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Handling Systemically Important Banks in Distress — Some Thoughts from a Swedish Perspective

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Abstract

This article discusses the management of systemically important banks in distress with the primary aim of creating a platform for further discussion. As a backdrop, the experiences gained in Sweden from two crises in less than 20 years are presented. After a discussion of the liquidity factor and central banks’ role as lender of last resort, the focus is on handling the initial acute phase of a crisis. The appropriate goals of a crisis management system are discussed, as are ways of achieving immediate control of a bank in distress and principles related to the valuation of a bank in need of assistance. The main point presented is that the analytical building blocks are universal and by identifying them a common ground for further analysis could be established. One conclusion is that the proposed EU regime for crisis management in the financial sector will not be the final word. Finally, some thoughts regarding a pan-European system for crisis handling, based on a common corporate law for banks, are presented.

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References

  1. Many thanks to Lars Hörngren and Thomas Ordeberg for invaluable comments. This article is mainly based on my 20 years’ experience as an active participant in the Swedish legislative process in this field and on my practical experience with supervision during the recent crisis as a member of the board of the Swedish Financial Supervisory Authority (Finansinspektionen). It should be noted that the Swedish FSA revoked the licence of Swedish banks twice during or around the crisis. The difficulties of handling a situation where a systemically important bank loses its licence are considerable if there is no special legal regime in place; for an account of the recent Swedish handling of such a situation, see G. Sjöberg, ‘Mastering the Financial Crisis — The Swedish Approach’, in J.A. Kämmerer and R. Veil, Mastering the Financial Crisis — Policies and Approaches in Europe (Bucerius Law School, forthcoming in April 2011). This article is based on my experiences as an official rather than as an academic. However, the views expressed here are my own and do not necessarily reflect the official Swedish position.

  2. COM(2010) 579. I have tried to take into account material published up to November 2010. The latest Swedish official position regarding these issues is a joint reaction dated 20 January 2010 from the Ministry of Finance, the Riksbank (Swedish Central Bank), the Swedish Financial Supervisory Authority and the Swedish National Debt Office, to the Commission Communication ‘An EU Framework for Cross-Border Crisis Management in the Banking Sector’.

  3. Bankkriskommittén, Fi 1993:02 and Banklagskommittén, Fi 1995:09. I was secretary of the first and head secretary of the second.

  4. See the Swedish Official Government Report Series, Offentlig administration av banker kris — slutbetänkande av Banklagskommittén [Public Administration of Banks in Distress — Final Report of the Banking Law Committee], SOU 2000:66, published in June 2000. For an English presentation of the proposal and its context, see S. Viotti, ‘Dealing with Banking Crises — Proposal for a New Regulatory Framework’, 3 Economic Review (2000) pp. 46–63, available at the Riksbank’s homepage: <http://www.riksbank.se/upload/Dokument_riksbank/Kat_publicerat/Artiklar_PV/er00_3_artikel3.pdf>.

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  5. According to the proposal, a write-down of the share capital had to be decided by a court and a decision to issue new stock had to be made by the shareholders due to the requirements in the Second Company Directive, SOU 2000:66, at p. 244 ff.

  6. Viotti, supra n. 5, at p. 50 f.

  7. The Government Support to Banks and Other Credit Institutions Act (SFS 1993:765) enacted on 1 July 1993.

  8. SOU 2000:66, at p. 84. Viotti, supra n. 5, at p. 50 f.

  9. This guarantee was issued in September 1992 but the formal decision by the Parliament was not taken until December 1992.

  10. SFS 2008:814. For a detailed account of the Act and the measures taken under it, see G. Sjöberg, ‘Lagen om statligt stöd till kreditinstitut’ [Government Support to Credit Institutions Act], Juridisk Tidskrift (2008–09) p. 576, and Sjöberg, supra n. 1.

  11. The Committee is called Finanskriskommittén (Financial Crisis Committee), with directives decided by the government (2011:6). I am a member of the Committee.

