Stefan Ingves: The need for a strengthened insolvency and resolution
framework for banks - a central banker's perspective
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, at the International Bar
Association's 14th Annual Global Insolvency and Restructuring Conference, Stockholm,
19 May 2008.
* * *
As a central banker, the tasks assigned to me are to maintain price stability and to promote a
sound and efficient payment system. In short, I deal with economics and finance. So what
does this have to do with your business, insolvency law? What is a central banker doing
opening this conference on insolvency and restructuring?
Actually, there are more links between the fields than you might think. As I said, one of my
tasks is to oversee the payment system. Without a functioning payment system, no modern
economy is able to function for very long. But what we call the payment system is really not
much more than a system where money is transferred electronically from one bank account
to another, in a longer or shorter chain of intermediaries with the central bank as a hub. If
there is a problem in one of those intermediaries, there is a problem in the payment system.
And if the problem is not technical but financial in nature, this may lead you right into the area
of insolvency law and bank restructuring regimes.
But in fact, there is also a link of a more general nature. Maintaining price stability, which is
the central bank's primary objective, means that overall prices should be stable. That task is
made more difficult if some markets are not working properly, for instance if there are
"bubbles", or misalignments, in asset prices. I think that we can never fully protect ourselves
against this happening. But a first step is to ensure that the market has an incentive to
assess risks properly. This can only be achieved if it is clear to the agents that they are
always responsible for their investment decisions. To ensure this, you need well designed
and credible insolvency frameworks.
So, what is the problem? Well, the situation varies between countries of course. But in many
cases, quite frankly, I do not think that our present regimes for dealing with weak banks are
adequate. In particular, I doubt that they will be of much use in a situation where the payment
system is at risk. And moreover, I fear that our attempts to deal with the situation in the heat
of the moment may require us to take action that will solve the immediate problem, but which
may in the end reduce the long term market discipline.
What I call for is a special insolvency and resolution framework for banks and other deposit
taking institutions. A system that works not only when there are minor banking problems, but
also when the payment system is at risk. Such a regime does not presently exist in Sweden
- in fact, many countries lack such a regime. Indeed, this gap in the regulatory framework
has been demonstrated in the recent period of financial turbulence, where a number of
countries have found it necessary to take extraordinary measures with regard to banks and
other financial institutions in order to maintain financial stability.
Today, I will try to sketch the broad features of such a resolution framework. In brief, it is a
question of finding a system that makes it possible to close banks quickly and efficiently at a
low cost to the deposit guarantee system, while making shareholders and uninsured
creditors bear the responsibility for their investment decisions. But it must also allow for
special measures to be taken in the exceptional situation where the failure of a bank risks
destabilising the financial system as a whole. Also in such situations the government needs
to have a strong negotiating position against the shareholders.
But, first, how did I arrive at this conclusion? Well, from an analysis of the role of the banks in
the economy and the safety net which has been built up around the sector. And from some
experience from dealing with real crises. To get the right perspective, I think it is useful to
start at this end.
What is so special about bank failures?
Bank failures have always been a problematic issue for governments. A bank failure affects
not only shareholders and professional investors, but also all the ordinary people who have
put their money in the bank in the belief that it will be safe there. It is not without reason that
you often hear the reference to widows and orphans running the risk of losing their money in
connection with bank problems.
And even if the depositors may in the end recover much of their money in a subsequent
insolvency procedure, they may lose access to the money in their bank account, and the
possibility to make payments from it, for quite some time. As most of us have most of our
money in a bank account, we may find it difficult to quickly find the means needed to pay our
rent and food if this happens. And you may also be affected by the failure of other peoples'
banks. For instance, if your employer's bank gets into problems, the pay-roll account might
be frozen and you might not get your salary. And if your employer cannot quickly get credit
from another bank, he may not be able to pay his subcontractors and his utility bills. He may
also find it difficult to manage the risks in his business, for instance in relation to trades in a
foreign currency. At worst, he may need to shut down entirely. A bank failure can thus have
negative effects on the real economy.
