1. Legal Framework for Bank Insolvency: Basic Arrangements and their Limits Augusto de la Torre The World Bank Finance Forum June 20-22, 2002

2. Contents The basic framework Prior considerations Elements Limits Basic-plus framework Systemic-run cases

3. 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

4. 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)

5. 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

6. 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

7. 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

8. 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