks and bank problems have unique elements, so

must their solutions• US PCA has large elements of supervisory discretion

(“discretionary provisions”) including whether:– To approve capital restoration plan– To replace certain managers and/or directors– To limit rates on new deposits– To limit growth rates– To divest selected nonbank activities



CAPITALIZED BUT VIABLE BANKS• In the EU, agency conflicts can result in

supervisors of cross-border banks taking action that helps own country but hurts others– Home country forbearance that imposes losses

on host– Home country supervisor demanding corrective

measures where most of the costs are borne in the host country

– Host country disciplinary measures, which impair the subsidiary’s ability to provide vital services to the group


CROSS-BORDER IMPLEMENTATION IN EUROPE: DISCIPLINING UNDER-CAPITALIZED BUT VIABLE BANKS

• The capital requirements directive (Art. 131) provides for some coordination of banks supervision between home and host and allows for the delegation of some supervisory responsibilities to the home country prudential supervisor (subsidiaries)– This does not resolve the agency conflict– Indeed, delegation may worsen the principal-

agent conflict



CAPITALIZED BUT VIABLE BANKS• Alternative is to form a college of supervisors to decide on

discretionary actions – College would make the discretionary decisions under

PCA that would be binding on all supervisors– College must start acting no later than bank violating

the capital standard (previous contacts in the context of CEBS) Resolution vs. Supervision

– Home supervisor likely to take lead in any discussions with the bank (unless problem focuses on a particular subsidiary)

• The college provides a mechanism for all affected Member States to have a voice in the corrective measures´ decision taken under PCA



CAPITALIZED BUT VIABLE BANKS

• The college seemingly implies loss of sovereignty but loss actually occurred with formation of large cross-border groups

• The college does not completely solve the agency problem caused by the mismatch between supervisory powers and supervisory accountability to voters.


CROSS-BORDER IMPLEMENTATION IN EUROPE: BANK RESOLUTION

• No framework of commonly accepted standards of bank resolution practice including a common definition of bank insolvency and a fully-fledged single legal framework or a common decision-making structure

• Bank resolution procedures largely depend on national laws. These national laws often fail to meet many of the requirements for a credible, efficient resolution system


CROSS-BORDER IMPLEMENTATION IN EUROPE:

BANK RESOLUTION

• As a result, the current system in most EU countries relies heavily on (government) recapitalization of large groups– Problem for cross-border groups is “burden

sharing”– Difficulties in agreeing on burden sharing

imply very late, very high cost resolution more likely than timely, low cost resolution



• PCA cum closure rule at a positive level of regulatory capital would reduce or eliminate “burden sharing” problem by requiring bank closure while reported capital is still positive

• Losses will be by definition smaller than in the absence of PCA to the extent that deposits would be backed by assets of at least the same market value, except in the case of rapid decline in asset value, massive fraud or inadequate monitoring by supervisors.



• Mechanics of coordination of banks´ resolution process

– EDIC or resolution agency under mandate might be best

– Formation of a resolution committee to decide the status of a bank should occur either automatically well before resolution becomes likely or it will have to be kept secret (markets will look for signals of supervisory intervention)

– Committee includes college of supervisors, national central banks, Treasuries and deposit insurers

– Likely to involve their being operated as some equivalent of a bridge bank (or bridge banking group) pending the return of its assets to the private sector.



• Mechanics of coordination of banks´ resolution process (cont.)– Home country supervisor takes lead in running the

bridge bank– Resolution committee acts as board of directors in

overseeing operations– Resolution committee approves privatization plan

• Resolution committee will face conflicts in priorities for running the bank and its privatization– For example, is maximizing sales proceeds the sole goal

of privatization process?

• Can a committee act fast enough?


