Financial Sector Assessment

Bank Liquidation

In liquidation, an insolvent bank is dissolved after a liquidator assumes legal control of its estate, collects and realizes its assets, and distributes the proceeds to creditors—in full or partial satisfaction of their claims—in accordance with the principle of equal (pari passu) treatment of similarly situated creditors and the applicable rules on priority. Liquidation will be appropriate if the bank’s restructuring does not appear feasible or if the restructur­ing involves the spinning off of the viable operations of the bank, thus leaving only its residual, nonviable part with the original legal entity. On the commencement of liquida­tion and until the final act of dissolution, the bank will continue to exist as a legal entity but will no longer be a going concern. However, bundles of assets may be sold as part of a business, rather than on a piecemeal basis, to ensure the maximization of their economic value.

The primary objective in a liquidation is to ensure the preservation and optimal col­lection of the bank’s assets so that creditors (including depositors) receive as much as pos­sible of what is owed to them. Effective bank liquidation presupposes that the legal system provides satisfactory answers to certain special problems, which may not be present in a non-financial firm. Accordingly, a jurisdiction must have a complete legal framework in place to handle the liquidation of banks. The absence of such a framework will not only result in disorderly closure of individual insolvent banks but also increase the risk of spill­over effects, with potential systemic implications.

In particular, the liquidation framework should comprise clear rules for formally plac­ing the insolvent bank in liquidation, terminating its banking activities, and assigning to a qualified agency the tasks related to the liquidation of its estate. With regard to the latter, the liquidation framework must contain provisions that ensure immediate and effective protection of the assets, including an automatic moratorium or suspension of all collection activity against the bank to prevent a race between creditors for the seizure of assets and to ensure the orderly realization of assets and equitable distribution of proceeds. It is also of vital importance that the rules provide sufficient flexibility to enable the liq­uidator to achieve the realization of assets in the most cost-effective way and that they ensure that proceeds are distributed to the various classes of creditors (including deposi­tors) in a fair and transparent manner, which does not violate their relative priority. Some of the key principles to govern the legal and regulatory framework for bank liquidation are as follows:

• Bank shareholders must be held responsible for the losses of the bank. When a bank is found to be insolvent, the supervisory agency must be in a position to write down shareholder equity and to eliminate shareholder rights.

• The supervisory agency should be given the responsibility to establish the list of qualified liquidators.

• The supervisory authority must have the right to appoint a bank liquidator to replace the shareholders. The bank liquidator must have the authority to sell all or part of the bank’s assets including branches.

• The law must determine the priorities for distributing resources from asset sales among creditors.

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