  12. Stefan Ingves, present Governor of Sveriges Riksbank, and Göran Lind, advisor to the Bank’s Executive Board, summarised the Swedish experience in S. Ingves and G. Lind, ‘Stockholm Solutions’, Finance & Development, IMF, December 2008, at p. 21, and S. Ingves and G. Lind, ‘The Management of the Bank Crisis — In Retrospect’, 7 Sveriges Riksbank Quarterly Review (1996) pp. 5–18. Urban Bäckström, former Governor of the Sveriges Riksbank as well as former State Secretary of the Ministry of Finance, summarised his experiences in his speech ‘What Lessons Can Be Learned from Recent Financial Crises? The Swedish Experience’, at the Federal Reserve Symposium Maintaining Financial Stability in a Global Economy, Jackson Hole, Wyoming, USA, 29 August 1997, available at: <http://www.riksbank.se/templates/speech.aspx?id=3861>.

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  14. M. Andersson and S. Viotti, ‘Managing and Preventing Financial Crises, Lessons from the Swedish Experience’, 10 Sveriges Riksbank Quarterly Review (1999) pp. 71–89; P. Englund, ‘Systemic Risks in the Financial System. Lessons from the Current Crisis’, in Expert Report no. 36 to Sweden’s Globalisation Council (2009).

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  16. For a different view, at least on a global level, see R. M. Lastra and G. Wood, ‘The Crisis of 2007–09: Nature, Causes and Reactions’, 13 Journal of International Economic Law (2010) p. 535.

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  17. G. Sjöberg, Brottslig och vårdslös kreditgivning 1980- [Criminal and Negligent Lending 1980-], Report to the Bankkriskommittén, Stockholm, 1995. It was also explored whether negligence in supervision (primarily of lending) had caused the crisis, see G. Sjöberg, Bank-och Finansinspektionens verksamhet 1980–1993 [The Financial Supervisory Authority’s Activities 1980–1993], Report to the Bankkriskommittén, Stockholm, 1994.

  18. According to the terms of reference of the Banklagskommitté, criminalisation of negligent lending was to be considered, but no such proposal was made, SOU 1999:82.

  19. This has resulted in a number of suggested approaches, see for a recent and comprehensive example, S. Claessens, R. Herring and D. Schoenmaker, A Safer World Financial System: Improving the Resolution of Systemic Institutions (London, Centre for Economic Policy Research 2010).

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  20. For a comprehensive description of the present system and its deficiencies, see G. G. H. Garcia, R. M. Lastra and M. J. Nieto, ‘Bankruptcy and Reorganization Procedures for Cross-Border Banks in the EU — Towards an Integrated Approach to the Reform of the EU Safety Net’, 17 Journal of Financial Regulation and Compliance (2009) pp. 240–275.

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  21. Professor Rosa Lastra sees four stages in the supervisory process, namely: licensing, supervision stricto sensu, sanctioning and crisis management, R.M. Lastra, Legal Foundations of International Monetary Stability (Oxford University Press 2006), Chapter 3, Section B. According to this definition, this article focuses on crisis management and in particular on its acute phases.

  22. In my view, the aim of supervision is to avoid a crisis and that of a crisis management system to handle an ongoing crisis. The exact borderline between the two is not given and, as is noted later, the triggers for a crisis management system are not self-evident. There are a number of good reasons to divide responsibility for supervision and crisis management between separate authorities, as was proposed for the Swedish SRR in 2000.

  23. In the terminology of the latest Commission Communication, the crisis management system comprises three classes of measures, namely (i) preparatory and preventive measures; (ii) early supervisory intervention; and (iii) resolution tools and powers, COM(2010) 579, at p. 4. The focus here is thus on parts of the measures that the Communication calls third class.

