Systemic Bank Insolvency: A Legal Framework for Early Crisis Containment

Preface

In response to the contagion effect of the 1997 East Asia financial crisis, the World Bank, International Monetary Fund and G 22 Finance Ministers and Central Bank Governors have joined together to help countries build an international financial architecture to improve world wide living standards and reduce the risks from global economic and financial integration. The pillars of this architecture include encouraging transparency and the adoption of international standards; strengthening the regulatory framework; reinforcing macroeconomic policies and financial systems; enhancing crisis prevention and management; and promoting social policies to protect the poor and most vulnerable. All these elements are crucial to building long-term public institutions and a private sector infrastructure that will promote a broad based sharing in the benefits of global growth while limiting the potential risks from cross border flows of capital.

In building the global financial architecture, however, we must not forget that even though most countries are subject to episodic financial crises the impact of such crises are far more devastating in transition and developing economies. As President Wolfensohn pointed out to the March 1999 Symposium on Global Finance and Development: "You need only consider the banking disasters of the Scandinavian countries and the U.S. with the savings and loan debacle to find examples of the fact that there will be crises as a matter of fact. But what made them a little easier to handle in both these instances were the institutional underpinnings that were in place, that facilitated recovery and protected vulnerable citizens."

The dangers for transition and developing countries that have only begun to build the necessary foundations for a resilient market economy are all too obvious. In the last two years we have seen first hand how financial shock waves, like the 1997 tsunami which swept away so much of the economic progress achieved by the countries of East Asia, can destroy the hopes of millions of people. When a crisis of confidence was triggered by the Thai Government decision in July 1997, to float the baht, few people anticipated the depth to which the Thai economy would plunge. Even fewer people expected the waves of panic to sweep through many other East Asian countries and no one imagined the eventual effect on Russia and Brazil. Each crisis revealed fundamental weaknesses in the financial structure yet each government was caught unprepared. Despite the lessons learned only a few years ago by the systemic failures in Scandinavia, Latin America and the U.S. no one had a contingency plan for managing the crisis.

Introduction

Recognizing the inevitability of systemic financial crises in all vibrant economies and the particular hardship of such crises in developing countries, the purpose of this paper is to (a) present a brief overview of the crisis containment and other short term programs that were developed by three of the countries severely affected by the East Asia financial collapse (Thailand, Indonesia and Malaysia), and (b) propose the idea of advance planning to manage the next systemic financial crisis through an contingency legal program.

For the purposes of this paper the term "systemic financial crisis" is defined as widespread banking failures that affect more than 20% of the banking system's total deposits and result in depositors, shareholders and creditors all trying to get their money out the banks at the same time. There is no question that the financial crises that struck Thailand, Korea, Indonesia and Malaysia in 1997, qualify as systemic banking crises. Crisis containment is the immediate measure undertaken by governments as they begin to recognize that the expanding financial system losses cannot be corrected through the normal mechanisms of regulatory and supervisory policies. Systemic bank restructuring is the whole panoply of extraordinary measures employed by governments to rehabilitate or close failed banks and return the financial sector to normality.

It should be emphasized that this paper does not purport to be a comprehensive study of the bank restructuring efforts in the three East Asia countries. Nor does it cover the origins of the crises except in so far as the crises revealed underlying vulnerabilities in the legal infrastructure of the financial sector. It is principally a think piece to begin the process of developing a better legal infrastructure for containing and managing future systemic banking failures in developing countries, keeping in mind the overall objective to build long term integrated approaches to stabilizing the economy and to protecting the most vulnerable population.

Crisis Response in Thailand, Indonesia, and Malaysia

THAILAND

After decades of high growth that masked fundamental structural weaknesses, Thailand was the first country in East Asia to break under the weight of "collapsing asset values (equity and real estate, especially), a sharp rise in liabilities (due mainly to unhedged foreign exposure and high domestic interest rates) and big declines in aggregate demand" Hidden beneath this precarious combination of macro and micro economic fault-lines were fragile government institutions, outdated regulatory systems and an inadequate legal and judicial framework for sustaining a market economy.

