Financial Times

Banking regulation and the courts- experience of other countries
By Dr. T. M. C. Asser
The public interest that justifies the institutional prudential regulation of banks is the national interest in the protection and preservation of a safe and sound banking system. That interest is of special importance because our experience in other countries teaches that a modern market economy cannot function effectively without an efficient banking system, for reasons that include the following:

* In pursuing its primary objective of domestic price stability, the monetary authorities rely almost exclusively on the banking system as transfer mechanism for its monetary policy. Thus, for example, in combating inflation that is caused by overspending by the public, the central bank may try to curtail borrowing by the public by increasing the discount rate at which banks may borrow from the central bank, or by reducing the money supply fueling the public's buying spree, or by raising the reserves that banks must maintain with the central bank.

These monetary policy measures are designed to increase the cost of money to the banks, which, in turn, pass these cost increases on to the public through increases in the rates of interest that they charge to their borrowers; this should slow down public borrowing, reduce buying pressures in the economy, and ultimately stabilize general price levels.

* Banks are indispensable agents in the payment and settlement systems of the country. Payments are increasingly made through the use of checks, bank transfers, or credit cards issued by banks or banking subsidiaries.

* Finally, banks play a critical role in the national economy by intermediating between public savings and the demand of the economy for credit, by receiving demand deposits and lending the amounts so deposited under medium- and long-term loans.

Banking regulation cannot guarantee the safety and soundness of each bank. There are simply not enough bank regulators to place one behind the chair of each bank manager to ensure compliance with prudential requirements, even if that would be desirable.

Instead, banking regulation must rely heavily on voluntary cooperation and compliance on the part of bank managers and owners.There is a powerful economic incentive for bank owners and managers to comply with the law. It is related to the cost of funding of their bank's operations: the better a bank's compliance with the banking law will be, the higher its credit rating and the lower its funding costs will be. This incentive grows in importance as bank depositors and lenders become more sophisticated. Consequently, bank regulators may promote education of the public about banks and banking activities.

But, what about bank depositors? Do their interests not deserve protection? They most certainly do. Thus, England explicitly recognizes in its law the interests of depositors as a regulatory objective. However, because a bank regulator has limited powers and cannot ensure that each bank will at all times be sound and safe, the bank regulator cannot guarantee the safety and soundness of every deposit.

Usually, where depositors' interests are mentioned in the law, it often concerns their protection by enforcement action, because normally it is only when a bank becomes unsafe or unsound that the interests of depositors need protection.

For example, in Australia, the regulator may revoke the authority of a bank to carry on banking business if it would be contrary to the interests of depositors of the bank for the authority to remain in force. And, in this country, the law provides that, if the Director of Bank Supervision is satisfied that a banking institution is likely to become unable to meet the demands of its depositors or that its continuance in business is likely to involve loss to its depositors or creditors, the Monetary Board may make order directing the institution forthwith to suspend business in Sri Lanka and directing the Director to take charge of all books, records and assets of the institution and to take such measures as may be necessary to prevent the continuance of business by the institution.

It is when a bank is insolvent or threatened with insolvency that the interests of its depositors are most at risk. This raises questions as to the relative ranking of these objectives. Should, in case of conflict between them, the interests of the banking system be given preference over those of bank depositors or should depositors' interests prevail? Generally, in our experience, countries tend to accord a higher rating to the public interest in a safe and sound banking system than to the interests of depositors. Evidence for this tendency is found where the prudential requirements imposed on other financial institutions that are repositories of public savings, such as pension funds and investment funds, are significantly weaker than the requirements imposed on banks.

One reason this tendency may be that, when in practice the interests of depositors are threatened they concern nearly always the interests of depositors of a single bank, whereas the interest of the banking system as a whole covers all banks and by implication the interests of all depositors. Fortunately, therefore, when the interests of the banking system are protected, the interests of most depositors are protected. In principle, the interests of the banking system and the interests of the majority of bank depositors will coincide.

It is understandable, therefore, that in case of a conflict between the interests of the banking system and its nation wide majority of depositors and the interests of a single bank and its depositors, the interests of the latter must give way.

It is in part to mitigate the undesirable effects of such conflict that bank regulators have been authorized by law to take enforcement action against individual banks to protect the interests of its depositors. In addition, those interests may be protected by deposit insurance and a relatively high statutory preference for depositor claims on the assets of a bank in liquidation.

Resolution of Insolvent Banks
There is a notable difference between protecting and preserving the banking system as a whole and protecting and preserving each banking institution. In its pursuit of the systemic objective of banking regulation, the bank regulator is not required to protect each and every bank from failing.

Banks will be permitted to fail, but only to the extent that their failure does not reduce the banking system below the threshold where it would no longer be viable and capable of fulfilling these functions. Most national banking systems include one or more banks whose position in the banking system is so critical, due to its size or the nature of its operations, that its failure would cause the banking system as a whole to cross this threshold. Such banks will generally be rescued by the government.

The bank regulator and the government will be careful not to disclose which banks are in that enviable category, in order to avoid the moral hazard that their managers would take unreasonable risks hoping to make unreasonable gains, in the expectation of a government bail out in case of failure.