The close and complex financial links between the banks also mean that a failure can have a
knock on effect on the other banks in the system. Particularly problematic in this respect will
be the failure of a bank which has a key position in the payment system. That is, a bank
which many other banks use as their intermediary when making payments to one another.
The mere rumour that such a bank is having problems can thus paralyse the payment
system.
A further complication is that banks are vulnerable in a special way. If confidence is shaken,
deposits and other financing can usually be withdrawn at short notice. The assets can not be
disposed of that easily. A bank may be forced to sell its assets at fire sale prices to meet a
run; if the worst comes to the worst the bank may become insolvent. Banks are therefore
very sensitive to a shift in confidence.
A bank failure can thus affect the smooth functioning of the financial system. The more
widespread the problem and the larger the risk of the crisis spreading through the system,
the greater is the threat to financial stability - and in the end to the real economy. Clearly, the
failure of a bank where a lot of people, companies and other banks have their accounts, and
which is an important provider of credit and risk management tools, will normally be more
problematic than the failure of a small bank. But also the failure of a small bank will have
wider effects, and even quite severe ones if it happens at a bad time.
Given these wider effects of any bank failure, a number of special regulations to deal with the
banks have been introduced over the years. As a result, the banking sector is now among
the most regulated industries in our economies. The safety net includes financial supervision
to monitor the risk taking of banks, with regulations on how much capital a bank needs to
hold and how it should manage its risks. The banks' owners enter into the business knowing
that a serious breach of these regulations should lead to a revocation of the licence and the
bank being closed.
The safety net also includes the ability of the central bank to lend on special conditions to an
illiquid but solvent bank when financial stability is at risk. In many countries, there is also an
explicit guarantee to the small depositors, for which the banking sector itself is to take the
responsibility.
But this safety net, while reducing the risks involved, provides no full protection against
failures. In particular, it does not extend to the case when the financial system is threatened
in its entirety. And while the formal depositor protection should reduce the pressure from the
public on the government to intervene in a bank failure, if the scheme is not properly set up,
this expectation may prove unfounded.
The government has a direct interest in an efficient insolvency and resolution
framework
So the stakes are still high for the government in a banking crisis. While owners have little to
lose when capital is low, and many creditors are protected by the deposit insurance, the state
- and the whole economy in the end - may at worse suffer enormous losses. Therefore,
unlike the situation in ordinary companies, the lack of an efficient insolvency regime will not
primarily be a creditor problem only, but a problem which will fall right into the government's
lap.
And if the insolvency framework is not efficient and cost effective, it may be rational for the
government to intervene beyond the ordinary regulatory framework. If there is no other way
to deal with the problem, it may even be rational to contribute capital directly. This may be
the case even if such an investment cannot be justified on the basis of a corporate capital
investment appraisal. The alternative of not intervening may simply be very much more
expensive.
Now, if this intervention by the government makes the owners and creditors better off than
they would have been otherwise, the rules of the game change completely. If owners and
creditors can speculate on a bail-out, market discipline will be eroded. Clearly, this needs to
be avoided. And the conclusion is that, if anything, it is even more necessary to have
effective and efficient insolvency and resolution frameworks for banks than for companies in
general.
In the Swedish banking crisis, the public interest was secured by special crisis
legislation
So, how do we fare in this respect? Well, let us take a look at some real crises.
I will start with the case with which I am most familiar, the Swedish financial crisis in the early
1990s. I got involved in the management of the crisis in my capacity as an official at the
Ministry of Finance. At the time, the country had severe macroeconomic and financial
problems, with a number of banks reporting losses. Moreover, the banks were finding it
increasingly difficult to obtain financing in the international capital markets, a source of
funding they were heavily dependent on. The international counterparties reduced their
exposures not only to those banks that were having fundamental problems, but to Swedish
banks in general.
In order to avoid a collapse of the banking system, it was necessary to take action. We tried
several measures to contain the "silent run" on the banks. What proved effective was the
declaration by the government that the banks would meet their debt obligations as they fell
due. This general guarantee, as it has been called, did not take the form of a legally binding
guarantee, but was merely a political commitment that the creditors would not suffer losses.