  24. The de Larosière Group distinguishes between the legal framework and its application. They claim, on the one hand, that a clear and consistent framework for crisis management is desired, but, on the other hand, that constructive ambiguity and uncertainty are appropriate in the application of these arrangements in future individual cases of distressed banks, see the Report of the High-Level Group on Financial Supervision in the EU chaired by Jacques de Larosière, Brussels, 25 February 2009, section 127. I disagree on the second point.

  25. Uncertainty about government policy can trigger a crisis. It has been pointed out that the sudden and unpredictable reversal in resolution policy which marked the failure of Lehman Brothers changed market expectations and led to a general flight to quality, which in turn decreased stability, see Lastra and Wood, supra n. 18, at p. 539 with further references. There is also evidence from Venezuela that the lack of a rule-based system ultimately leads to damaging results for the taxpayers, see Lastra, supra n. 25, at p. 131 with further references.

  26. Lastra, supra n. 25, at p. 130.

  27. The Swedish proposal of 2000 included such an option, see SOU 2000:66, supra n. 5, at pp. 14 and 151.

  28. This was a key objective behind the proposal for a Swedish SRR in 2000, see Viotti, supra n. 5, at p. 52.

  29. The objectives of a policymaker regarding reorganisation and liquidation are (against a backdrop of literature review) discussed in Garcia, et al., supra n. 23, at p. 246 ff.

  30. The American system run by the Federal Deposit Insurance Corporation (FDIC) is an example of such a system. Close to 150 banks failed during 2009 and FDIC employs around five thousand people.

  31. The Commission intends to propose the establishment of national funds. Banks subject to the crisis management framework would contribute ex ante to the funds, but ex post financing would also be a possibility, COM(2010) 368 and COM(2010) 579.

  32. Or more elegantly put by Professor Charles Goodhart in a speech: ‘Failures normally occur in the first instance because of a shortage of liquidity, an inability to pay due bills, even though the underlying problem will, almost always, have been one of insolvency, whether real or just rumored’, available at: <http://www.kansascityfed.org/publicat/sympos/2009/papers/Goodhart.09.11.09.pdf>.

  33. ELA was provided by the Swedish Central Bank twice during the recent crisis. Two relatively small institutes received ELA. In both cases it was assumed that a default would result in a serious disruption of the financial system and seriously undermine confidence in the payment system. See for details, Sjöberg, supra n. 1. With the notable exception of the Swedish central bank, the unwillingness among central banks in general to discuss or disclose, in clear and unambiguous terms, the policies behind the practices regarding ELA does not help in analysing the need for complementary mechanisms, but this is not discussed further here.

  34. One example is the latest Communication from the Commission, COM (2010) 579, which states (on p. 6) that recovery and resolution plans ‘should not assume access to any support from public funds’.

  35. For an account of the risks associated with the traditional composition of banks’ balance sheets, both individually and at systemic level, see M. Brunnermeier, A. Crockett, C. Goodhart, A. Persaud and H. Shin, The Fundamental Principles of Financial Regulation (London, Centre for Economic Policy Research 2009), chapter 2.

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  36. See, e.g., D.W. Diamond and R.G. Rajan, ‘Fear of Fire Sales and the Credit Freeze’, NBER Working Paper No. 14295 (April 2009).

  37. The measures that were aimed at the system in general amounted to several hundreds of billions of SEK (several tens of billions of EUR) and the traditional ELA to less than ten billion SEK (less than one billion EUR). Sjöberg, supra n. 1.

  38. For an extensive analysis of systemic risk, see S. L. Schwarcz, ‘Systemic Risk’, Duke Law School Legal Studies Paper No. 163, 97 Georgetown Law Journal (2008), available at SSRN: <http://ssm.com/abstract=1008326>.

  39. The boundary problem is addressed in, e.g., C. Goodhart, ‘The Boundary Problem in Financial Regulation’, 206 National Institute Economic Review (2008) p. 48; C. Goodhart, ‘The Boundary Problem in Financial Regulation’, in The Fundamental Principles of Financial Regulation, 11th Geneva Report on the World Economy (Geneva, International Centre for Money and Banking Studies and Centre for Economic Policy Research 2009), Appendix A; and C. Goodhart and R.M. Lastra, ‘Border Problems’, 13 Journal of International Economic Law (2010) p. 705.