There are several good reasons why insolvent banks should be permitted to fail. One of these is that experience around the world shows that in the vast majority of cases the expeditious closure of a bank that slides, or is about to slide, into insolvency is needed to preserve assets to meet its depositors' claims.

Another reason is that a bank failure has an important demonstration effect on managers and owners of other banks, reminding them that unsound banking practices exact a heavy price; this is thought to help dissuade bank owners and managers from taking on excessive risks.

The question is then which branch of government should have the final word in determining whether an insolvent bank must be liquidated or not: the bank regulator representing the executive or the judiciary.

Treatment of Bank Insolvency in the Courts
In most countries, bank insolvency is subject to judicial administration, meaning that the administration and winding up of insolvent banks is entrusted to the courts.
The only major country that has had a positive experience with an extra-judicial bank liquidation system is the United States.

The experience of the United States, at the federal level, is mainly due to the fact that bank liquidation is carried out by a strong and firmly established federal deposit insurance agency and in the context of a well developed system of administrative law that serves as an adequate basis for procedural and substantive rule making.

Although a similar extra-judicial regime for the resolution of insolvent banks has been proposed for Switzerland and operates in Italy and Norway under similar legal circumstances as in the United States, a majority of West European countries follows a system of judicial bank liquidation under application of general bankruptcy law.

It should also be noted that in none of the lesser developed countries where an extra-judicial system of bank liquidation was introduced, that system has worked in a satisfactory manner; therefore, at least one country (Moldova) has decided to revert to a court based system.

One of the arguments used to justify extra-judicial bank liquidation is that maintaining public trust in the banking system as a whole requires a speedy resolution of failing banks, while judicial procedures are generally too slow to meet this requirement.

Although it can be admitted that there are systemic interests in authorizing the bank regulator to sell a failing bank on a going concern basis at the inception of the insolvency process (vesting) without the delays inherent in an adversarial judicial procedure, these systemic interests begin to weaken as a failing bank sinks deeper into insolvency, when the opportunities for a quick sale disappear and the balance of interests begins to shift towards the interests of depositors and other creditors in realizing the value of the assets of the bank through liquidation.

A bank liquidation process is rarely fast, due to the quantity, diversity and complexity of a bank's assets and liabilities. Consequently, the systemic and therefore public interests in speedy decision making that characterizes the initial phase of a bank insolvency and that may in certain cases justify curtailing the protections that general insolvency law tends to offer to depositors and other bank creditors, are not a significant issue in the liquidation phase of a bank and do therefore not constitute a valid reason for moving bank liquidation out of the courts.

Finally, where the resolution of insolvent banks is assigned to the bank regulator, questions arise as to the ability of the regulator and its staff to administer quasi-judicial resolution procedures with the blindfolded even-handedness required of it by principles of natural justice.

For instance, in the United States, the law provides for the appointment of the Federal Deposit Insurance Corporation as receiver of failing national banks.
Following subrogation in the rights of compensated depositors, the FDIC often becomes the largest creditor of the bank entrusted to its administration.
This gives an appearance of precluding the kind of disinterested administration that courts offer creditors of banks in liquidation.

Where the liquidation of insolvent banks is submitted to judicial administration, the banking law will usually specify strict grounds for liquidation that include that the bank is not paying its obligations as they fall due or that the value of the assets of the bank is less than the value of the outstanding debt of the bank.

The banking law typically also requires that applications for the liquidation of insolvent banks be made by the bank regulator, or when made by bank creditors that they have the consent of the bank regulator; the requirement of consent of the regulator serves to prevent that a bank would be liquidated where the interests of the banking system require its rescue.

However, such provisions in the banking law cannot guarantee that each time that the bank regulator applies to the court for liquidation of an insolvent bank, the court will commit the bank to liquidation.

In its legal technical assistance work, the International Monetary Fund has encountered many situations in countries where the judiciary refused to liquidate insolvent banks, even though their liquidation was requested on formal legal grounds that met the criteria of the banking law.

Standards of Administrative Law
Normally, an application by the bank regulator for the liquidation of an insolvent bank must follow a procedure that accords due process to the bank and be based on a formal decision of the bank regulator that gives adequate reasons why the bank must be submitted to liquidation. These reasons must be related to the statutory provisions authorizing the decision.

Thus, in the hypothetical case that the banking law uses mandatory language and provides that an insolvent bank must be liquidated, the regulator must, whenever it finds that a bank is insolvent, decide to commit the bank to liquidation. Its decision must show that the bank is insolvent according to the definition of insolvency in the banking law, for instance, that the value of the bank's assets is less than the value of the bank's outstanding debt.

If, instead, the banking law uses permissive language and says that an insolvent bank may be liquidated, the situation is different. The power granted by the provision is said to be discretionary. The provision offers the regulator a choice, whether to liquidate the bank or not. In either case, a decision will be needed.

If the regulator decides to commit the insolvent bank to liquidation the decision must show that the bank is insolvent and give the reasons why the regulator opts for liquidation of the bank. And if the regulator decides not to liquidate the bank, the decision must give the reasons why the regulated opts to keep the bank open.

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