The first segment of the financial sector to feel the impact of declining asset values was the finance companies, a specialized type of credit institution that was limited by law to raising funds through time (rather than demand) deposits and whose primary line of business was real estate lending. Finance companies had been allowed to expand for the last three decades despite the fact that these institutions had been the cause of a previous financial crisis in the 1980's and had much lower capital and more lenient loan classification and loan loss provisioning requirements than commercial banks. By 1997, finance companies accounted for approximately 25% of total financial system assets while commercial banks accounted for 65% of system assets (the remainder of the assets were held by specialized state banks). Because the fate of many finance companies were intertwined with the real estate market their non-performing loans (NPLs) rose rapidly as the asset values declined and their liquidity was severely constrained. It is estimated that at least 20-30% of finance company loans were non-performing (at least six months overdue) by March 1997.

Although their losses were apparently not as severe as the finance companies, the commercial banks also experienced a decline in their asset values and, in particular, the quality of assets held by their off-shore banking units (Bangkok International Banking Facilities or BIBFs). Banks were permitted to create BIBFs in 1993 as part of the Government's plan to construct an international financial market alternative to Hong Kong and Singapore. Using BIBFs Thai banks could take deposits or borrow in foreign currencies and lend to domestic borrowers or foreign companies through the international market without being subject to the same regulatory scrutiny as domestic banking operations. By March 1997 at least 10-15% of commercial bank loans were estimated to be non-performing.

Throughout the spring of 1997 the Government became increasingly concerned about the deteriorating loan portfolios of many finance companies and some commercial banks but lacked accurate information as to the true extent of the problem loans. The lack of accurate accounting data for loan values was exacerbated by weak and inconsistently applied prudential regulations. Even the reported capital adequacy ratios were based on a pervasive system of regulatory forbearance: substandard and non-performing loans were routinely permitted to roll over without increased provisioning and accrued (but unpaid) interest was included in earnings for the purpose of paying out shareholder dividends and management bonuses.

Even if the Government had been fully informed of the losses, however, it was unclear which agency had responsibility for developing a strategy for resolving the failing finance companies and commercial banks. Although the Minister of Finance (MOF) was responsible for approving all commercial bank and finance company licenses, issuing regulations and liquidating insolvent institutions, the MOF had delegated most of its authority to the Bank of Thailand (BOT). As a practical matter the BOT exercised regulatory and supervisory control over commercial banks and finance companies but the MOF retained the authority to overrule BOT decisions. When the problems of the finance companies and commercial banks started to escalate it was apparent that neither agency wanted to take responsibility for making unpopular decisions. Consequently, there was no unified or consistent Government strategy for handling the initial phase of the crisis.

Moreover, there were substantial questions as to the legal authority of the BOT and the MOF to takeover failing institutions, seize their records, remove officers and directors, and dispose of assets. Without new legislative authority, which the Government was reluctant to seek because of potential public reaction, the BOT was forced to rely on its existing weak regulatory authority and the resources of the Financial Institutions Development Fund (FDIF). The FIDF had been created as a separate legal entity within the BOT during the 1980s finance company collapse in order to provide liquidity to distressed banks and finance companies but it had rarely been used and had no staff of its own.

Faced with growing public concern about the stability of the finance companies in March 1997, the Government tried to shore up confidence by announcing that ten unnamed finance companies would be required to increase their capital because of deteriorating real estate loans. In the event that these companies could not raise new capital the FIDF would buy their shares until the capital level was met. At the same time the Government announced that it was increasing the provisioning levels for the non-performing loans of the remaining finance companies and commercial banks but these institutions were said to be sufficiently capitalized or have the capacity to raise capital on their own. Recognizing that the announcement might cause a run on the weaker finance companies, the Government sought to calm fears by clarifying that the FIDF would also inject liquidity into the ten failing finance companies.

Rather than calming fears the Government's announcement only spurred more depositors to withdraw their funds. As deposits flowed out the Government (through the FIDF and BOT) quietly pumped money into dozens of finance companies and a few banks. This increased the Government's need for cash and put further pressure on the weakening baht. In another attempt to demonstrate its ability to handle the growing crisis, the Government, on June 29, 1997, announced it was temporarily suspending 16 finance companies and would fold them into a government controlled finance company unless they could produce acceptable plans for restoring their capital by July 11, 1997. To explain its actions and still the growing panic the Government issued a press release stating that no other finance companies would be suspended and all depositors and creditors (domestic and foreign) would be guaranteed repayment. Unfortunately, the press release was not explicit about the legal authority for the guarantee or how it would operate in practice.

