Financial Globalization Opportunities and Challenges for

							Legal Framework for Bank Insolvency:
    Basic Arrangements and their Limits

             Augusto de la Torre
              The World Bank




              Finance Forum
               June 20-22, 2002
                   Contents
The basic framework
  Prior considerations
  Elements
  Limits

Basic-plus framework

Systemic-run cases
              Basic Framework
        Considerations and Definitions
Bank resolution—a key leg of the tripod of capital,
monitoring, and exit
  See ―Beyond the Washington Consensus: Institutions
  Matter‖ (1998), chapter 3

Exit by closure–the ultimate disciplining device
   There are no internationally accepted standards, yet
   ―Fear of closing‖—contagion risk from loss allocation to
   bank creditors, and asset value destruction

―Sound exit framework‖ = incentive-compatible
interaction of LOLR, corrective regimes, closure,
resolution techniques, deposit insurance, liquidation
  Elements of the Basic Framework (1)
     Idiosyncratic and Not-Too-Big Cases
LOLR—avoid zombies while deterring unwarranted runs
  Avoid over-generous windows and payments-related
  overdrafts (under-priced, un-collateralized, unlimited)
  Involve bank regulator to ascertain solvency vs. liquidity
Corrective regimes—avoid paralysis vis-à-vis gray zones
  Move balance in favor of rules vis-à-vis discretion
  Regularization plans (responsibility of banks) and strong
  monitoring & enforcement powers (presumption of legality)
  Restrict regimes to private-sector solutions (moral suasion
  behind the scenes)
  The perils of classical ―intervention‖—co-administration
  (legal risk) of an open bank (moral hazard)
 Elements of the Basic Framework (2)
    Idiosyncratic and Not-Too-Big Cases
Closure—desiderata
   Minimize moral hazard w/o undue increase in contagion risk
   Maximize asset value preservation
Closure—key problems
   ―Hostages‖ and ―refrigeration‖
    Inadequacies of traditional liquidation
A framework for closed-bank resolution
   P&A-type techniques (deposit transfer funded by asset trust)
   Limited deposit insurance able to contribute to purchase and
   assumption, subject to less-cost rule
   Judicial liquidation of residual balance sheet
Legal protection—of process, assets, and officials
              Basic Framework
             Limits and Pre-requisites

Purely idiosyncratic failures are not very common

BF requires significant segment of sound banks
  Capable of absorbing quickly the assets and deposits of
  failed bank

BF presumes flight to quality (within system) only
  Safe LOLR is limited by ―borrower of last resort‖
  LOLR can fuel systemic run (flight out of the system)

BF requires resources (or access to) in the DIF
          Basic-Plus Framework
              Too-Big-to-Close Cases
Open-bank capital assistance…
…restricted to ―officialized‖ banks
  The ―accordion‖ procedure (Spain, Colombia)
…and subject to tight rules to avoid abuse
  Discretional—decision taken by highest level authorities
  of relevant agencies (U.S.) – discretional
  But funded w/o recourse to DIF (i.e., through the budget)
LOLR liquidity assistance against government bonds
Ex-ante contingency planning and ―fire drills‖

Works as long as massive systemic run can be contained,
which is problematic for highly indebted EM governments
    Generalized (―Type IV‖) Crises

Contract-abiding containment fails to avert a massive run
    Bank holidays, deposit freezes, deposit securitization
    Default spreads across internal and external contracts
By definition, ex-ante legal frameworks are violated
Issues go well beyond the scope of financial sector legal
and regulatory framework
    Fiscal, exchange rate, debt issues are salient
Focus must shift to prevention and better understanding
of the nature of the new, disturbing varieties of crises