THE EXIT MECHANISM AND RESOLUTION OF PROBLEM FINANCIAL INSTITUTIONS*

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

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

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

Paper Outline ctd. • Deposit insurer’s 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

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.

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.

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.

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.

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;

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

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.

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?

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

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.

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

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.

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.

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).

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

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.

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.

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

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.

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.

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?

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

5.1 Resolution Methods ctd. troubled-institution. - providing prospective acquirers adequate opportunity to review the target bank’s operations especially its asset quality.

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)

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

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.

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

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

7.0 Deposit insurer’s 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.

7.0 Deposit insurer’s 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.

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.

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;

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.

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.

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.

THE EXIT MECHANISM AND RESOLUTION OF PROBLEM FINANCIAL INSTITUTIONS*