Ignoring the lessons for effective prudential supervision, failed bank resolution and depositor protection
| Pages | 186-209 |
| Published date | 24 July 2009 |
| Date | 24 July 2009 |
| DOI | https://doi.org/10.1108/13581980910972205 |
| Author | Gillian G.H. Garcia |
| Subject Matter | Accounting & finance |
Ignoring the lessons for effective
prudential supervision, failed
bank resolution and depositor
protection
Gillian G.H. Garcia
Gillian G.H. Garcia Associates, Alexandria, Virginia, USA
Abstract
Purpose – The purpose of this paper is to establish three sets of principles – the first for effective
prudential supervision of financial institutions; the second for the timely resolution of failed institutions
and the management of financial crises; and the third for the successful protection of deposits. It also
aims to show how these principles have been eschewed, especially in the USA and the UK.
Design/methodology/approach – The first set of principles and examples of their violation are
determined from material loss reviews conducted by agency inspectors general, government reports,
and academic research. The second set of principles is derived from International Monetary Fund
practice and research; violations are those reported in government reports, published research, and
press articles. The third set of principles is chosen from those proposed by the Basel Committee on
Banking Supervision and the International Association of Deposit Insurers. Violations are those
reported in academic and practitioner research and the press.
Findings – Many of the three sets of principles have been ignored in the current financial crisis.
Research limitations/implications – Experiencein previous crises has shownthat eschewing these
principles delays the resolution of individual failed institutions, increases resolutions costs, anddelays
the recoverfrom the crisis. If the legal and regulatorysystem is to be reformed appropriatelyto prevent a
recurrence, futureresearch must discover the reasons why theprinciples have not been followed.
Originality/value – The paper assembles three sets of principles and instances where they have
been violated in order to help policymakers, practitioners and researchers to focus on where and what
reforms are needed to prevent a recurrence of the current severe financial crisis.
Keywords Banks, Savings,Regulations
Paper type General review
I. Introduction
Financial economists used to think they knew how to keep the financial system safe
and sound so that the real economy could thrive. They had learned many lessons from
past crises in both developed and emerging economies – lessons on how to identify
problem banks and then either return them to strength or resolve them effectively if
they ultimately failed. This paper shows that many of the resulting rules for prudential
supervision, bank resolution, and deposit insurance have been ignored in the current
turmoil, especially in the USA[1]. While still being mostly applied to small institutions
there, the old resolution rules have, so far, been abandoned for systemically important
banks and other large complex financial institutions (LCFIs).
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1358-1988.htm
The author thanks George Blackford, Andrew Campbell, John Raymond LaBrosse, and Joseph
Mason for their help and comments, but remains responsible for any errors.
JFRC
17,3
186
Journal of Financial Regulation and
Compliance
Vol. 17 No. 3, 2009
pp. 186-209
qEmerald Group Publishing Limited
1358-1988
DOI 10.1108/13581980910972205
After this introduction, Section II examines cases where supervisory warning signs
have been ignored, especially in the USA – both old signs that in the past have
suggested that individual institutions were courting disaster and new red flag variants
that have emerged more recently. Section III explores US violations of the to-do and
not-to-do rules for handling system-wide problems – rules that have been established
from the lessons learned in past crises across the world. Section IV looks at breaches of
the rules for effective deposit insurance that have led to the imposition of blanket
guarantees. It notes that while the crises of the 1980s and 1990s typically followed a
progression from full guarantees to systems of limited deposit protection, this pattern
has been reversed in the current crisis as countries have augmented their limited
coverage with additional, even wholesale, guarantees. Section V summarizes and
concludes by asking where these findings leave us today.
II. Ignoring supervisory red flags
Earlier crises, particularly the US banking and thrift debacles of the 1980s and early
1990s and subsequent Latin American and Asian events, suggested a large number of
warning signs for identifying problems at individual institutions[2]. The well-known
signs shown in Table I range from fast growth, often by acquiring larger or fail ing
institutions (particularly cross national borders and after inadequate due diligence ) to
heavy reliance on non-retail funds and inadequate liquidity; excessive leverage;
concentration of assets, often in risk y, exotic and cross-border loans; weak
management (especially with regard to risk-control practices and setting appropria te
incentives); hubris and extravagance[3]. Many of these factors have been recognized
for some time and some are enumerated in the US Department of Treasury (2002, p. 6)
material loss review (MLR) for Superior Bank FSB, which failed in 2001[4]:
Indeed, we believe that Superior exhibited many of the same red flags identified with problem
banks of the 1980s and early 1990s. These included (1) asset concentration, arguably the most
dominant factor to Superior’s failure, (2) rapid growth into a new high-risk activity, (3)
deficient risk management systems relative to validation issues, (4) liberal underwriting of
subprime loans, (5) unreliable loan loss provisioning, (6) economic factors affecting asset
values, and (7) non-responsive management to supervisory concerns.
Fast growth
Fast growth was widely recognized as a major factor contributing to bank and thrift
weakness in the 1980s and early 1990s (Barth, 1991). It has also been ident ified as a
problem in both the UK and the USA in the current crisis – at Northern Rock (NR) and
the Royal Bank of Scotland (RBS) in the UK and at ANB Financial and IndyMac among
others in the USA.
Some firms grew internally and needed to raise funds in order to do so. Others
advanced through ambitious takeovers that stretched capital resources and
management abilities, particularly where the acquisition crossed national borders.
RBS was exposed by its takeover ambitions in collaborating in the purchase of ABN
Amro, and by its earlier acquisitions of Citizens Financial and Charter One in the USA.
Even HSBC, which has so far weathered the crisis better than many of its competito rs,
publicly regretted its 2002 acquisition of household finance, a US institutio n that served
low-income customers with spotty credit records and subsequently incurred heavy
losses (Croft, 2009). Lloyds Banking Group deteriorated into substantial nationalization
Ignoring
the lessons
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