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p. 34 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 II. Financial Regulation: General Principles III. Financial Regulatory Structure IV. Banking Regulation V. Bank Insolvency and Depositor Protection A. Lender of Last Resort B. Depositor Protection Schemes C. Deposit Insurance: International Standards D. Bank Insolvency 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 : V. Bank Insolvency and Depositor Protection

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A. Lender of Last Resort

The high cost to society of the collapse of the banking system is a principal reason why authorities in virtually all countries provide some sort of a financial safety net. This resulted in the development of the theory for the need for a "Lender of Last Resort" (LoLR).

The LoLR provides liquidity support in order to allow banks to meet depositors' demands and avoid closure, thereby supporting confidence and stemming potential systemic collapse. This may involve the potential outlay of public funds in the event that the stability of the banking system is threatened.

This arrangement inevitably creates moral hazards because it holds open the prospect that stakeholders will be at least partially indemnified from losses from failing intermediaries.

A moral hazard has two components: (i) potential incentives to management to take additional, perhaps excessive, risks due to the promise of a government bailout; and (ii) the consequent risk to public funds due to the potential cost. These problems were most clearly illustrated by the United States savings and loan crisis of the 1980s and have been, and in many cases continue to be, a feature of recent financial weaknesses.

The response to this problem has been the development of the "traditional process of bank regulation and supervision." The goal of the traditional regulatory and supervisory process is simple on its face: the prevention and resolution of financial intermediary crises. Unfortunately, while the goal is simple, its achievement is anything but.

At its most basic, the traditional formulation for preventing and resolving bank crises involves two sets of processes: ex ante and ex post crisis.

The ex ante measures focus on two related goals:

• Supporting sound management and internal controls (a well-managed bank is less likely to be the subject either of a crisis or of contagion) and
• Regulation and supervision (bank management has short memories and needs to be given rules to follow, and also need to be monitored to ensure compliance).

Main issues relate to the administrative process and rule/discretion-based approaches (e.g., prompt corrective action).

The ex post measures focus on bolstering confidence, stemming contagion and resolving problem intermediaries. Immediate measures focus on suspension of accounts (never popular), the provision of support through the LoLR mechanism (to deal with illiquidity) and various mechanisms for depositor protection, of which deposit insurance is the most significant (to minimize the effect of the insolvency of banks to the depositors). In addition to the immediate measures, other ex post measures are required to deal with the insolvency of individual institutions. With respect to individual institution insolvencies, four key mechanisms exist:

1. Organization of a rescue package
2. Provision of open assistance
3. Merger or acquisition (public or private)
4. Liquidation and pay-off

Finally, in some cases, measures will be required to address systemic insolvency, but these are rarely, if at all, organized in advance of such an actuality.

In looking at the role of law, it is worth looking in greater depth at issues that arise in the traditional crisis management process. Typically, suspension of accounts is not provided for ex ante.

Of greater concern is the LoLR process. Under the current formulation, provision of LoLR support should follow the following rules:

1. support should only be provided to temporarily illiquid but solvent banks;
2. support should be provided freely but at penalty interest;
3. support should be provided to anyone with good collateral who meets both rules (1) and (2);
4. the LoLR should clearly indicate its readiness to lend ex ante;
5. nonetheless, the decision to provide support should remain discretionary; and
6. this discretion should be based upon the test of the existence of potential systemic risk.

There is a mixture of implicit and explicit structures for the LoLR. In most cases, the LoLR is the central bank, but in some cases can also be the deposit insurance authority (usually in conjunction with the central bank).

While the LoLR is typically not thought of in terms of legal issues, in fact, the formulation is clearly based upon the presupposition of a functioning legal system supporting financial transactions, as well as upon an effective regulatory and supervisory process.

"Temporarily illiquid but solvent" requires two sets of preconditions: (i) supervisory information in order to determine the respective condition and (ii) a definition of insolvency, which is generally a public policy choice enshrined in insolvency legislation.

"Freely but at penalty interest," fortunately, is relatively self-sufficient, except that the LoLR must have the ability in fact to provide potentially unlimited support, which will often only be available through control over the monetary supply.

"Anyone with good collateral" clearly requires both a legal judgment and a qualitative judgment. The legal judgment is based upon the ability to take collateral-different legal systems vary greatly on this point.

"Readiness to lend clear ex ante" requires a legal system that supports lending, which is very much determined by the respective system of private law.

The remaining two criteria "simply" require an effective system of information-gathering on the part of the LoLR in order to make the respective determination-and if that system were perfect, of course, there would be no need for the support in the first place.

Law and legal infrastructure play a central role not only in building an effective financial safety net, but also in financial stability generally and moreover in financial and economic development. Based on this conclusion, governments should address weaknesses in transparency, deterrence, and accountability before adopting explicit deposit insurance schemes, with specific focus on banking regulation and supervision, protection of property rights, enforceability of contracts, and quality of accounting and disclosure.

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