International connections, an increased complexity of banking products, and the lack of a uniform global framework for bank recovery and resolution results in complications where financial institutions fail and the distribution of assets depends on several legal systems and sovereign frameworks. It follows that bank failure and liquidation of institutions with a cross-border character are cumbersome, lengthy, and often deliver disappointing results. As such, creditors should understand the local frameworks and international customs to prepare themselves for what is about to come.
The failure of a financial institutions has distinct and secluded objectives for the most important stakeholders involved. The regulator aims to control and maintain confidence in the financial system. Shareholders of the subject company wish to avoid and limit responsibility and liability whilst securing their investment. Meanwhile, creditors and bank depositors have the clearest goal: they want their money back, as fast as possible. The different desired outcomes create a magnificent conflict of interest where resolution and consensus always require one, some or all of the stakeholders to settle for less.
Banking failure is often caused by liquidity shortages. To maintain the stability of the financial system, banks and other financial institutions are under strict regulatory requirements. Violations, especially by smaller and non-systemic banks, are more and more sanctioned by severe fines and closure of the financial institution. Continuation of the business activities, restrictions to these activities and even a forced closure of the institution are realistic options these days.
Resolution, systemic risk and public interest
In a free market economy supply and demand determines the feasibility and commercial position of a company and allows customers to reject misconduct by choosing alternative suppliers. Laissez faire economics furthers this perspective by limitation of control and regulation whilst governing disputes by contractual agreements between the parties and to the civil courts. The downside of this freedom is that deliberate wrongdoing that results in bank failure or bank liquidation can lead to closure at the expense of creditors.
To avoid that the general public is negatively impacted by the failure of financial institutions and taxpayers are urged to bail out the organization, bank resolution for non-systemic financial institutions is an isolated event. This means that losses of the company and costs of the winding up are taken by creditors and shareholders of the company. Such bail-in scenario is derived from traditional corporate liquidation procedures.
Bank customers often mistakenly assume that bank liquidation differs from traditional insolvency proceedings. This line of thought is strengthened by the public attention to and media coverage of emergency relief to globally systemic important financial institution that have been largely rescued during the global financial crisis of 2008. Financial institutions that fail and are not considered systemic and are thus not too big to fail, are treated by local company, insolvency and bankruptcy law.
Local laws in an international setting
Customers of financial institutions often require services that allow for cross-border usage. Internet banking, card services and the more complex tools such as trade finance or derivatives and FX trading all require counterparts with access to global markets. Therefore, even the smallest financial institutions retain international services from different professional contract parties to maintain their activities.
Independent and sovereign states develop their own rules that may differ from other jurisdictions. Matters of bank failure and bank liquidation therefore result in difficulties of absolute jurisdiction and recovery. Corporate liquidation can follow the principle of a single point of entry, or consider the multiple points of entry strategy. The bank holding company or individual business units then become responsible for the bank liquidation. Although this is a theoretically sound approach, the practical implications are often inconvenient and cumbersome.
The offshore financial sector
Offshore jurisdictions often collaborate with a substantial clientele of international and non-resident business people. Their activities mainly involve transactions outside the offshore financial center. To emphasize corporate efficiency, financial services for offshore companies are often obtained in the more traditional financial centers. As such, offshore bank failure may relate to financial institutions located in offshore financial centers, or international business corporations registered in offshore jurisdictions with banking facilities abroad. Both situations require a strict and tailored approach to secure creditors’ assets.
Offshore or local bank closure
Foreign Direct Investment is utilized in alternative ways by offshore financial centers. Such offshore financial centers often have little economic resources and seek ways to make their country attractive for foreign businesses. The offshore jurisdiction then provides for a combination of an inviting atmosphere for foreign business to conduct activities from the offshore jurisdiction with a flexible and prosperous company law. This allows corporations to register in the jurisdiction for local business purposes, or to conduct corporate activities exclusively outside the jurisdiction.
Sovereign states draft their own rules for natural persons and corporations. Most of these laws in different countries look similar but are not always identical. As such, it happens frequently that non-residents and expats misunderstand these differences and get victimized by false assumptions. Offshore and local bank closure therefore require close scrutiny of the applicable frameworks. Creditors must ensure the right approach to minimize risk and maximize repayment. They can do so by consideration of every possible angle that is available during the resolution, recovery and liquidation procedures.
Final considerations for creditors in bank failure
To ensure the proper functioning of the free market, and avoid that moral hazard triggers excessive risk taking by both the bank and its customer, creditor protection is limited to a capped amount secured via deposit protection schemes and local laws that safeguard contractual agreements and winding up procedures.
Creditors of failing financial institutions are often caught by surprise by the limitations on their account and the restrictions to transfer the balance into a safer environment. Regulators and central banks may impose capital controls that further narrow the possibilities for prioritization of individual creditors. Yet, the pre-liquidation stage of a bank failure, resolution and recovery scenario still provides for out of court settlement and alternative dispute resolution.