THE EXIT MECHANISM AND RESOLUTION OF PROBLEM FINANCIAL INSTITUTIONS

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THE EXIT MECHANISM AND RESOLUTION OF PROBLEM
FINANCIAL INSTITUTIONS

• By G. A. Ogunleye
• Managing Director/CEO
• Nigeria Deposit Insurance Corporation
• Abuja, Nigeria
• Paper Presented at the IADI 3rd Annual
  Conference, October 26, 2004

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Paper Outline

• Introduction
• Definition of failing/failed financial
  institutions
• Appraisal basis of asset and liability of a
  failing/failed financial institution and the
  agency in charge of the appraisal
• The trigger criteria for determining a
  failing/failed financial institution, and the
  agency in charge of such determination

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Paper Outline ctd.

• Consideration and determination of resolution
  methods, and pros and cons of each method
• Factors and supplementary measures to be taken
  into consideration when withdrawing
  failing/failed financial institutions from the
  financial market

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Paper Outline ctd.

• Deposit insurers role in the process of
  determining and assessing the viability of a
  problem institution
• Indemnification of financial safety-net players
  while handling failing/failed financial
  institutions
• The principles for a deposit insurer and its
  future role when confronting similar problems

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1.0 Introduction

• Financial institutions, especially banks are at
  the centre stage of business and economic
  activity.
• Promoting a healthy and efficient banking system
  is a crucial policy goal of Government and
  society at large.

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1.0 Introduction ctd.

• In a situation of prevalent distress amongst
  financial institutions, the application of an
  appropriate failure resolution method becomes a
  necessary medication to restore health to
  individual institutions and to the entire
  financial system.

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2.0 Definition of failing/failed financial
institutions

• A financial institution is said to be failing
  when its capital has been substantially eroded or
  it could no more meet its liabilities as they
  mature for payment. For example, inability to
  honour legitimate deposit withdrawals on demand.

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2.0 Definition of failing/failed financial
institutions ctd.

• A financial institution on the other hand is said
  to have failed (i.e. insolvent) when the value of
  its realisable assets is less than the total
  value of its liabilities i.e. the shareholders
  funds is negative.

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2.0 Definition of failing/failed financial
institutions ctd.

• In specific terms, a failing/failed financial
  institution may exhibit all or a combination of
  the following characteristics
• - inability to meet due obligations,
• - capital below a given threshold
• - operations adjudged to be unsafe unsound

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2.0 Definition of failing/failed financial
institutions ctd.

• - poor Corporate governance
• - absence of a sustainable business strategy
• - weak asset quality
• - poor systems and controls, etc

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3.0 Appraisal basis of asset liability of a
failing/failed institution and the agency in
charge

• It is a critical pre-resolution function.
• Prompt notification of impending failure of
  institution to Deposit Insurer is imperative.
• Going concern or gone concern valuation.
• Does Bank Secrecy Law constrain access to
  information?
• Confidentiality agreement to facilitate access to
  information.
• Reliability of financial records of depository
  institutions.

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3.0 Appraisal basis of asset liability of a
failing/failed institution and the agency in
charge ctd.

• Liability Information
• Identification of owners of deposit accounts.
• Aggregation of deposit balances to determine DIS
  exposure .
• Access to deposit data before closure reduces
  risk or manipulation of records, expedites
  reimbursement process and helps to sustain public
  confidence.
• Netting of collateralised deposits/Right of set
  off/counter claims.
• Discountenance ineligible liabilities (e.g.
  insider deposits)
• Should deposits of closed or failed institutions
  qualify for interest accrual?

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3.0 Appraisal basis of asset liability of a
failing/failed institution and the agency in
charge ctd.

• Asset Information
• - Assets valuation should be based on
  Regulatory Accounting Principles (RAP) (where
  available) which tend to be more conservative
  than GAAP.
• - Assets fall into two major categories
• - Risk Assets
• - Tangible Assets

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3.0 Appraisal basis of asset liability of a
failing/failed institution and the agency in
charge ctd.

• - Risk Assets are mainly held in form of loans
  investments.
• - At a minimum, risk assets should be appraised
  on the basis of
• - repayment capacity of borrowers.
• - availability of secondary market for loan
  assets.
• - collateral protection.
• - efficiency of legal framework for debt
  recovery.

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3.0 Appraisal basis of asset liability of a
failing/failed institution and the agency in
charge ctd.

