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Legal Framework for Bank Insolvency: Basic Arrangements and their Limits

Legal Framework for Bank Insolvency: Basic Arrangements and their Limits. Augusto de la Torre The World Bank Finance Forum June 20-22, 2002. Contents. The basic framework Prior considerations Elements Limits Basic-plus framework Systemic-run cases.

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Legal Framework for Bank Insolvency: Basic Arrangements and their Limits

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  1. Legal Framework for Bank Insolvency:Basic Arrangements and their Limits Augusto de la Torre The World Bank Finance Forum June 20-22, 2002

  2. Contents • The basic framework • Prior considerations • Elements • Limits • Basic-plus framework • Systemic-run cases

  3. Basic FrameworkConsiderations and Definitions • Bank resolution—a key leg of the tripod of capital, monitoring, and exit • See “Beyond the Washington Consensus: Institutions Matter” (1998), chapter 3 • Exit by closure–the ultimate disciplining device • There are no internationally accepted standards, yet • “Fear of closing”—contagion risk from loss allocation to bank creditors, and asset value destruction • “Sound exit framework” = incentive-compatible interaction of LOLR, corrective regimes, closure, resolution techniques, deposit insurance, liquidation

  4. Elements of the Basic Framework (1)Idiosyncratic and Not-Too-Big Cases • LOLR—avoid zombies while deterring unwarranted runs • Avoid over-generous windows and payments-related overdrafts (under-priced, un-collateralized, unlimited) • Involve bank regulator to ascertain solvency vs. liquidity • Corrective regimes—avoid paralysis vis-à-vis gray zones • Move balance in favor of rules vis-à-vis discretion • Regularization plans (responsibility of banks) and strong monitoring & enforcement powers (presumption of legality) • Restrict regimes to private-sector solutions (moral suasion behind the scenes) • The perils of classical “intervention”—co-administration (legal risk) of an open bank (moral hazard)

  5. Elements of the Basic Framework (2) Idiosyncratic and Not-Too-Big Cases • Closure—desiderata • Minimize moral hazard w/o undue increase in contagion risk • Maximize asset value preservation • Closure—key problems • “Hostages” and “refrigeration” • Inadequacies of traditional liquidation • A framework for closed-bank resolution • P&A-type techniques (deposit transfer funded by asset trust) • Limited deposit insurance able to contribute to purchase and assumption, subject to less-cost rule • Judicial liquidation of residual balance sheet • Legal protection—of process, assets, and officials

  6. Basic FrameworkLimits and Pre-requisites • Purely idiosyncratic failures are not very common • BF requires significant segment of sound banks • Capable of absorbing quickly the assets and deposits of failed bank • BF presumes flight to quality (within system) only • Safe LOLR is limited by “borrower of last resort” • LOLR can fuel systemic run (flight out of the system) • BF requires resources (or access to) in the DIF

  7. Basic-Plus FrameworkToo-Big-to-Close Cases • Open-bank capital assistance… • …restricted to “officialized” banks • The “accordion” procedure (Spain, Colombia) • …and subject to tight rules to avoid abuse • Discretional—decision taken by highest level authorities of relevant agencies (U.S.) – discretional • But funded w/o recourse to DIF (i.e., through the budget) • LOLR liquidity assistance against government bonds • Ex-ante contingency planning and “fire drills” Works as long as massive systemic run can be contained, which is problematic for highly indebted EM governments

  8. Generalized (“Type IV”) Crises • Contract-abiding containment fails to avert a massive run • Bank holidays, deposit freezes, deposit securitization • Default spreads across internal and external contracts • By definition, ex-ante legal frameworks are violated • Issues go well beyond the scope of financial sector legal and regulatory framework • Fiscal, exchange rate, debt issues are salient • Focus must shift to prevention and better understanding of the nature of the new, disturbing varieties of crises

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