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p. 26 of 58 BACK | NEXT Purpose and Structure of the Toolkit Part One: Introduction and Overview Part Two: Preconditions and Infrastructure for Financial Sector Development Part Three: Financial Regulation and Supervision I. Financial Stability, Development and Institutional Design A. Design of the Financial Safety Net B. Roles and Responsibilities of Financial Authorities II. Financial Regulation: General Principles III. Financial Regulatory Structure IV. Banking Regulation V. Bank Insolvency and Depositor Protection VI. Securities and Derivatives Regulation VII. Insurance and Pensions Regulation VIII. Regulation of Financial Conglomerates Part Four: Regional Financial Integration Part Five: ADB's Intervention in the Financial Sector Bibliography Glossary and List of Abbreviations Acknowledgements

Financial Sector Legal and Regulatory Toolkit : Part Three: Financial Regulation and Supervision : I. Financial Stability, Development and Institutional Design

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A. Design of the Financial Safety Net

1. Contingency Planning
2. Structured Early Intervention Programs
3. Lender of Last Resort
4. Depositor/Investor Protection and Insurance/Compensation Arrangements
5. Financial Intermediary Resolution/Liquidation

According to the G-22 Working Group on Strengthening Financial Systems [ PDF ], a financial safety net normally consists of

• contingency plans for dealing with troubled financial institutions,
• structured early intervention programs,
• mechanisms to ensure the provision of liquidity in conditions of stress,
• depositor protection arrangements, and
• insolvency procedures.

The distribution of powers and responsibilities between the financial safety net participants is a matter of public policy choice and individual country circumstances. A number of key components, however, should be addressed.

Contingency Planning

Supervision cannot, and should not, provide an assurance that financial institutions will not fail. As a general principle, supervisors should develop contingency plans for dealing with financial institutions insolvencies in the context of their individual financial systems, as well as consideration of any cross-border situations that could arise.

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Structured Early Intervention Programs

Financial authorities should consider implementation of properly designed early intervention programs. This issue is an essential aspect of financial regulation discussed below in the context of banking, securities, insurance and pensions, and financial conglomerates.

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Lender of Last Resort

Financial authorities should develop appropriate systems of liquidity support for financial institutions and the financial system generally. The most common mechanism to ensure the provision of liquidity in conditions of stress is the Lender of Last Resort (LoLR) function. These issues are discussed further below in the context of bank insolvency and depositor protection.

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Depositor/Investor Protection and Insurance/Compensation Arrangements

Financial authorities should establish appropriate means of consumer protection. The most common form is a system of deposit insurance. These issues are discussed further below in the context of bank insolvency and depositor protection.

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Financial Intermediary Resolution/Liquidation

Effective and timely resolution of insolvencies is probably one of the most important elements of a well-designed financial safety net. The existence of weak financial institutions, especially banks, can undermine the entire financial system. Therefore, weak financial institutions should either be on a path that will restore their financial health or, if that is not deemed to be feasible, closed in a timely fashion.

A coherent system for the restructuring and resolution of weak financial institutions is crucial in reducing the risk of contagion within the financial system and to the economy at large. An effective resolution system also reduces the overall costs to the government of dealing with failing institutions, as well as other costs (ranging from the loss of asset values to the social costs of having a smaller financial system). Finally, it greatly facilitates the alternative of taking action at the right time. For these reasons, methods for restructuring and resolution of financial institutions are important for maintaining financial stability.

Financial authorities should establish an appropriate framework for restructuring or resolving problem financial institutions.

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