“AN OPTIMAL APPROACH TO BANK RESOLUTION”
By
Jean Pierre Sabourin
Chair of the Executive Council and President of the International Association of Deposit Insurers and Chief Executive Officer of the Malaysia Deposit Insurance Corporation
Thank you, Mr Chin-Tsair, Tsay.

I am delighted to be here in Taipei to share my thoughts and experiences on deposit insurance. Although I may be considered a seasoned practitioner, having had almost 30 years experience in deposit insurance, I still find it extremely challenging and satisfying to address deposit insurance issues. Those who know me understand my passion for my life’s work.

2.   Hence, after my retirement from the Canada Deposit Insurance Corporation (CDIC), I have wholeheartedly accepted to continue to be involved in deposit insurance as the first Chief Executive Officer of the newly-established Malaysia Deposit Insurance Corporation (MDIC).  From being head of an international leader in deposit insurance, I am now leading an infant institution that aims to fast track its development to be on par with other established deposit insurers.  This is indeed an assignment which, I have no doubt, will be challenging and most satisfying. 

3.   This year’s theme is on “Challenges for Deposit Insurers in Resolving Bank Failures”.  The issues that will be discussed during these two days are particularly relevant in light of the challenges posed by the changing environment.  Some of these are not as visible as hurricanes, tsunamis and spiraling oil prices, and their consequential trickle-down effect have yet to be totally absorbed by the economies of our respective countries.  In this regard, I would like to share some thoughts from my vantage position.  As Chair, I have had the benefit of getting preliminary results of surveys and studies conducted by IADI.    Depending on the results and the type of studies conducted, IADI is able to identify, to some extent, the emerging vulnerabilities and the capability gaps that need to be addressed by its members as well as the appropriate institutional requirements, resources and capacity-building programmes deemed necessary. Of course IADI is not capable of solving these issues alone but it can heighten awareness and work with others to see how these matters can be addressed.

4.   My paper today is divided into two parts.  In the first part, I shall highlight some key findings from the study conducted by the Subcommittee on Resolution of Bank Failures.  I will identify some of the potential sources of vulnerability.  In the second part, I will share my thoughts on what I believe is an optimal approach to bank resolution. 

5.   First, let me congratulate those who have undertaken the study and thank those deposit insurers who have contributed to it.  Members will recall that a survey questionnaire was circulated in June 2004.   A total of 34 countries responded to the survey. The results of the survey have been analysed by the IADI’s Subcommittee on Resolution of Bank Failures and a consultation draft entitled “General Guidance for the Resolution of Bank Failures” has been released for comments.  Although these findings are not profound, given the small size of respondents, the results are nonetheless useful as they provide a general pointer to some of the vulnerabilities for deposit insurers in the coming years. 

6.   The survey highlighted three major challenges that could affect insurers.  First, consolidation and conglomeration of bank assets is an emerging global trend, cutting across developed and emerging economies.  Among the respondents of the IADI study, five countries had a concentration ratio of 93% of assets which were held by their top five large banks.  In terms of the average concentration of assets held, this ratio was rather high as it accounted for more than 30% of assets by the top banks.   The trend of increasing concentration of assets within a smaller group of banks inevitably raises the risk exposure for deposit insurers and other safety net participants.  The failure of one large bank has a greater impact on the position of the deposit insurer and increases the potential for systemic crisis within the financial system.   

7.   Another finding is that financial systems remain vulnerable to economic stress and to banking structural weaknesses within the financial systems.  24 out of 34 respondents to the survey have reported some form of crisis in the last 10 years in their banking systems.  It would appear that a combination of macro and also bank-specific weaknesses had contributed to the crisis that had affected the respondents.  Among the macro-economic factors which had contributed or caused the banking crisis or individual bank failures, the study ranked economic recession, unsound financial regulatory or supervisory system, financial deregulation and political issues as most important.  As for the bank-specific factors which had contributed to bank failures, respondents have identified four main weaknesses, namely unsound banking practices, inappropriate risk management, poor corporate governance and management fraud and embezzlement.

8.   The third salient finding of the study is that the bank resolution costs are significant.  19 of the respondents reported that the minimum resolution cost was US$709,000 and the maximum was US$162 billion with an average of US$20 billion.  As to the resolution costs as a percentage of one year’s GDP for a country, the lowest ratio was 0.002% and the largest was 35.8%, with an average of 5.5%.  For those countries with high resolution costs, the effects on the economy and financial stability were significant.  For small economies or even the larger economies, a loss of 5.5% of GDP can have a severe impact on a country for years to come.  