Within days it was clear that the Government's press release had prompted a massive outflow of capital (both foreign and domestic) along with further speculation against the baht and a depositor run on the remaining finance companies and weaker commercial banks. On July 2, 1997, the Government announced it would no longer support the baht and let it float against other currencies. With this dramatic action the Government finally acknowledged that the financial sector systemic crisis was beyond its ability to control. It called on the World Bank and the International Monetary Fund to help design a macro and micro economic program to restore the economic health of the country.

From July through to October 1997, financial sector specialists from the Bank and the Fund worked at a feverish pace to understand the nature of the financial sector crisis and to advise the Government on a recommended plan of action. It soon became clear that the Bank of Thailand lacked the legal powers to accomplish most of the measures being recommended by the Bank and Fund. By mid-October the Government was ready to seek emergency legislation to implement a restructuring program. On October 14, 1997, four Emergency Decrees were announced. These decrees: (a) confirmed the authority of the Government to issue the temporary blanket guarantee protecting all depositors and creditors; (b) established a temporary Financial Sector Restructuring Agency (FRA) for the purpose of assuming control over the suspended finance companies and other financial institutions as necessary; (c) amended the legislation regulating the finance companies and commercial banks to give the BOT authority to increase their capital requirements and change their management; (d) established an Asset Management Corporation (AMC) to acquire and dispose of the assets held by the suspended finance companies and any other financial institutions that were taken over by the FRA; and (e) authorized the FIDF to lend to the financial institutions taken over by the FRA and to raise the fee charged to financial institutions whose depositors and creditors were covered by the blanket guarantee.

With the enactment of the Emergency Decrees management of the Thai financial sector crisis moved to the next phase of developing a longer term resolution and financial sector reform program, which is outside the scope of this paper.

INDONESIA

As speculative attacks on the Thai baht intensified in July 1997, fears spread of Indonesia's vulnerability to financial crisis since many of the same factors that caused bank failures in Thailand were also present in Indonesia, in particular collapsing real estate values. Bank Indonesia (BI), the central bank, acted promptly to limit the banking sector's exposure to property, and to ban new credits to property companies. On July 10, 1997, figures released by BI revealed that problem loans on real estate projects had more than doubled. The weakness pulled the Indonesian rupiah down to an all-time low.

Despite the efforts of BI to protect the rupiah, it continued to fall until August 14, 1997, when BI allowed the rupiah to float. The ensuing collapse of the rupiah raised concerns over corporate debts as many private companies had borrowed extensively in foreign currency. From mid-July to mid-October 1997, the cumulative depreciation of the rupiah exceeded 30%, while the fall in the Jakarta stock exchange index reached 35% – the largest declines in the region. With the fall in the rupiah, banks and corporations that had borrowed from abroad without hedging faced sharp increases in their rupiah debt service cost. The deep systemic weaknesses in Indonesia's financial and corporate sector became ever more apparent by Autumn 1997, and in October 1997, the Indonesian authorities called on the World Bank, International Monetary Fund and the Asian Development Bank to help them deal with the crisis.

All three international financial institutions (IFIs) soon realized that the depreciation of the rupiah, combined with a sharp shift in market sentiment, had already had a devastating impact on the banking sector. An initial review of banking industry found 34 banks to be insolvent and many more appeared to be severely weakened. Runs on banks, some of them vindicated by the banks' actual financial condition, some not, had been a daily occurrence since August. Rumors were rife, and lists of insolvent banks were published daily in the press, often reflecting with striking accuracy the discussions held by the authorities during the previous day.

In October 1997, when the Government's first bank restructuring program was drawn up, it was envisaged that the crisis could be resolved largely through market-based solutions: insolvent private banks were to be liquidated without deposit compensation and insolvent state banks were to be merged, restructured with new capital or privatized. Instruments of government intervention, as envisaged at the time, included placing the healthier private banks under the conservatorship or intensive supervision of BI.

