Financial Sector Assessment

Publicly Assisted Bank Restructuring

More recently, there has been broad international convergence on the principle that the discretionary, open-ended application of public funds to keep afloat insolvent banks and to make good their losses is unjustifiable. This practice transfers commercial losses to the taxpayer, validates bad bank management, and prevents the operation of the financial sector under conditions of market discipline and undistorted competition.

Generally, in situations of individual bank failure, no public funds should be used in the bank’s restructuring or liquidation, except in relation to payments under state-guar­anteed deposit insurance schemes. However, to facilitate the continuation of the viable part of insolvent banks on a going-concern basis and to minimize the cost of bank failure, the laws of some countries should authorize (or even require) that the deposit protection agency—or another agency with restructuring functions and powers—must provide lim­ited financial assistance for the restructuring of insolvent banks in official administration. That provision must be to the extent that it is likely to result in a least-cost resolution from the perspective of the agency (as distinct from that of the bank or its stakehold­ers).

More specifically, a public agency may be empowered to assist bank-restructuring operations whenever the value of its assistance does not exceed, on its estimation, the amount that it would have to pay out against insured deposits in the event of closure and liquidation. The forms that the agency’s assistance can take may vary and may include the subsidization of the sale of impaired assets, loss-sharing arrangements, or direct trans­fers of cash funds to the insolvent institution or its acquirers to absorb losses. Invariably, however, it will be aimed at making possible the bank’s merger with a solvent institution or a purchase-and-assumption transaction, in circumstances where this change would not be commercially feasible otherwise.

A fundamental principle underpinning any type of publicly assisted bank restructur­ing is that recapitalization with public funds (accompanied by government assumption of control and ownership, or government approved restructuring plan) should be attempted only in situations where the bank’s existing owners are made to absorb all accumulated past losses. This principle means that the shareholders’ net position in the bank should be verified and recognized through appropriate write-downs of the own-fund items. For banks that are under insolvency proceedings and that are not yet completely insolvent in the balance-sheet sense, shareholders’ participation in the restructured institution should be diluted. For balance-sheet insolvent banks, public funds should be forthcoming only after the shareholders have surrendered their shares or the shares have been otherwise eliminated in recognition of accumulated past losses. More generally, the shareholders should not gain any benefit from a bank’s restructuring except to the extent that they have directly participated in its costs.14

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