• - Investment portfolio should be appraised on
  the basis of GAAP.
• - Tangible assets should be appraised on the
  basis of professional valuation with preference
  given to forced sale value.
• Agency in charge
• Depends on the mandate and statutory powers of
  the safety-net participants.
• - Licensing authority
• - Supervisor
• - Deposit Insurer
• - Receiver

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4.0 The trigger criteria for determining a
failing/failed financial institution, and the
agency in charge

• It is a vital component of prompt corrective
  action.
• Resolution criteria should be well-defined,
  transparent and understood by all stakeholders.
• Three approaches identified
• 1. Rules-based approach - driven by statutory
  provisions which require corrective action within
  a given time-frame.
• It is inflexible/one-size fits all
• Discretionary approach - relies on judgement of
  supervisory authorities on timing and severity of
  intervention.
• It is flexible.
• Discretion can be abused or mis-applied.
• 3 Sliding-scale intervention approach - strikes
  a balance between rules-based and
  discretionary approaches.

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4.0 The trigger criteria for determining a
failing/failed financial institution, and the
agency in charge Ctd.

• Trigger Mechanisms
• Capital Adequacy Criteria - failure to maintain
  stipulated capital adequacy threshold triggers
  intervention.
• Illiquidity Criteria - failure to maintain
  stipulated liquidity threshold triggers
  intervention. For example EU directive on
  deposit guarantee schemes is concerned with
  illiquid rather than insolvent banks.

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4.0 The trigger criteria for determining a
failing/failed financial institution, and the
agency in charge Ctd.

• Financial non-viability criteria
• Circumstances that could trigger intervention
  include
• - deterioration in the quality or value of
  assets.
• - undue exposure to off-balance sheet risk.
• - questionable reporting of earnings, operating
  losses or expenses (financial engineering).

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4.0 The trigger criteria for determining a
failing/failed financial institution, and the
agency in charge Ctd.

• Agency in charge
• Depends on mandate and statutory powers of
  safety-net participants
• Licensing authority
• Supervisor
• Deposit insurer

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5.0 Consideration determination of resolution
methods, and pros and cons of each method

• A resolution could be defined as a method of
  addressing the problems of troubled insured
  institutions with a view to protecting
  depositors, minimising disruptions to the
  financial system as well as minimising costs to
  the monetary authorities.

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5.0 Consideration determination of resolution
methods, and pros and cons of each method ctd.

• To be efficient, reliable and credible, a failure
  resolution framework must take into cognisance
  certain policy and operational considerations
  such as
• - Least cost consideration.
• - Systemic repercussion of failure of a large
  bank.
• - Avoiding disruption of banking services in
  particular market or region.
• - Need to promote market discipline.

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5.1 Resolution Methods

• There are a number of different mechanisms
  available either to restructure a financial
  institution for viability or liquidation.
• Three major options available
• Liquidation and Depositor Reimbursement
• Purchase and Assumption
• Open Bank Assistance

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5.1 Resolution Methods ctd.

• Liquidation and Depositor Reimbursement
• - Two methods adopted
• - Payout depositors paid directly by
  deposit insurer
• - Deposit transfer depositors accounts
  are transferred to another institution that
  makes the insured deposits available to them.

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5.1 Resolution Methods ctd.

• Purchase and Assumption (Bridge Bank inclusive)
• - A healthy institution assumes some or all of
  the obligations and purchases some or all of the
  assets of a failed institution.

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5.1 Resolution Methods ctd.

• Policy Issues
• i) should uninsured depositors be protected
  along with insured depositors?
• ii) which assets should be offered to the
  acquirer?
• iii) should impaired assets be offered to
  acquirer under a loss-sharing arrangement?

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5.1 Resolution Methods ctd.

• Bridge Bank
• Safety-net participant takes ownership or control
  of a failed institution and operates it for a
  period of time.
• Bridge bank is typically used to resolve the
  failure of large or complex institutions.
• The objectives of bridge bank include
• - preventing further deterioration of a

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5.1 Resolution Methods ctd.

• troubled-institution.
• - providing prospective acquirers adequate
  opportunity to review the target banks
  operations especially its asset quality.

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5.1 Resolution Methods ctd.