9.   The above findings are broadly in line with the assessment of the Bank for International Settlements as discussed in its 75^th Annual Report.  According to the BIS, the main challenges remain macroeconomic in nature.  Longer term pressures could, however, come from uncertainties in interest rates and increased exposure to real estate especially if a prices decline amidst a general slowdown in consumer spending.  The BIS has also highlighted that consolidation activities have picked up.  However, the BIS has raised a red flag in this area.  It would appear that there is increasing skepticism about the functionality of the conglomerate model which seeks to create cross-sectoral and cross-selling synergies. 

10.   On the residential side, mortgage lending has surged in the last five years in most economies. In the United Kingdom, there has been a cumulative increase of 160%. In Australia, the increase is 100% and in the United States (75%). In the Euro area, the increase is 50% but in Japan, the increase is the smallest at 30%.  The uncertainties in the housing market do imply some direct and indirect risks to the financial system.  Should adjustments in house prices and rents result in the fall of household wealth, the macro-effect could be significant. Given the potential effect of the vulnerabilities identified above, it would be prudent for all safety net players to take pro-active steps to minimize their potential effects. At the very least, contingency plans and measures can be instituted.  If one could save 10% of the total cost of past resolutions through contingency planning, one would save at the very minimum US$2 billion.  Contingency planning makes economic sense.

Ladies and Gentlemen,

11.   Having identified the vulnerabilities, I should like to set down an approach for dealing with bank resolution.  I call this the OPTIMAL approach.   OPTIMAL is the acronym for Objectives, Process, Timing, Intervention, Market Discipline, Assessment and Legislative framework. I have developed this approach as a practitioner’s guide to meeting best practices in bank resolution.   The Optimal approach also scopes out the key parameters and issues that deposit insurers should address in designing deposit insurance systems or in the design of a resolution framework.  However, for the purpose of this paper, I shall focus on its relevance for the design of the bank resolution framework.

12.   Bank resolution is the process involving the valuation of assets of a troubled bank, finding acquirers for all or part of the assets of the failed bank or liquidating assets, identifying claimants, and reimbursing insured depositors.  This is the reactive approach to bank resolution. However, the more effective failure resolution mechanism is the pro-active or pre-failure approach which I believe is more effective.  This requires intervention at a very early stage and is aimed at minimizing disruption and costs to the overall financial system.  It is from this context of pro-active intervention that I would like to share my thoughts on what is an Optimal Approach to Bank Resolution.  

13.   First, it is crucial that the objectives of a resolution be clearly spelt out and agreed to by all parties involved in maintaining financial safety before a problem occurs.  From the deposit insurer’s perspective, there exist a number of risks inherent in mandates. In my experience, the role and powers available for resolution are not always clearly apparent or aligned with mandates.  The mandates, role and powers have to be assessed properly to ensure that there are no existing gaps with regard to how a deposit insurer is expected to meet its objectives.  We all know that insurers which are “payboxes”, “least-cost” and “risk-minimisers” have different resolution mandates.   No matter the mandate, a deposit insurer should nevertheless be clear as to whether any resolution to be undertaken are subject to least cost principles or consumer protection or systemic prevention objectives. There are many examples where “payboxes” have been required to recapitalise failed or troubled banks, purchase non-performing loans or fund resolutions, notwithstanding their limited mandates.

14.   In their design, many deposit insurers are not empowered to resolve troubled banks. However, in the case of the Malaysia Deposit insurance Corporation (MDIC), Malaysia adopted a different approach.  Several guiding principles were identified which later set the benchmark for determining the priority of each design feature.   One such guiding principle required that the deposit insurance system be able to reinforce and complement the existing regulatory and supervisory framework.  As a result, the deposit insurance system evolved from an initial narrow paybox mandate to a broader least cost mandate which empowered the insurer to resolve banks that have ceased or are likely to cease to be viable - I stress here the early intervention mandate.  Accordingly, an appropriate large range of resolution powers were given to MDIC. However there are also checks and balances built into the system whereby it is clear when MDIC will act.  It will act to minimize losses to the system once the supervisor makes a formal determination of non-viability.   Further, consistent with its least-cost mandate, MDIC is empowered to transfer ownership rights over property by way of a statutory vesting instead of the normal process. 

15.   Consideration of the public policy objectives should also include a consideration on who should bear the loss of a bank failure.  In the normal course, losses in bank failures should be borne, first, by shareholders, debt holders, unsecured creditors and lastly, by depositors. Furthermore, every creditor should be held accountable for meeting their financial obligations to the failed bank.  Experience shows that as simple as it seems, this is not so clear-cut in many systems.  I am certain that everyone here can cite many examples of political and other hurdles that present themselves when dealing with troubled banks.