CONCLUSIONS

• The EU safety net framework across borders not only does not have minimization of taxpayers losses as a goal but has embedded in it incentive conflicts that are likely to substantially increase taxpayer losses

• Adoption of PCA cum positive level of capital closure rule would substantially reduce the likelihood of a failing bank and the problems of resolving one should that be necessary

• But an effective PCA for any bank requires acceptance of its conceptual basis and an adequate institutional framework (i.e. supervisors be given the same authority to take corrective measures; creation of bridge banks)


CONCLUSIONS

• An effective PCA for cross-border groups in the EU would also require additional coordination measures: – Enhanced availability of information

(supervisors and markets)– Supervisors´ decision process on a collegial

form– Resolution committee or agency


EXIT FOR LARGE COMPLEX CROSS-

BORDER BANKS WITHOUT SYSTEMIC

EFFECTS


NOT TOO BIG TO FAIL

• Need means of keeping key functions operating in the case of failure to avoid unacceptable disruption to the financial system

• Direct impact problems– Too many depositors to allow gap before they can access their

funds

– Key player in particular markets – disruption and fall in asset prices

– Key part of payment system

• Contagion – indirect impact– Run on otherwise healthy banks, general loss of confidence


COUNTRY DIFFERENCES• In US Systemic Risk Exemption allows FDIC to

take a wider view and not simply minimise its own losses when resolving a failed bank

‘serious adverse effects on economic conditions and financial stability’ – Normally loss minimising by the FDIC is quite a good

match with overall loss minimisation – spillovers are small and FDIC equates with the junior creditors

– Never used– Occurrence may be greater in small countries where a

few banks are dominant


NEED TO BE ABLE TO ESTABLISH WHAT SYSTEMICALLY IMPORTANT

• ‘Replaceability’ (Hüpkes)• Context dependent – how fragile is rest of

system• Market share might allow the drawing of

prima facie lines• Definitions of what does/does not

constitute financial stability not very helpful


ALL AN ISSUE OF EXPECTATIONS

• ‘financial stability is a state of affairs in which an episode of financial instability is unlikely to occur, so that fear of financial instability is not a material factor in economic decisions taken by households or businesses.’ (Allen and Wood, 2006)

• Can be related to measurable indicators but likely to be highly nonlinear and only clear when the authorities misjudge it


ONE OBVIOUS STEP IS TO REDUCE SYSTEMIC RISK

• Avoid banks getting too big.

• Avoid too much concentration in individual markets

• Better risk management

• Strong PCA to solve problems before failure


REQUIRMENTS FOR HANDLING THE FAILURE OF A SYSTEMIC BANK

• A rapid implementation so that the systemically essential functions can be maintained without a material break

• A predetermined means of deciding what losses are to be taken into account and how they are to be assessed

• A means of allocating losses that respects the hierarchy of claimants under insolvency and does not make the claimants any worse of than they would be under normal insolvency procedures.

• the method should not reduce the risk that shareholders and those responsible for the losses would otherwise bear, in particular it should not introduce a moral hazard that would encourage institutions to take on increased risk

• the method needs to be equitable across financial institutions irrelevant of their size or the sequence in which insolvencies occur.


NZ APPROACH• Outsourcing policy• Banks must organise themselves and their relationship

with the authorities in such a way that a failure or other major shock can be handled without having significant impact on the system –defined as– The bank’s clearing and settlement obligations due on a day

can be met on that day– The bank’s financial risk positions on a day can be identified

on that day– The bank’s financial risk positions can be monitored and

managed on the day following any failure and on subsequent days

– The bank’s existing customers can be given access to payments facilities on the day following any failure and on subsequent days.


KAUFMAN 4 POINT PROGAMME

• Prompt legal closure when the bank’s capital declines to some prespecified and well publicised minimum value greater than zero (legal closure rule),

• Prompt estimates of the recovery value and assignment of any credit losses (haircuts) to de jure uninsured bank claimants,

• Prompt reopening (e.g., the next business day), particularly of larger banks, with full depositor access to their accounts on their due dates at par value for insured deposits and recovery value for uninsured deposits and full borrower access to their pre-established credit lines, and

• Prompt re-privatisation and re-capitalisation of the bank in whole or in parts at adequate capital levels.