In the months that followed, BI continued its efforts to resolve problem banks. Nonetheless, the Jakarta Stock Exchange lost 9.8% of its value on January 20, 1998, and the rupiah followed suit losing 35% in one week. A massive loss of confidence ensued and, in the face of pervasive runs across the banking sector, there was vast liquidity support from BI. The exchange rate appeared to be headed into free-fall as it went from 3,500 rupiah per U.S. dollar in December 1997 to 17,000 rupiah per U.S. dollar in late January 1998.

On January 26, 1998, the Government issued Emergency Presidential Decrees containing its three-point stabilization plan:

· a temporary Government guarantee for all depositors and creditors of domestic banks;
· the establishment of the Indonesian Bank Restructuring Agency (IBRA) under the auspices of Ministry of Finance; and
· an immediate but temporary pause on foreign currency debt service (of interest and principal).

The blanket guarantee was intended to stop runs on the banks in order to facilitate an orderly workout of the troubled institutions. At the same time the Government imposed the following conditions on all domestic banks: (a) acceptance of the BI's enhanced regulatory, supervisory, and enforcement powers, (b) a commitment of cooperation in diagnostic and reporting requirements, (c) the acceptance of operational and financial improvements as determined necessary by BI and IBRA, (d) dividend restrictions, (e) fee for coverage under the guarantee, (f) liability for BI/IBRA costs associated with diagnostic studies and supervisory burdens, and (g) personal liability of senior managers, directors, and certain categories of owners for gross negligence, willful misconduct, malfeasance, and false reporting.

IBRA was established to lead the bank restructuring efforts for the most illiquid and insolvent banks. It was envisaged that IBRA would (a) take over the claims deriving from BI's emergency liquidity support to banks (which had risen to 12% of GDP by January 1998, from 2% in October 1997), as well as the cost of the guarantees for depositors and creditors; (b) supervise banks in need of restructuring and manage the restructuring process; (c) decide on the best course for restructuring unsound banks, including recapitalization, mergers, takeovers, or liquidation; (d) take full responsibility for managing state bank resolution; (e) develop a specialized asset management/loan work-out capability to manage, and eventually sell, the assets acquired in the course of bank restructuring; and (f) lead the process of privatizing the banks it acquired. IBRA was created with a five-year time horizon, and was to operate under the auspices of the MOF. It was expected that while IBRA would initially be funded by government bonds issued specifically for this purpose (with the interest on bonds borne by the budget), it would become more self-financing over time as recoveries increased.

Although the issuance of Presidential Decrees began the bank restructuring processes, the Decrees were of limited legal authority due to complexities of the Indonesian legal system. Under Indonesia law, temporary institutions like IBRA can be quickly established via Presidential Decrees but they cannot be made truly operational without the enactment of parliamentary laws and detailed implementing regulations. As a result, even if the Government wanted to expedite operation of the restructuring program through IBRA, the legal process was too slow to keep pace with the declining values in the financial system. In fact the delay in establishing and staffing IBRA led some analysts to conclude that the Government was not fully committed to the radical steps that needed to be taken to restore the banking system. For example, IBRA's implementation regulations were only issued on February 27, 1999, over 13 months after the Presidential Decrees were announced. The lack of clear and adequate legal authority for IBRA eventually resulted in the passage of new amendments to the Banking Law in the summer of 1999. Another problem that slowed the resolution of insolvent banks was the lack of consensus and coordination among various government agencies and ministries. There was also a lack of legal clarity regarding Bank of Indonesia's supervisory and regulatory responsibility for the entire banking system. While its role on the private banks was clear, its role in the state owned banks was not.

All these factors, and in particular, the cumbersome and inefficient legal system, contributed to the slow start of systemic bank restructuring efforts and the Government's inability to contain the crisis.

MALAYSIA

Unlike Thailand and Indonesia, the Malaysian legislative framework for the supervision of the banking institutions was strengthened following the 1985-86 recession. The central bank, Bank Negara Malaysia (BNM), was the sole supervisor of the banking system and the Banking and Financial Institutions Act 1989 (BAFIA), provided a strong framework for the integrated supervision of the financial system. Since the passage of BAFIA, BNM adopted many international regulatory measures designed to increase the efficiency and soundness of the financial system while at the same time reducing its exposure to the more vulnerable sectors of the economy. The supervisory and regulatory framework (including capital adequacy ratios, public disclosure and improved risk management controls) were continuously revised to be consistent with international standards and best practices. The quality of the asset portfolio and the level of capitalisation of the banking sector reflected these regulatory measures. By June 1997, the net non-performing loan (NPL) ratio was at a low of 2.2% and the risk-weighted capital ratio (RWCR) of the Malaysian banking system was 12%.