16.   In formulating the objectives for bank resolution, it is important for deposit insurers to get it right from the start as to how and what objectives and goals should guide the determination of how bank resolution can effectively be undertaken.  Without this soul-searching, a bank resolution framework may be patchy at best and at its worst, full of holes and unintended consequences.

17.   Second, a sound robust process is important for effective resolution of troubled banks.   In this regard, appropriate policies and standard operational procedures should be prepared in readiness although a resolution may not be imminent.  These procedures should include manuals on taking control of a bank and its assets, reimbursing depositors’ claims, including scoping out the resolution options that may be available depending on the circumstances and the environment at the time.  Deposit insurers with limited human resource capacity should undertake contingency plans as well as consider the merits of outsourcing arrangements for acquiring specialised resources such as, in carrying out an independent valuation of assets and liabilities of a troubled bank.   I should stress that it is vitally important to put in place an open and transparent process for the marketing and disposition of assets, both tangible and intangible, and how deposit liabilities can be transferred to a new entity.        

18.   Timing of resolution is also important.  Banks fail and often they fail at the wrong time.  In any economy, the failure of a bank is important information for the public and in certain circumstances, such information could lead to a crisis in confidence affecting the entire banking system, notwithstanding the protection offered by deposit insurance.  Hence, the selection and availability of resolution options is often dictated by the strength of the economy as well as the strength of the banking system at the time of failure. In addition, when there is a lack of strong banks, the costs of bank resolutions are likely to increase. In the worst case scenario, existing banks may even be weakened should they be permitted to undertake purchase and assumption of assets and liabilities of the failed bank. When allowing the merging of two sick banks, one must remember that seldom is the off-spring healthy.

19.   In the light of the above, how then should deposit insurers react? Deposit insurers should undertake scenario planning and understand their capabilities and limitations. It is far too late to start asking questions about authority to act or how a failure could be handled when one is saddled with an imminent failure. Having found myself in this situation in the past, I can attest that the risks and costs are endless and whatever options are available, they are at best reactive.

Ladies and Gentlemen,

20.   Bank resolution is often synonymous with the process of reimbursement of depositors. However, bank resolution encompasses a two-phase process, that is, a pre-emptive intervention phase and a failure phase.  As you would no doubt be aware, good medical practice requires that treatment of a patient should take place before the patient becomes terminally ill. If we follow this medical analogy, treatment begins with vaccination for all major illnesses. We should do the same for banks.  Hence, the next factor within the OPTIMAL approach is Intervention. This refers to the range of intervention powers that the supervisor and the deposit insurer should utilize before and during the intervention process. I believe that a sound policy should have three main components, including early intervention powers, namely:

• Clear mandate between the supervisor and the deposit insurer that recognises the need for promoting sound risk management systems in banks and the requirement of prompt and corrective action powers to resolve emerging problems before they become terminal;
• Clear transparent guide to intervention that make clear how supervisors and deposit insurers will respond as a bank’s risk profile increases,  and
• The power to close a troubled bank while its capital is still positive. The trigger point should be a non-viability determination as opposed to hopeless insolvency.
  

21.   Let us remember that capital is the last line of defence for deposit insurers provided the supervisor triggers the intervention and resolution mechanism when capital is still positive.  In the absence of this power, the cost of resolution cannot be optimised, even though the deposit insurer may have a broad range of intervention powers.

22.   The standard resolution options, such as Purchase and Assumption and Open-Bank assistance are well documented. I would therefore not go into detail into these options. 

23.   Instead, I would like to highlight the pre-intervention powers that deposit insurers should have.   In Malaysia’s case, it has the power, among others, to acquire assets from banks subject to the caveat that such activities are carried out for the purpose of reducing or averting a risk to the financial system or a threatened loss to MDIC.  In this regard, the objective of that action and its intervention powers is consistent with the financial stability mandate of MDIC.   


Ladies and Gentlemen,
                         
24.   Market discipline is a crucial element within the OPTIMAL approach, given its important role in minimizing cost of bank resolutions. Under an ideal scenario, open and transparent information flows require banks to justify their level of risk exposure and capital holdings to financial market participants. If information flow is transparent and timely, it will enhance market discipline. In that light, unsecured depositors would react and walk with their money. Large depositors can provide a check on unwarranted risk-taking behaviour on the part of banks. This would provide the market discipline which balances the moral hazard of deposit insurance as well as provide an early warning system. Better information also provides investors with the needed knowledge to assess and monitor on an on-going basis the health of a bank.  