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  40. For the opposite view, see A. Crocket, ‘Rebuilding the Financial Architecture’, 46 Finance & Development (2009) p. 18.

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  41. In my view, the present problem is not lack of regulation or proposed regulation. On the contrary, the collective impact and the objectives behind different proposals must be analysed; compare, for example, the work on the proposed Alternative Investment Fund Management Directive which is described in E. Ferran, ‘The Regulation of Hedge Funds and Private Equity: A Case Study in the Development of the EU’s Regulatory Response to the Financial Crisis’, Working Paper 176, 15 February 2011, available at: <http://ssm.com/abstract=1762119>. Ferran explores two overarching concerns that are frequently expressed about laws made in the immediate aftermath of a crisis, namely regarding opportunistic use of crisis situations to achieve unrelated goals and crisis-induced regulatory overreaction.

  42. I am not suggesting narrow banking as a solution as has been done for many years by various scholars and recently by, e.g., J. Kay, ‘Narrow Banking: The Reform of Banking Regulation’, Centre for the Study of Financial Innovation, available at: <http://www.johnkay.com/wp-content/uploads/2009/12/JK-Narrow-Banking.pdf>. Narrow banking was seen as an interesting concept during the Banklagskommitté’s (1995–2000) work on the Swedish Banking Act and perhaps influenced the functional approach adopted by the Committee.

  43. Lastra, supra n. 25, at p. 113.

  44. See further, for example, T. M. Humphrey and R. E. Keleher, ‘The Lender of Last Resort: A Historical Perspective’, 4 Cato Journal (1984) p. 275, and R.M. Lastra, ‘Lender of Last Resort. An International Perspective’, 48 International Comparative Law Quarterly (1999) p. 339.

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  45. ‘Solvent’ is used in the meaning of having adequate capital with a correct valuation of assets. Perhaps a further condition should be added, namely that the bank has a viable business. However, this is a more controversial question which is not pursued further here. Professor Charles Goodhart claims it is impossible to distinguish between illiquidity and insolvency, C. Goodhart, ‘Myths about the Lender of Last Resort’, 2 International Finance (1999) p. 339.

  46. For a similar view on the moral hazard connected with ELA, see Lastra, supra n. 25, at p. 115 f.

  47. See, e.g., E. Perotti and J. Suarez, ‘Liquidity Risk Charges as a Macroprudential Tool’, Centre for Economic Policy Research, Policy Insight No. 40, November 2009.

  48. The proposal of 2000 for a Swedish SRR stated that immediate control was necessary to avoid blackmail from the bank in question and moral hazard, SOU 2000:66, at p. 14. Viotti, supra n. 5, at p. 50.

  49. Under the current Swedish legislation, guarantees are issued after a voluntary contract has been entered into between the bank and the Support Authority. The technicalities are quite complex, see Sjöberg, supra n. 1.

  50. The Second Company Directive (77/91/EEC, Article 58, second paragraph) requires decisions regarding a reduction of the share capital and new issues of shares to be taken by the shareholders. In a common European corporate law for banks (see below) this obstacle could be removed.

  51. This does not mean that it should be impossible to include in a legal regime the option to write off certain types of debt under conditions clearly set out in the law. The proposal of 2000 for a Swedish SRR included such an option, SOU 2000:66, at pp. 17 and 212 ff. Viotti, supra n. 5, at p. 50.

  52. This would be what Eva Hüpkes calls a temporary derogation from corporate governance requirements, E. H. G. Hüpkes, ‘Special Bank Resolution and Shareholders’ Rights: Balancing Competing Interests’, 17 Journal of Financial Regulation and Compliance (2008), at p. 283 f.