Nonetheless, the regional crisis exerted pressures on the currency and stock markets, causing the ringgit to depreciate and the Kuala Lumpur Composite Index to drop by about 35.1% and 44.8% respectively in the second half of 1997. As the regional financial crisis persisted, the effects on the economy and the financial system began to be felt. Structural weaknesses in the financial system also became more evident with the prolonged crisis. Strong loan growth between 1994-1997, about 25% per annum, led to a high loan exposure in the banking system. The underdeveloped bond market also resulted in the banking sector providing RM722 billion, or 57% of the total financing for private sector growth at the end of 1998.

The prolonged regional financial crisis and subsequent contraction of the economy led to some deterioration in the quality of the asset portfolio of the banking institutions with the net NPL to total loans ratio increasing to 8.9% by end-June 1998. The rising level of NPLs also eroded the capital base of a number of banking institutions. Finance companies became vulnerable, given the highly fragmented nature of the industry (39 companies) and their primary focus on hire-purchase financing and consumption credit, both of which were adversely affected by rising interest rates and the slowdown of the economy.

Because the regional crisis prompted concern over the soundness of domestic banks, there was a continuous outflow of deposits from domestic banks to foreign banks in Malaysia throughout the later half of 1997 and first half of 1998. At the same time, the market was rife with rumors of bank failures and the conflicts between the Prime Minister and the deputy Prime Minister only added to the chaos. Confidence needed to be restored rapidly in the financial markets in general and the banking sector in particular in order to avoid a massive run on the banking system.

In March 1998, the Government announced a series of measures to stabilize the financial sector, including: (a) a complete guarantee of deposits in all licensed institutions. This action, together with BAFIA's provision that deposits have priority over all other liabilities of financial institutions and the Government's history of keeping its promise on earlier guarantees of deposits (co-operatives in 1986), stopped the runs on domestic banks; and (b) the establishment of a National Economic Action Committee (NEAC) to deal with the crisis and advise the Government. In particular, the NEAC was charged with providing advice on how to minimise the contractionary effects of the crisis on the real sector and strengthen the financial system;

In April 1998, the Government enacted a comprehensive plan to restructure the banking sector using a four-pronged approach: (a) comprehensive examination by BNM to establish the true state of affairs in the weak banks; (b) creation of an asset management company, Pengurusan Danaharta Nasional Berhad (Danaharta) to manage and sell the assets of failed financial institutions; (c) creation of a special purpose vehicle, Danamodal Nasional Berhad (Danamodal) to recapitalise banks that were required to write down their assets; and (d) creation of the Corporate Debt Restructuring Committee (CDRC) to work out feasible debt restructuring schemes without having to resort to lengthy judicial proceedings.

The Government did not need to provide additional legal and investigative powers to the BNM since the BAFIA provided a full range of authority. Danaharta, following the model of other successful asset management companies, (such as the U.S. Resolution Trust Agency) was authorized to carry out the rehabilitation and restructuring of failed institutions and to maximize recovery value of assets. To ensure that banking institutions utilised Danaharta to remove their NPLs, those institutions with gross NPL ratio exceeding 10% were required to sell all their eligible NPLs to Danaharta or write down the value of these loans.

Danamodal was established on August 10, 1998, as a wholly owned subsidiary of BNM to address the practical constraints faced by bank shareholders who needed to recapitalise after writing down the value of their loans. Banking institutions, which needed recapitalisation from Danamodal, were required to sell their eligible NPLs to Danaharta. As a strategic shareholder in these recapitalised banking institutions, Danamodal was intended to institute sound risk management practices, good corporate governance and higher operational efficiencies through its on bank boards of directors. Danamodal was also intended to facilitate mergers in line with BNM's objective to consolidate and rationalise the banking sector.