• Open Bank Assistance (OBA)
• It is typically availed to large institutions
  whose failure can have systemic repercussion.
• Assistance could be in the form of
• - capital injection
• - purchase of bad loans
• - loans/liquidity support
• - loss-sharing arrangement (in respect of low
  quality assets)

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5.1 Resolution Methods ctd.

• Drawbacks of OBA
• Perceived as inequitable by small institutions
• Weakens market discipline
• Inherent risk of loss as exposure may be
  irrecoverable or partially recovered

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6.0 Factors and supplementary measures
often considered when withdrawing
failing/failed financial institutions from the
financial market.

• Reimbursement should be prompt and accurate and
  if such reimbursement would not come immediately
  after the closure, the depositors should be
  informed of the time-frame.
• The process of reimbursement to depositors should
  be made as simple as possible.

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6.0 Factors and supplementary measures often
considered when withdrawing failing/failed
financial institutions from the financial market
ctd.

• Continuous communication through public advocacy
  should be employed in order to maintain public
  confidence in the system.
• All the assets of the failed institution must be
  properly secured.
• Transparency and accountability must be ensured
  when valuing the assets of the failed institution
  as well as when such assets are to be disposed.

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6.0 Factors and supplementary measures often
considered when withdrawing failing/failed
financial institutions from the financial market
ctd.

• The deposit insurer must ensure maximum recovery
  of the risk assets of the failed institution
  using necessary legal means/recovery agents.
• Sell performing assets very quickly after the
  resolution transaction or as part of it (i.e.
  when resolution option is not liquidation).
• Timely and equitable settlement of all bona-fide
  claimants.
• Reinforce discipline through legal actions in
  cases of negligence or other wrongdoings by the
  directors and officers.

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7.0 Deposit insurers role in the process of
determining and assessing the viability of a
problem institution.

• Role is dependent on mandate and powers of
  deposit insurer.
• The deposit insurer should undertake continuous
  assessment of the financial condition of the
  problem institution. Information available
  through this means must be complete, adequate and
  reliable.
• Deposit insurer should have access to prudential
  information available to other safety-net
  participants.

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7.0 Deposit insurers role in the process of
determining and assessing the viability of a
problem institution ctd.

• In addition to the financial condition reports
  generated by the deposit insurer, it should have
  the discretion to employ the services of
  consulting/audit firms with the capability of
  carrying independent valuation of the assets and
  liabilities of the problem institution.
• Deposit insurer to work closely with the
  regulator/supervisor to agree on the assessment
  of the financial condition of the problem
  institution.

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8.0 Indemnification of financial safety net
players while handling failing/failed financial
institutions

• Protection for all individuals working or who had
  worked for any safety-net organization should be
  codified in law.
• Specific provisions in the legal protection
  should include granting express statutory
  immunity to individuals from civil and criminal
  liability for their decisions, actions or
  omissions taken in good faith in the normal
  discharge of their legal responsibilities.
• Inclusion of appropriate indemnification
  provisions in employees contracts of employment.
  

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8.0 Indemnification of financial safety net
players while handling failing/failed financial
institutions ctd

• Legal protection should not extend to protecting
  individuals where they had acted in bad faith ,
  for example, where they had acted fraudulently or
  maliciously
• Employees of safety-net players must be properly
  educated on key areas of conflict of interest and
  should be given codes of conduct pertaining to
  the discharge of their duties and the
  responsibilities thereof

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8.0 Indemnification of financial safety net
players while handling failing/failed financial
institutions ctd

• All safety-net organizations must be held
  accountable for their decisions and
  actions/inactions.
• Swearing to the Oath of Secrecy and
  Confidentiality is important for employees of the
  deposit insurer, where such is not codified in
  law.

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9.0 The principles for a deposit insurer and its
future role when confronting similar problems as
mentioned above

• The deposit insurer should seek powers to take
  over a problem institution when it is still a
  going concern
• It should be empowered to take prompt corrective
  actions when the trigger limits are reached.

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9.0 The principles for a deposit insurer and its
future role when confronting similar problems as
mentioned above ctd.

• Specific legal delineation could be made with
  respect to the role of deposit insurer as a
  receiver and liquidator such that the deposit
  insurer can commence a deposit pay out to
  depositors whenever a troubled institution is
  closed by the Supervisors.
• The deposit insurer should have powers to bring
  to book, officers including directors of the
  problem institution, who might have contributed
  to the problem of the troubled-institution.