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  53. According to the proposal of 2000 for a Swedish SRR, the decision to assume control was supposed to be taken by a court of law after an application by the Support Authority, SOU 2000:66, at p. 207 f.

  54. Hüpkes, supra n. 77.

  55. The Communication mentions different resolution tools, including the sale of the bank or parts of its business without the consent of shareholders, the possibility to transfer assets to a bridge bank or a bad bank, and a debt write-down. The resolution powers are said to be the various legal powers that, in different combinations, authorities exercise when applying the resolution tools. Finally, it states that there will be no rigid description regarding the legal means by which the powers are exercised, COM(2010) 579, at pp. 9 and 10.

  56. Compare, for example, Article 1 of Protocol No. 1 to the European Convention for the Protection of Human Rights and Fundamental Freedoms. For an extensive walk through the subject, see Hüpkes, supra n. 77.

  57. However, the Commission states that recovery plans ‘should not assume access to any support from public funds’, COM(2010) 579, at p. 6. It is not clear whether ELA is included or not.

  58. Under the heading ‘Debt write down’, the Communication discusses, in general terms, policy questions, including a write-down of all equity. Valuation is not directly addressed, COM(2010) 579, at p. 11.

  59. COM(2010) 579, at pp. 3 and 4.

  60. The situation has been described as a trilemma, i.e., three objectives have to be balanced: financial stability, financial integration and national fiscal sovereignty, see D. Schoenmaker, ‘The Financial Trilemma’, Duisenberg School of Finance — Tinbergen Institute Discussion Papers No. TI 11-019 / DSF 7, 10 February 2011.

  61. However, this is done elsewhere, see Commission Communication COM(2010) 579, at p. 12 ff.

  62. The Swedish stabilisation fund has received a lot of attention. As part of the support programme, the Swedish Parliament (Riksdag) decided to establish a stabilisation fund in order to finance measures aimed at supporting financial stability. The fund is administered by the Swedish National Debt Office, which is also responsible for organising support for banks. Initially, the Parliament decided to provide SEK 15 billion to the fund through a special appropriation. Banks and other credit institutions should pay yearly risk-adjusted fees to the fund in order to accumulate a sum corresponding to, according to the initial plans, 2.5 per cent of GDP within 15 years (today this would equal around SEK 77.5 billion or EUR 7 billion). Another aim was and is to include the deposit insurance fund, currently worth about SEK 20 billion, in the stabilisation fund. However, at the moment the amalgamation of the two funds is subject to further deliberation by the Financial Crisis Committee (see supra n. 12), as are the plans for risk-adjusted fees. Although the fund was initiated through the Support Act, the level of the annual fees was decided by way of an amendment to the Act enacted on 30 December 2009. The fee is 0.036 per cent of the liabilities and appropriations of the institution. In addition to the fees, charges for bank guarantees and possible returns on other support measures are transferred to the fund. Solutions based on private funding at European level have been suggested by others. Deutsche Bank CEO Josef Ackermann proposed a European Rescue and Resolution Fund (Davos, January 2010) and IMF Managing Director Dominique Strauss-Kahn suggested a European Resolution Authority mainly pre-financed by the industry (March 2010). The final aim of the Commission seems to be a single EU fund (COM(2010) 579, at p. 15).

  63. See Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards (July 1988, updated to April 1998), at paragraph 7 (‘Basel 1’), and International Convergence of Capital Measurement and Capital Standards: A Revised Framework (June 2004), at paragraph 20 (‘Basel II’). A revised version of these standards (‘Basel III’) is currently being finalised.

  64. See Financial Stability Board, Reducing the Moral Hazard Posed by Systemically Important Financial Institutions: FSB Recommendations and Time Lines, 20 October 2010, at p. 1.

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    Gustaf Sjöberg (Associate Professor)

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Sjöberg, G. Handling Systemically Important Banks in Distress — Some Thoughts from a Swedish Perspective. Eur Bus Org Law Rev 12, 227–250 (2011). https://doi.org/10.1017/S1566752911200028

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