Early intervention and prompt corrective action in Europe

The present crisis has revealed that, as expected, much of the safety net for handling failures in the banking system is deficient, particularly for cross-border banks, and the present problems had to be handled by a range of ad hoc measures. The principal new measure that needs to be undertaken in most countries is the implementation of a satisfactory special resolution regime for banks. This paper, however, deals with two further steps that could assist the operation of the safety net. The first is to ensure earlier intervention so there is more time to put a satisfactory rescue or resolution in place. The second is to implement a regime of prompt corrective action (structured early intervention and resolution, SEIR) so that both supervisors and banks know that a regime of increasing intensity will take place according to a strict timetable that will end in the authorities stepping into the bank while it still has positive capital, if the earlier stages are not effective. The paper evaluates the means of doing this in a European environment making use of the experience in the United States. It concludes that, while a lot can be done even within the current framework of national supervision, particularly through pre-positioning, cross-border banks can be better treated either by revising the home-host responsibilities or by moving to a supranational level of responsibility for SEIR for those banks whose continued operation is considered necessary for financial stability in any member state.

Introduction: The recent crisis has taught us (at least) five main lessons, all of which were known beforehand but not appreciated so graphically: 1. Banks can get into trouble extremely rapidly – the authorities therefore need to have extensive ‘pre-positioning’ if they are to handle the difficulty efficiently
2. Depositors need to be guaranteed almost uninterrupted access to their funds and full insurance of most deposits if bank runs are to be avoided
3. The whole system of prompt corrective action (PCA) needs to start early, before the capital triggers are reached and hence requires a basis in risk assessment and market signals
4. It is necessary to be able to step into a bank and take it over before its capital is entirely depleted
5. If these were not enough, acting on cross-border banks is much more difficult as the tools and responsibilities are national, hence the chances of a disorderly failure are much greater.
It is easy to extend the list: it is clear that the market for troubled banks is highly imperfect – no reasonable bids could be obtained for Northern Rock and the rescue of Bear Stearns involved the commitment of substantial public funding, as did that of Roskilde in Denmark. Public funding of the banking system has had to be extended on a scale not previously thought of in a bid to stop systemic collapse. Financial stability involves more than a narrow interpretation of banks, with the perceived need to support not just investment banks but Fannie Mae, Freddie Mac and the insurer AIG. The existing regulatory system has been shown up as being even more procyclical than had been feared. There has been serious mispricing of risk and even more serious underestimation of the importance of liquidity.

Author: David G Mayes

Source: Research Discussion Papers, Bank of Finland

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