25.   When a bank has failed, a different type of market discipline is required.  In effecting the sale of failed bank‘s assets, it is important to implement market auction mechanisms so that the prices for bank assets are determined by market forces to enable the best prices to be obtained and thereby optimising recovery for everyone.  Indeed, deposit insurers have a fiduciary duty to all stakeholders to obtain the best value for the assets of the failed bank given that the vast majority of deposit insurers are established as government entities.  Towards this end, all resolution mechanisms should build in a transparent and objective set of critieria that would encourage a larger pool of potential buyers.  High standards in internal and external review and auditing process and reporting should be maintained at all times to maintain credibility and reputation of the deposit insurer.

26.   Another element in the OPTIMAL approach is Assessment which is an on-going review and adjustment process of all the elements that are encapsulated within this approach.

27.   From experience, bank resolution mechanisms vary from country to country according to the economic condition of the country and the resources available.  As a general rule, market based solutions are the most efficient and least costly to taxpayers. If private sector purchasers are not found, liquidations are generally cheaper than keeping insolvent banks open.  However, in some countries, insolvent banks are kept afloat to provide employment, to save reputations and sometimes as a symbol to national pride. The fiscal position of the national treasury is also a very important determinant in dealing with insolvent banks. Accordingly, depending on the economic circumstances, a “One size fits all” approach is not feasible. 

28.   Based on research and available experience in the field, bank resolution is much more complex than earlier perceived.  For this purpose, deposit insurers and other safety net players should do whatever is necessary to conduct  environmental scans and audits on a regular basis and also prior to undertaking bank resolutions, in the following areas:

• Legislative framework from the perspective of capacity, currency and relevance of bank resolution powers;
• Economic environment from the perspective of risk, threats, opportunities and challenges;
• Political environment from the perspective of the likely support that government can provide for the various resolution mechanisms. Without the right political will, it is impossible to do the right thing;
• Social environment from the perspective of whether the preferred resolution mechanisms may trigger social unrest and the tolerance of the public with the outcomes desired by the deposit insurer; and 
• Resource environment from the perspective of availability of professional expertise, capable accountants and lawyers, liquidators and so forth in dealing with a bank failure.

29.   In this context, it is also prudent to conduct stress testing, scenario testing as well as contingency planning.  The adage that “A stitch in time saves nine” is relevant in raising the level of preparedness of deposit insurers.

30.   Last but not least is Legislative framework in the OPTIMAL approach. In general, bank resolutions cannot be conducted successfully outside an appropriate package of legislative framework.  The legal framework must display a consistent and appropriate risk-reward structure that punishes fraud, speculation and reward prudent and honest behaviour. It is also crucial to recognise that the appropriate legislative powers are inseparably linked to the ability to maximise recovery on non-performing loans held by insolvent banks. Consequently, the success of bank resolutions is dependent to a very large extent on the adequacy of bankruptcy and corporate re-structuring laws.

31.   The efficiency and reliability of the judicial system to provide consistent judicial decisions on insolvency and corporate laws is critical.  Market incentives that encourage debt rescheduling should also be in place, such as the legal capacity of government entities to convert debt into equity or to restructure market or remove broad public policy barriers. Because the insolvent bank usually holds a large portfolio of non performing loans in real estate, the ownership transfer mechanism for such assets may need to be re-assessed.  In addition, governments may need to develop new legislation to further deepen and expand capital markets to encourage domestic and foreign investment.

32.   In the final analysis, the long term success of the bank resolution process depends on having a fair, objective, transparent and reliable legal environment as well as strong and enforceable prudential regulations. In this regard, the legislative framework should support:

• Transparent forms of bank ownership that clearly define the legal structure and liability of borrowers;
• Judicial and alternative dispute resolution mechanisms that can be relied on to enforce contracts;
• Accurate and credible registration of titles and property rights that are maintained for all categories of property used as loan collateral, including access to lien information; and
• Established procedures and institutions for handling the conversion of collateral into cash in a timely and efficient manner.

Ladies and Gentlemen,

33.   An optimum solution to bank resolution is not always possible.  What is optimum may not be optimal for a financial system as there could be hidden social costs and even political costs which could destabilize the financial system.  Similarly, it is sometimes not prudent to seek the lowest cost approach for the deposit insurer as compared with a cost-effective approach for the financial system.  The degree of economic development and the state of readiness of the deposit insurer in managing a bank resolution plus the country-specific circumstances, have a strong bearing on the selection of the resolution option as well as the efficiency of the resolution process.  I would like to suggest an optimal approach.  In propounding this approach, my intention is for it to be used as a guide for evaluating the environment and the tools that may be available to the respective deposit insurer.  I hope you will find the OPTIMAL approach a practical guide for application.

On that note, I wish you successful deliberations.

Malaysia Deposit Insurance Corporation
28 September 2005 

Mdicdcex1diaDIIF(15-16 Sept 05), Dalian, ChinaJP Keynote SpeechIADI Taipei 28Sept2005 Final (2).doc