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Problem Bank Resolution: Evaluating the Options

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  • Paul Hoffman
  • Anthony M. Santomero
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    Abstract

    The authors describe the function of intermediation in the financial sector and the role of regulatory supervision in managing the inherent structural vulnerability of the process. Financial intermediaries provide both a risk taking and a maturity transformation function in mobilizing savings assets into productive real investments. These inherent activities create a natural structural vulnerability which regulatory oversight is intended to mitigate. The consequence of failure to effectively manage the inherent structural vulnerability can lead to "runs" in which depositors withdraw funds leading to institutional insolvency. The vulnerability to runs becomes a public policy concern when a loss of confidence in the sector leads to a contagious loss of confidence in other institutions. In response to these dangers, governments and regulators throughout the world have established "financial safety nets" to be triggered at various stages in evolving financial crises. The "safety nets" can be seen as comprising at least seven elements or separate stages in managing financial crises: 1) the chartering function screens out institution managers who would be likely to take on excessive insolvency exposure; 2) if institution managers do try to expose their institution to shocks, the prudential supervision function is established to prevent this; 3) if a shock still occurs, the termination authority removes the institution's license before too much damage is caused; 4) if losses still occur, the insurance function may prevent creditors from running; 5) if the institution closes, the insurance function may sustain the confidence of creditors at similar institutions; 6) if runs take place at other institutions, the lender of last resort function may help solvent institutions meet the claims of liability holders; and 7) if other failures occur the monetary authority may confine the damage to the institutions directly affected. The role of regulators is to return the financial structure to its position before the crisis and restore confidence in the system and should not be punitive or involve reconstruction of the system, which can wait until a later time. Solutions will differ depending on how many institutions are affected and whether the problem affects impacts on the entire system or market. There are three generic options available for problem resolution: 1) permitting continued operation under some restrictions; 2) forcing a merger with another institutions or 3) closure of some form. Within these three options are seven ways to either continue operations, force a merger or liquidate. These are: 1) forbearance - granting of time for an institution to resolve its problems; 2) capital infusion with existing management; 3) regulatory control (temporary); 4) de facto nationalization of the institutions; 5) Good-bank, Bad-bank split; 6) purchases and assumption; 7) liquidation with and without governmental assistance. The authors review and summarize the experiences in the US, Scandinavia and France where a variety of these resolution options have been recently applied. Forbearance was used in an attempt to resolve the US Thrift Crisis of the 1980s. This option did not create the desired results and the Resolution Trust Corporation was established in 1989 in order to organize the process. When Norway was faced with a major banking crisis in 1991, it nationalized the banking system. Sweden similarly infused its failing banks with capital during a crisis in 1993, effectively nationalizing them. The "good bank-bad bank" method was used extensively in the Swedish bailout. Finland's central bank took over failing banks in 1991 and the remaining ones were consolidated into one entity. The French government has bailed out troubled Credit Lyonnais, costing the government as much as 135 billion francs. From their review of foreign intervention in bank crises, the authors conclude that: 1) Costs of intervention are generally larger than anticipated; 2) Interventions aimed at preserving the current institutional structure generally do not achieve the expected outcome; and 3) The only true resolution appears to come from a change in the aggregate economy.

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    File URL: http://fic.wharton.upenn.edu/fic/papers/98/9805.pdf
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    Bibliographic Info

    Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 98-05.

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    Date of creation: Nov 1998
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    Handle: RePEc:wop:pennin:98-05

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    1. Marvin Goodfriend, 1991. "Money, credit, banking, and payments system policy," Economic Review, Federal Reserve Bank of Richmond, issue Jan, pages 7-23.
    2. Selgin, G., 1993. "In Defence of Bank Suspension," Papers 367, Georgia - College of Business Administration, Department of Economics.
    3. Leonard I. Nakamura, 1990. "Closing troubled financial institutions: what are the issues?," Business Review, Federal Reserve Bank of Philadelphia, issue May, pages 15-24.
    4. R. Alton Gilbert, 1994. "Federal Reserve lending to banks that failed: implications for the Bank Insurance Fund," Proceedings, Federal Reserve Bank of Chicago, issue May, pages 229-240.
    5. Sally M. Davies & Douglas A. McManus, 1991. "The effects of closure policies on bank risk-taking," Finance and Economics Discussion Series 158, Board of Governors of the Federal Reserve System (U.S.).
    6. Eric S. Rosengren & Katerina Simons, 1994. "Failed Bank Resolution and the Collateral Crunch: The Advantages of Adopting Transferable Puts," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 22(1), pages 135-147.
    7. Davies, Sally M. & McManus, Douglas A., 1991. "The effects of closure policies on bank risk-taking," Journal of Banking & Finance, Elsevier, vol. 15(4-5), pages 917-938, September.
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    Cited by:
    1. Cordella, Tito & Yeyati, Eduardo Levy, 2003. "Bank bailouts: moral hazard vs. value effect," Journal of Financial Intermediation, Elsevier, vol. 12(4), pages 300-330, October.
    2. Acharya, Viral & Song Shin, Hyun & Yorulmazer, Tanju, 2009. "Endogenous choice of bank liquidity: the role of fire sales," Bank of England working papers 376, Bank of England.
    3. Acharya, Viral V & Shin, Hyun Song & Yorulmazer, Tanju, 2007. "Fire Sales, Foreign Entry and Bank Liquidity," CEPR Discussion Papers 6309, C.E.P.R. Discussion Papers.
    4. Xavier Freixas & Curzio Giannini & Glenn Hoggarth & Farouk Soussa, 2000. "Lender of Last Resort: What Have We Learned Since Bagehot?," Journal of Financial Services Research, Springer, vol. 18(1), pages 63-84, October.
    5. Mats Josefsson & Michael Andrews, 2003. "What Happens After Supervisory Intervention? Considering Bank Closure Options," IMF Working Papers 03/17, International Monetary Fund.
    6. X. Freixas, 2000. "Optimal Bail Out Policy, Conditionality and Constructive Ambiguity," DNB Staff Reports (discontinued) 49, Netherlands Central Bank.
    7. Kane, Edward J., 2001. "Dynamic inconsistency of capital forbearance: Long-run vs. short-run effects of too-big-to-fail policymaking," Pacific-Basin Finance Journal, Elsevier, vol. 9(4), pages 281-299, August.
    8. Yorulmazer, Tanju, 2003. "Herd Behavior, Bank Runs and Information Disclosure," MPRA Paper 9513, University Library of Munich, Germany.

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