To facilitate the restructuring of corporate debt, the CDRC was set up to provide a platform for both borrowers and creditors. A large number of borrowers in financial difficulties had initially sought legal protection under Section 176 of the Companies Act 1965 rather than negotiating for loan restructuring. With the setting up of CDRC, borrowers were able to direct their debt restructuring to CDRC. Under the CDRC debt-restructuring framework, creditor committees comprising banking institutions were to be formed to work out the debt restructuring. By increasing the speed with which corporate debts could be restructured it was anticipated that this would also expedite restructuring of the banking institutions. When the process under CDRC could not obtain consensus among the banking institutions, Danaharta was intended to assist by buying NPLs from the dissenting banking institutions and thereby facilitate the restructuring process.

Danaharta, Danamodal and CDRC were intended to be interdependent and complementary in order to present a comprehensive and coherent plan for strengthening the banking sector. However, to ensure cooperation among these entities, the government appointed a Steering Committee, chaired by the Governor of BNM, to oversee and monitor their policies, operations and progress.

The ability of the Malaysian government to act quickly and effectively was significantly enhanced by the existence of a strong legal framework for BNM. There was no question that BNM already had most of the specific powers necessary to deal with banking crisis. For example, BNM had the power to investigate, prosecute, take over the management of banks and impose a moratorium on their operations. It also had the power to acquire the shares of financial institutions and require a capital increase if a bank's capital was impaired by losses. Because BNM's powers were explicit and clear, it deterred legal challenges during the implementation of the restructuring program. In addition, the strong administrative law foundation in Malaysia, which allowed judicial review of administrative and quasi-judicial actions, helped public acceptance of the strong powers that were vested in institutions like BNM, Danaharta and Danamodal.

Conclusions

The crisis in each of the three East Asian countries revealed serious flaws not only in their macroeconomic policies but, just as importantly, in the structure and regulation of the financial system and the legal framework necessary to both sustain a growing economy and correct a failing one.

Most of the work now being carried out by the IFIs, the Basle Committee on Banking Supervision and the Financial Stability Forum (which was established by the G7 in the spring of 1999) are intended to help countries build a stronger and more resilient macro and micro financial framework to resist or minimize systemic crises. The structural and institutional mechanisms being discussed can be best categorized asCrisis prevention: including the development and implementation of good practice standards and transparency codes, and incentives for both borrowers and lenders to act prudently; and Crisis resolution: emphasizing the creation of a more orderly environment for restructuring external debt, fair and equitable principles to guide the restructuring of banking systems in wake of a crisis, and effective mechanisms for handling corporate insolvency. In addition, the World bank and the International Monetary Fund have jointly undertaken a pilot financial sector assessment program (FSAP) to identify significant financial systemic weakness and to help countries design programs that will reduce the potential for systemic crisis.

While we applaud and encourage the search for a better gauge of underlying vulnerabilities and a more accurate measure for predicting when those vulnerabilities will erupt into a systemic crisis, logic and history tells us that this is extremely difficult to accomplish. Every crisis is by its very nature unanticipated. We can look back on the early 1980s crisis in Chile and Argentina, the mid 1980s crises in Norway and Sweden, the U.S. savings and loan crisis in the late 1980s, the Mexican crisis in the mid 1990s and now the East Asia crisis - in each case the underlying faults in the financial system were not understood by the policy makers, depositors or investors until an apparently external event set off a devastating chain of failures. Given the human and financial costs of successive financial crises over just the past two decades, we must continue to devote considerable effort to avoiding future crises. But we must also accept the fact that financial crises will always be with us.

Recognizing the inevitability of systemic financial crisis in developing countries and their devastating impact on the most vulnerable populations, we believe it is equally important to focus on Crisis containment. The experience in Thailand, Indonesia and Malaysia teaches us that early crisis containment is critical to reducing the human and economic cost of a systemic financial crisis. Three important lessons emerge from the different ways in which these three countries first reacted to the crisis.