At the same time it was necessary to deal with the banks in distress. And it was quite
obvious that we could not do this within the normal court-based insolvency procedure. This
procedure would simply be too slow, and would not take into account the need to keep the
operations running in order to maintain the functioning of the financial system.
With creditors insulated against losses by the guarantee, and with the formal insolvency
regime assessed to be inappropriate, we needed to find another way to ensure that losses
for which the shareholders were responsible would not fall on the tax-payers. In order to
secure this, we needed to take control of the banks concerned before capital was completely
eroded. Needless to say, we found ourselves in a rather poor bargaining position against the
shareholders.
Fortunately, a Bank Support Act, laying out the principles for the possible actions, could be
implemented quite swiftly. A special crisis management authority was also set up. Inspired by
the US model, where the authorities can take control of a bank when capital falls below a
certain level, this temporary crisis legislation gave the government the right to take over the
shares in undercapitalised banks. The Bank Support Act also made it possible to tie
conditions to the actual use of the guarantee. Thus, the main rule was that any financial
support given directly to a bank would result in a proportional dilution of the original
shareholders' holdings. The Bank Support Act also laid the basis for arranging private
takeovers where possible. And, not least, for the orderly winding up of unviable banks.
The measures imposed, while quite restrictive to the shareholders, were deemed as
appropriate by the legislator and the judicial system in light of the wider public interest of
maintaining financial stability at a low cost to the government and the tax-payers.
All in all, I think that it is fair to say that the outcome was not too bad, given the
circumstances. I am also not too worried that the measures imposed have led to a
weakening of market discipline in this country.
Nevertheless, this does not mean that we could not have done better if the appropriate
legislation had been in place already at the outset of the crisis. Moreover, I am afraid that it
may be more difficult to handle a crisis by drafting temporary legislation in the midst of a
crisis today. First, the banking sector is more internationalised. In the Swedish case, many
banks are part of large cross-border banking groups with strong intra-group links, which may
not be easy to dissolve quickly. This means that it is not obvious that a crisis could be
handled on a national basis. Second, Sweden is now a member of the EU. Any measure
taken will thus have to be in compliance with EU legislation.
Sweden has actually also had recent experience of the failure of a deposit taking institution.
The failure in 2006 of the credit institution Custodia again displayed the problems in relying
on the ordinary corporate bankruptcy regime. Custodia was tiny, so there was clearly no
systemic risk. But it highlighted a number of deficiencies in the legal framework. It turned out
to be a long process to finally have the institution closed, something which may have
contributed to the failure coming at higher costs to the deposit insurance scheme than
necessary.
Other countries appear to have had similar experiences
Taking a broader outlook, it is not uncommon that countries rely on some modification of the
ordinary corporate insolvency procedure to deal with weak banks, and in some cases a
different regime altogether. And many countries seem to be able to handle small problems
within their ordinary framework.
But when it comes to those exceptional circumstances where the payment system and the
stability of the financial system are at risk, the common denominator between different crises
seems to be that the authorities did not find it possible to rely on the normal rule. Instead
there have been special provisions or special crisis legislation.
A case which I followed closely was the Asian crisis in the late 1990s. Like in Sweden in the
early 1990s, it was necessary to take specific measures to avoid a serious interruption of the
financial system. And there are a number of emerging markets which have had similar
experiences and have been confronted with the same dilemma of how to secure financial
stability without overly eroding market discipline in the long run.
But I think that until recently, most industrialised countries may have felt quite removed from
this problem. The recent experiences in the UK, the US and Germany with extraordinary
measures needed to deal with the crises in the building society Northern Rock, the
investment firm Bear Sterns and the bank IKB respectively, is a reminder that these
situations can, and in many cases have, surfaced anywhere.