METHODS OF KEEPING SYSTEMIC FUNCTIONS OPERATING IN THE

FACE OF FAILURE• Traditional solution – Open Bank Assistance

– Not enough time to work out how to do anything else– Large banks can be so complex it is difficult to sort

out what the insured deposits are

This is in effect ‘too big to fail’

• Purchase and assumption difficult – buyer cannot complete due diligence– Scale can lead to competition problems– Possibly best broken up


METHODS OF KEEPING SYSTEMIC FUNCTIONS OPERATING IN THE

FACE OF FAILURE• Traditional solution – Open Bank Assistance• Purchase and assumption difficult • Bridge banks offer a way forward

– Temporary solution till return to private sector– Takes bank away from existing owners– Can to some extent separate out the systemic

functions– Need legal power – this not possible in many EU

countries– Only used by FDIC10 times and not in last 12 years– Some experience in around 6 other countries


EXPERIENCE WITH BRIDGE BANKS

• Available since Competitive Equality Banking Act of 1987 in light of experience from Continental Illinois

• bridge bank is a new limited life national bank, chartered by the Comptroller of the Currency

• Used 10 times, only once since FDICIA• Enables FDIC to separate banks from the holding company.

Sometimes has put them all in one bridge sometimes into separate ones depending on what makes them most saleable/least loss.

• Buys time, keeps charter value • FDIC suggests it is only way to handle a large failure• BUT not sufficient on its own – need greater preparation and

early access to a large bank to be ready fast enough • Is operation under FDIC control going to increase losses


THE MAYES HALME AND LIUKSILA (2001) SOLUTION

• Very similar concept to bridge bank• Authorities intervene at prescribed benchmarks – preferably

above zero but in EU zero net worth – and takeover the bank from the shareholders

• Make an approximate evaluation of the extent of any shortfall and make it good, probably by writing down the claims in proportion, starting with the most junior (equity for debt swap?)

• Reopen the bank as usual on the next trading day probably with guarantee against future loss

• No one worse off than in insolvency• Requires public law on banks to operate• Adequate access to information and bank systems to make

appraisal and identify claimants


WHO SHOULD BE RESPONSIBLE?

• Potential conflict of interest for supervisor – bank failure = regulatory failure. Conflict for central bank (Kahn and Santos) because of exposure to loss

• Need agency that is closely involved with systemic institutions so they are convinced that the can recover properly in the event of failure or other problems – less important for non-systemic banks? Need set up in normal times to address loss minimisation

• Does not need to be large but needs to be able to call on staff immediately in the case of a problem.


POWER TO ACT

• Key problem for many countries is lack of legal framework for early intervention

• Need to be adequately informed (involved in bank examinations etc?)


ISSUES

• Role of courts• Is it possible to distinguish insured from

other deposits fast enough to avoid systemic difficulty?

• Is it possible to carve out systemic functions? Are they legally distinct?

• Can one really offer equal treatment to small and large banks?


IN MANY CASES PROBLEM IS MULTI-NATIONAL

• No single authority has the power to act• Conflict of interest bank may only be of systemic

importance outside the home country• Problems of branches in the EU (Winding Up Directive)• May be impossible to operate either intervention OR

open bank assistance – home country with power may be unwilling or unable to support entire institution (Swiss case)

• What is fair burden sharing if failure is partly the fault of the lead supervisor?

• Do not have agreements on PCA/SEIR


TWO MAIN DIRECTIONS

• Give one authority the job and assign it adequate powers

• Adopt national solutions for each systemic location (this is the NZ and US solution) Make subsidiaries largely free-standing then each can be bridged individually

• Not possible for EU – not clear that existing co-operation would work – how would a bridge bank be formed? Could be done by an EDIC European Deposit Insurance Corporation but no appetite for international institutions at present

• Only 30-50 banks in the EU are likely to have systemic functions

Documents

David Mayes Pärnu 12/1/07 AVOIDING BANKING CRISES David G Mayes Bank of Finland and University of Auckland