1. Prompt action is of the essence but a coherent plan is even more important. Failure to address crises in a timely manner invariably results in a rapid deterioration of financial sector conditions and a concomitant escalation in the costs of restructuring and attendant macroeconomic consequences. The sooner the problem is recognized and dealt with the lower the costs to the economy, the banking system and the public. On the other hand, a program which is not well thought out is likely to be more destructive of long term restructuring efforts than no program at all. For this reason it is crucial that the government quickly establish which institution or agency is to be given overall responsibility for formulating a comprehensive program. The more thought that is given to developing a systemic approach (covering the entire financial system and not just the most visible failures) using the lessons learned from other crises, the more likely the program will be effective, and equally important, accepted by depositors, investors and the public.

2. Public fears must be minimized before they lead to social unrest. The historic evidence demonstrates that closing a large number of banks without providing sufficient assurance to most depositors will result in a public panic and an escalation of the crisis. The Indonesian program, as it was first outlined in October 1997, proposed the immediate closure of nonviable banks. In the absence of an explicit guarantee this caused massive runs on the banking system and contributed to a climate of deep political uncertainty. The policy had to be reversed two months later and a temporary blanket guarantee introduced. In the case of Indonesia the advantages of issuing a temporary guarantee before closing 16 banks should have outweighed the moral hazard concerns. In Malaysia, the quick implementation of a temporary deposit guarantee was credited with preventing bank runs.

The key advantages of a temporary blanket guarantee, as the Indonesian and Malaysian experience suggests, are that it helps to (a) stabilize the liability side of banks, (b) provide more time for the authorities to initiate a restructuring strategy, and (c) preserve the integrity of the payments system. Not only must the government be empowered to issue such a guarantee, but the guarantee must be carefully constructed to avoid unintentional inclusions and minimize moral hazard. The latter problem can be mitigated to some extent by: (a) intensifying the supervision of banks, (b) capping deposit rates at a premium above the average levels offered by the "best" banks (to prevent weak banks from capturing deposits), (c) explicitly announcing that the blanket guarantee is a temporary measure, and (d) requiring institutions to contribute a guarantee fee.

3. The government must have clear legal authority to take actions to contain the crisis at the earliest possible stage. The third lesson is that all action taken during the crisis must have a sound legal basis. To enable speedy and effective diagnosis of the problems and quick action to salvage whatever assets remain in the banking system, the government must have adequate and unequivocal legal powers to contain and manage the crisis.

The legal powers that appear to be essential are:

(a) the authority of supervisors to issue a desist and stop operations orders, immediately dispatch examiners to banks, physically take control of bank offices and branches, seize records and undertake other salvaging activities to avoid the abandoning of branches, looting and destruction of books and accounts;

(b) the authority of supervisors to replace bank management (if necessary);

(c) the authority of supervisors to appoint third parties to conduct immediate and comprehensive audits of the troubled banks and carry out other necessary assignments under the law. These third parties must also be provided the immunities and protections granted to government officers;

(d) the authority of the relevant government agency(s) to support the comprehensive restructuring program and implement the program with a minimum risk of legal challenges. If the restructuring plan involves mergers or takeover of weaker banks by stronger ones it will be useful for the law to provide for expeditious merger and takeover arrangements; and

(e) the authority of courts to expedite review of legal challenges to government action. Consistent with this approach, a special court could be established for the sole purpose of accepting cases relating to the banking crisis.

Recommendations

A systemic banking crisis has been compared to a natural disaster such as tidal wave or earthquake. Although there may be no physical destruction, financial crises are violent in their own way and can destroy the hopes and economic well being of millions of people; and like natural disasters, financial crises affect everyone in their path but have the most lasting impact on the most vulnerable population. Just as many countries develop advance contingency plans for helping the innocent victims of natural disasters, they should also consider the advantages of having a contingency plan for systemic financial disasters.

Such a plan would not spell out every detail of the actual measures to be taken during a systemic banking crisis since those will depend on the exact nature of the crisis, but lay the legal foundation for the government to launch immediate and effective action to contain the crisis, prevent further deterioration of a banking system and protect small depositors.

The experiences of Thailand, Indonesia and Malaysia demonstrate the need for a preexisting legislative framework that allows the government to immediately exercise "extraordinary" or "super" powers. If, in the midst of the crisis, the government must first initiate legislation in order to take emergency action the inherently chaotic nature of a systemic collapse is likely to produce a seriously flawed legal framework. Moreover, the rush to create emergency legislation when the government has not yet developed a comprehensive program can result in hastily conceived legislation that may seriously damage the government's credibility and restrict its options for long term restructuring. Rather than wait for the crisis to occur, it seems much more sensible for governments to consider enacting during normal times, a series of legal measures that can only be exercised during a systemic crisis.