They also seem to confirm that the measures that you wish to take may be in conflict with
laws and regulations which were not drafted with the specificity of a banking crisis in mind,
but nevertheless apply to banks in these situations. A telling example is the Northern Rock
experience, where it was assessed that the preferred option to fix a private takeover might be
difficult to arrange given the design of the regulations on insider trading and take-overs. More
generally, there is also a debate on whether measures that restrict the rights of the existing
shareholders might be in conflict with company law and even with human rights more
generally, and on whether guarantees extended might be in conflict with state aid rules.
I want to make it clear that I have no views on market abuse regulations, regulations on
shareholder rights in company law or state aid rules as such. They fulfil an important function
and as far as I can see usually work well together. The fact that human rights must be
respected can hardly be called into question. And I wish to emphasise that I do not call into
question the role of the EU in the regulation of our markets. On the contrary, it is important to
deal with these issues on an international level.
But the overall framework has not been drafted with the specific situation in the banking
sector in mind. It may therefore be difficult to find suitable solutions in a crisis situation
without running the risk of breaking a number of regulations. It is not acceptable that
decision-makers should have to fumble in an acute crisis situation, trying to steer clear of this
risk. It is also important that the action by the authorities in such a situation is evaluated
against a regulatory framework fit for its purpose. A framework which makes it possible to
maintain a proper balance between the different parties involved also in a crisis situation.
There is a need for a special insolvency and resolution framework for banks
In my opinion, all this points in one direction. A special insolvency regime is needed for
banks and other institutions that are covered by the safety net.
In this country it has long been said that banks should be covered by the ordinary corporate
bankruptcy legislation, at least as long as there is no direct threat to the system. This is
because government intervention over and above the existing safety net for the banks should
be avoided.
I believe that this is the wrong way to look at it. The ordinary bankruptcy regime does not
sufficiently recognise the need for speed when dealing with banking problems. Moreover, the
techniques normally used, such as a stay on payments, are ill adapted to banks. To
supplement financial supervision and the deposit guarantee with a special insolvency regime,
would not be adding an additional safety net to the benefit of depositors. It is quite simply a
way of ensuring that the safety net protects those it was intended to protect but no others,
and at a reasonable cost to the deposit guarantee system and society as a whole.
But it should also be recognised that in situations where there is a threat to the financial
system in its entirety, it may be needed to take partly different measures than in an ordinary
bank failure. In these situations, the key focus must be on maintaining the vital functions in
the interest of society as a whole.
Perhaps the idea to have a partly different framework in these situations seems odd to you?
After all, we normally expect the same legislative acts to apply regardless of the state of the
economy or the situation in the financial system.
But the situation is not unique. A similar situation exists in the health sector, where society
has set up a framework to deal with our usual flus, broken bones and heart attacks. There
are doctors and hospitals to deal with our problems. And there may be guidelines on how
long sick leaves will be needed for a certain diagnosis. But I think that it is also clear that in
some severe situations, a different framework will need to be applied. In case of an epidemic
disease, such as the avian flu, there may be a need to direct those infected to separate
hospitals. And it may be necessary to establish an order of priority for the allocation of the
scarce medical resources. One where the guiding principle may be the survival of the society
as a whole. It may also be the case that the crisis regulations clash with the normal
regulations. For instance, you are normally not entitled to take a sick day if you are actually
healthy. Now, even healthy people may be asked to leave their offices to avoid the disease
from spreading, while the key employees may be asked to go to work to keep the operations
running. When the principles clash, it will be vital for society that the ones needed to contain
the epidemic will prevail. And if that special framework is not already in place, the politicians
will need to get involved.
Clearly, a bank failure cannot be compared to a serious injury or sickness in terms of
personal suffering. But it can be an event which will make many people's lives very difficult.
And a systemic banking crisis, like an epidemic, may stall the functioning of our entire
economies. It is therefore important to be able to deal with an ordinary bank failure as well as
a more serious systemic crisis. And just like in the health sector, when the regulations clash,
it must be clear which ones will dominate.
There is another similarity, I believe. Like with the flu, it may be difficult at first to tell the
nature of the disease. It may not be obvious at first if it will be possible to deal with the
problem bank within the normal framework, or if there will be a need to take special
measures. Therefore, all cases should be dealt with within the same overall structure.
