Supervisory Guidance on Dealing with Weak Banks

Executive Summary

Weak banks are a worldwide phenomenon. Supervisors should be ready to deal with them. This report provides a toolkit offering practical guidance in the areas of problem identification, corrective action, resolution techniques and exit strategies. The intended target audience of this report is the banking supervisory community worldwide, including international financial institutions advising supervisors.

A weak bank can be variously defined. In this report, it is "one whose liquidity or solvency is or will be impaired unless there is a major improvement in its financial resources, risk profile, strategic business direction, risk management capabilities and/or quality of management". In such cases, and given the need to maintain confidence in the financial system, a supervisor should try to preserve the value of the bank's assets with minimal disruption to its operations, subject to minimising resolution costs. It may well be that the bank as a legal entity ceases to exist.

For supervision to operate effectively, the proper regulatory, accounting and legal framework, as set out in the Basel Core Principles for Effective Banking Supervision, must be in place. A supervisor must distinguish clearly between symptoms and causes of bank problems. The report analyses these. A supervisor must also identify and tackle problems at an early stage before they become acute. The report considers the relevant sources of information and the avenues available for supervisors.

While supervisors have a range of corrective action tools at their disposal, primary responsibility for addressing weakness and problems rests with the Board and management of the bank. Supervisory measures have to be proportionate. Corrective action should fit the scale of the problem and be set within a clear time frame. A balance has to be struck between rigid prompt corrective action regimes and general, less binding frameworks. One effective combination would include "automatic" rules for pre-agreed acceptable supervisory actions plus room for flexibility in particular circumstances. A balance has also to be struck between informal methods, normally where the bank's problems are less serious and bank management is co-operative, and more formal actions that are binding on the bank, with penalties for non-compliance. Closure of the bank and revocation of the licence remain the ultimate sanction.

Corrective action plans must be detailed and specific, showing how the bank's financial position will be restored. A supervisor must be able to assess if there is satisfactory progress or if additional actions are necessary. A supervisor should also have agreed upon mechanisms in place for consulting or informing the government, central bank and other regulatory agencies, domestic and foreign. In particular, the supervisor and the central bank usually have common interests that require consultation before taking actions against a weak bank. Disclosure is another critical area. The overriding consideration must be whether the disclosure contributes to the supervisor's objective in resolving the weak bank.

If the prospect of insolvency is imminent, alternatives are necessary. They include a merger with or acquisition by a healthy bank; a purchase and assumption transaction; and open bank assistance and bridge bank techniques. These are outlined in the report. If no investor is willing to step in or if the reimbursement of depositors is less costly than other options, repayment of depositors (in full or in part) and liquidation are unavoidable. vii. Public funds may be used to provide liquidity support, or in exceptional circumstances, solvency support. On a case by case basis, the central bank may consider the discretionary provision of emergency liquidity assistance, in addition to its normal facilities, to illiquid but presumed solvent banks. Solvency support, on the other hand, will involve taxpayers' money and the decision should always be taken and funded by the government and the legislative body, and not the central bank. However, close cooperation and sharing of information between the central bank and government is necessary. Liquidity and solvency support should always be linked to other more permanent corrective measures.

In some cases, a supervisor will have to consider additional issues where the bank is part of a larger group or it is a foreign bank. The relevant factors and possible options, such as ring-fencing, are examined. Special considerations, both political and financial, can also apply to state-owned banks where the timescale for resolving problems may need to be longer.