Broad legal powers can be conferred on the bank supervisor and/or another government entity under a "Contingency Legal Powers (CLP)" framework. The conditions and procedures for activating the CLP can be incorporated in the body of the banking law, another legal instrument or even the Constitution. The conditions can be in the form of minimum trigger points that have historically indicated the onset of a systemic banking crisis. The trigger points can include exchange and interest rates, stock market indices, rate of NPA, etc. The President/Prime Minister can be the official authorized to activate the CLP framework. The process and procedures for taking emergency actions could also be drafted to follow the models used for emergency actions in the event of natural disasters.

One of the greatest challenges to enacting a CLP is the willingness of the public to support extraordinary powers for the government when there is no imminent need or threat. To justify these powers , governments will need to demonstrate the risks of not being prepared for a crisis and provide sufficient safeguards to assure the public that they will be protected against abuses of the emergency authority.

An effective CLP framework should also empower the bank supervisor and related governmental authorities to undertake the actions necessary to implement a comprehensive bank restructuring program.

A possible CLP framework might contain the following:

Contingency Legal Powers Framework

1. Conditions necessary for activating emergency powers.
2. Designation of the agency responsible for implementing emergency powers.
3. Enhanced powers in relation to financial institutions in distress.
4. Provisions for the appointment of advisors and consultants.
5. Provisions for the to removal of directors and officers from office.
6. Power to issue desist and stop operations orders.
7. Power to issue moratorium and bank holidays.
8. Power to appoint additional examiners and investigation officers.
9. Power to examine institution and persons.
10. Power to prosecute criminal activities related to failed institutions.
11. Power to rehabilitate/restructure banks.
12. Provisions for special mergers or acquisitions.
13. Protection and immunity for bank supervisors and third parties hired by supervisors.
14. Coordination and cooperation of authorities.
15. Power to issue emergency regulations and rules.
16. Expedited judicial review of challenges to government actions.
17. Special measures to protect the most vulnerable.

The foregoing list is only a general and generic sample. The constitutional environment, legislative authority, strength of judicial review, history of conduct for quasi–judicial and administrative bodies, political process and relative state of public governance would determine the exact nature of the CLP framework and the necessary safeguards against abuse. It is by no means an easy task to strike the fine balance between the need for effective emergency power and the need to prevent abuse in the name of a crisis. Nevertheless, we submit that the potential for abuse of the CLP framework is likely to be far less than the danger of having inadequate legal power to contain a systemic crisis or initiate a comprehensive restructuring program.

References

1. Responding to the Global Financial Crisis, Systemic Bank and Corporate Restructuring, Experience and Lessons for East Asia, Stijn Claessens, the World Bank Group, 1998.
2. Beyond Capital Ideals: Restoring Banking Stability, Jerry Caprio and Patrick Honohan, The World Bank, 1998.
3. Draft Report on the Regulatory treatment of Banks in Distress, Tobias Asser, IMF, 1999.
4. Bank Negara Malaysia Annual Report 1998.
5. Asiaweek, The Essential Guide to Crisis, July 17,1998.
6. BIS Review: 18t R.C. Mills Memorial Lecture, Speech by Governor of the Reserve Bank of Australia, Sydney, July 1999.
7. BIS Review: Reinventing Bretton Woods Committee Conference on International capital mobility and domestic economic stability, Canberra, July 1999. Speech by Deputy Governor of the Reserve Bank of Australia.
8. BIS Review: Speech by Mr. Yutaka Yamaguchi, Deputy Governor of the Bank of Japan at the Japan Center for Economic Research in Tokyo on July 13, 1999.
9. A Legal Framework for Systemic Bank Restructuring, Margery Waxman, The World Bank, June 1998.
10. BIS Review: Speech given by the Governor of the Sveriges Riksbank, Mr. Urban Bäckström, at a seminar at the South African Reserve Bank in Pretoria on August 9, 1999.
11. The Malaysian Banking And Financial Institutions Act 1989.

A Legal Framework for Early Crisis Containment

September 8, 1999