A speedy insolvency procedure with a fast pay-out to depositors at a low cost to the
deposit guarantee scheme...
Setting up a framework to deal with an ordinary bank failure does not need to be overly
complicated. Experiences from, for instance, the United States and Canada show that it is
quite feasible to close banks that do not follow the rules without this leading to consumers
losing confidence in the financial system, and at relatively low cost. The solution is based on
the deposit guarantee authority having a right, in fact an obligation, to intervene in a bank
when the capital falls below a certain level. One first ensures that the depositors covered by
the guarantee have access to their funds. Then the authorities can choose from a broad
arsenal of measures, including the transfer of the assets and liabilities to another bank or the
merger with another bank, to solve the problem at the least cost to the deposit guarantee
scheme.
I think that there are two characteristics of these kinds of systems which merit particular
attention. First, the ability to take swift measures and to write down claims quickly. It is
important to restore access to the liquidity held in the bank accounts as quickly as possible
not only for the insured depositors, but also more generally. Second, the system is
constructed such that the principle that owners take the first loss, and after this the creditors
in any order of priority that might exist, cannot be circumvented. The swift intervention means
that there is no point in running to the bank to "get first in line". The fact that the possibility of
a profit reflects a risk of a loss is fundamental in a market economy, and the system thus
ensures that this principle is maintained.
...with robust financing of the deposit guarantee
A related issue refers to the need to set up a deposit guarantee scheme in such a way that
the responsibility for the small depositors is fully internalised by the banking sector not only
on paper but also in practice. In addition to the need for a quick pay-out to depositors to
avoid the risk of a run, it is also important that the financing of the scheme is robust.
Many schemes rely on a mutual responsibility, where the remaining banks will come up with
the financing to cover the insured depositors of a failed bank, in some cases relying on a
fund which has been built up in advance. This works fine as long as it is only small banks
that suffer problems. However, if a larger bank is affected, there is a risk that the problems
will spread as other banks are forced to contribute substantial funds from their own balance
sheets. Given that many markets are very concentrated, with a few banks dominating the
market, the failure of the largest banks will be difficult to finance in these kinds of mutual
systems.
Particularly vulnerable are the kind of small private schemes which rely solely on the
remaining banks coming up with money after a failure. The deposit guarantee can then
rather become a destabilising factor without the problem bank necessarily needing to be a
particularly important actor in the payment system or on the financial markets.
Clearly, you want to avoid a situation where government intervention may be necessary
simply because of a poorly designed deposit guarantee system.
A solution to the problem was put forward in a Swedish government enquiry a few years ago.
The trick is to make the banks internalise the cost of the guarantee not at the industry level,
but at the level of the individual bank. The way to do it is to set up a state-administered
system to which all the banks pay a fee in relation to their risks, much like an ordinary
insurance policy.
Sure, the state still stands the risk in the event of a large failure. But in this system, it is duly
compensated for the risk. And the financing is robust. If implemented widely, this solution will
also make for a more level playing field between banks from different countries competing
partly on the same markets. I therefore hope that the proposal will get more international
attention than it has so far.
There must be a strong negotiating position for the government even when financial
stability is threatened
The above set up is a good set up to be able to handle the average bank failure. But, again,
in some situations a different regime may be needed. In particular, this may be the case
when it comes to larger and more complex banks in a situation of markets turmoil, when
there is a systemic threat to the financial system. In this situation, it may not be possible to
immediately revoke the licence for a bank which is in serious violation of the supervisory
regulations. The focus will need to be on maintaining the key operations in the financial
system. To secure this, the bank may need to stay open, at least for a while. The challenge
is to secure also in these cases that the state does not end up with the losses that the
shareholders and creditors should bear.
The first principle is to ensure that the bank's owners will bear the first loss in a crisis. This
does not need to be very complicated in practical terms. In principle it is a case of the
supervisory authority having the possibility to quickly and efficiently write down the capital
against losses and ensure that the owners' control over the bank is reduced to a
corresponding degree. Such a write-down in capital must, of course, be final in order to have
the desired effect. It is also important to ensure that the owners will not find the time to
violate the decision by transferring assets outside of the bank. The appointment of a
temporary administrator with a mandate to sign off any large payment or asset transfer may
thus be a useful tool.
The next step, to ensure that the state does not have to bear the creditors' losses, is more
difficult, however. The reason for this is that the banks' funding consists to a large degree of
borrowing with a short duration, which in turbulent times may tend to disappear.
There are sophisticated regimes under development...
It is possible to resort to more or less sophisticated solutions to deal with the problem.
One means is to fix a system that enables the authorities to take control over the bank and to
write down not only capital but also claims in an orderly manner, while extending a guarantee
to the new financing needed when the bank is under public control. The payments needed to
maintain the stability of the financial system would be effectuated, while other payments
could be temporarily stopped.
A draft model for such a system was presented by the Banking Law Committee in Sweden in
2000 and the proposal is currently being considered by the Swedish Government. As I
understand it, there is also work being done in other countries to bring about solutions that
would mean that the authorities could claim in all credibility that it was possible to reduce
claims even in more complex cases, where there was a risk to financial stability. Ideas that
have been put forward include immediately being able to impose a partial payment stop on
certain claims, haircuts, in connection with the authorities taking control over the bank and
transferring the assets to a temporary bank, known as a bridge bank.
To be effective, all these proposals make considerable demands for having IT systems in
place that can quickly distinguish different types of claims. A number of other preparations
are also required, for instance to be able to transfer contracts. It is thus not enough for the
legal structure to be in place; there must also be a practical solution that quite simply does
not provide any incentives to "push one's way to the front of the queue".
I welcome these efforts to strengthen the frameworks and look forward to seeing the results.
But I believe that one should have realistic expectations of the possibility to write down
claims in a shaky market situation. The experiences from the Swedish banking crisis and
also the Northern Rock case show us that in such situations it may be necessary to have an
extensive guarantee of the banks' obligations to stop a bank run or secure continued access
to the international capital markets.
...and a simpler way which has proven its worth in real crisis situations
I would therefore recommend also introducing regulations that give the government the right
to take over the ownership of a bank in a certain situation. If this is done in the right way, it
will not only deal with the requirement that the shareholders should be held responsible, it
will also minimise the risk that the government will need to bear costs that the creditors
should bear.
For this to work, the government should have the right to take over the shares before the
capital is completely wiped out. There are at least two reasons for this. First, there is a risk
that the owners will "gamble for resurrection" when the capital is low. Second, it is almost
always the case that the situation proves to be much worse than one thought. When the
capital is at zero on paper, there may in actual fact be a large deficit.
It is not without controversy that the government is given the right to nationalise a bank. It
may be particularly sensitive in countries that have a recent history of state ownership. But I
believe that the possibility for compulsory acquisition of the shares is a proper tool. Again,
the owners enter into the business knowing that a serious breach of the supervisory
regulations should result in the revocation of the licence and the loss of control over the
bank. The fact that an expropriation may be an alternative to the revocation of the licence in
such a situation when financial stability is at risk is important to restore a proper balance of
powers. As long as these powers of the state are clear beforehand, this should be
acceptable to the shareholders.
Returning again to the Swedish crisis, I believe that it was a decisive factor that the banks
realised early on that the government support measures were no free lunch. When this was
made clear, the owners had strong motives to recapitalise the banks themselves.
Of course, the idea should not be to end up with a state owned banking system; equally
important is to have an exit strategy.
Regardless of how the system for managing problems is constructed, it is also important that
there is finality in the intervention. There are several examples of what can go wrong
otherwise. Any errors should be corrected by means of damages, rather than reversing the
decision.
There should be many tools
If there is a system in place that means there is a credible threat that the owners will lose
their influence in a situation where the bank is in serious violation of the regulations, then
there is scope to try out alternative methods of solving problems in individual cases. It is
desirable that the authorities should have a broad range of tools at their disposal. It is
reasonable that the deposit guarantee or the government can take part in a vol