In society, banking and finance play a critical role in controlling the redistribution of money. Payments are made to support individual lifestyles, to finance business activities and to save for a rainy day to name a few. The ecosystem that facilitates such transactions is often based on financial intermediation, fractional reserve or credit creation. Such activities contain liquidity risk and capital risk before ultimately leading to the primary performance measure, net interest income.

Deposit taking credit institutions, as banks are often referred to by authorities, take money from savers, investors and other creditors to lend out to borrowers. This financial intermediation between borrowers and savers of capital uses illiquid assets to create liquid claims and create value during the process. However, retail customers and commercial businesses may experience stressful situations and default on their loans. Banks bear the credit risk associated with such defaults. This instantly reveals the difficult position of account holders when placing a deposit in the bank. Contrary to what most believe, a bank deposit belongs to the bank and not to the account holder. The account holder merely has a contractual claim against the bank. This is not much of a problem, until the moment the bank fails, gets resolved and must be liquidated.

Financial institutions increase their stability and profitability by leverage. When the boundaries of applicable benchmarks are exceeded, financial gains or losses can occur. This is caused by a variety of administrative and financial tools available to financial business units and accounting departments. Examples are securities lending and repo transactions, securitization of loan portfolios and fractional reserve lending. Most bank customers have little interest in these mechanics rather than the notion that these mechanics expand the economy and allow credit to become available to finance private consumption and business growth. However, as became painfully clear during the global financial crisis, leverage and excessive risk taking can disrupt the payment system, decrease lending, cease investing and create a climate that ultimately leads to a reduction of productivity.

Financial Sector Regulation in a Free Economy

Bank regulation seeks to protect the financial system and the overall economy. It aims to prevent bank instability, a decline in confidence in the payment system and public intervention at the expense of the tax payer. Regulation, however, comes at costs for market players and society. The impact of regulation on financial lending power is significant but provides for a safety net able to absorb the initial shocks of a systemic crisis. Over time economic growth by supporting consumption and production became the norm. Additionally, it was assumed that deregulation drives competition. Thus, a balance between financial regulation and the principles of the free market economy is constantly sought.

In an open market economy, customers should be free to choose their preferred financial supplier. The current regulatory bank risk model requires the market to discipline financial institutions for wrongful behaviour, financial misconduct, and imprudent activities. Historic events clearly show that a gap potentially caused by moral licensing of bank customers and the information asymmetry between assumed and actual conduct by financial institutions exists. Bank regulation therefore imposes strict capital requirements, leverage ratios and reserve capital for market risk so that financial turmoil does not result in panic and unnecessary bank failure.

An important distinction in regulatory intervention is made between institutional and systemic failure. The interconnectedness of the financial sector furthers the risk of contagion and impacts society at large. Institutional failure is often an internal problem that can be resolved internally, by the private sector, or by the application of local insolvency rules. Widespread events may lead to a bank failure. These include but are not limited to financial difficulties, such as liquidity and solvency shortages, and regulatory violations. Especially the latter is troublesome and may confuse regulators, account holders, investors and shareholders since some banks are penalized for wrongdoing while others are forced to close.

Financial Institution Failure and Reasons for Intervention

During the ordinary day to day operations of financial institutions the incomings and the outflow of deposits follows a natural pattern. Bank liquidity management maintains adequate levels of liquidity to honor withdrawals. In times of economic turmoil, more depositors may secure their savings and take out their money. In the current climate this is further enabled by the ease of online banking and direct payment systems that do not require a physical appearance at the teller to withdraw or transfer money on deposit.

Economy theory alleges that the fear of monetary loss during financial crises encourage account holders to withdraw their deposits and investors to sell their shares. One of the characteristics of bank funding is the liquidity provision by a maturity mismatch, they hold liquid deposits from account holders and provide long term loans to users of capital. The acceleration of a downward trend may trigger a run on the bank and potentially force financial institutions to sell their assets below market value. This leads to a disruption of the monetary system and reduction in production. Hence the reason that regulators monitor bank failure from a close distance. However, bank failure does not always lead to bank liquidation.

Bank failure occurs when a financial institution is unable to honor its obligations towards its customers and other creditors. This detrimental situation can have different triggers, of which some are more serious than others. The interconnectedness of the financial system mandates global regulators to impose strict rules on systemically important financial institutions, i.e. banks whose operation is critical for society. Other institutions, like domestic deposit taking credit institutions, private banks and credit unions are governed by a comprehensive framework of local legislation, international conventions and bank regulation.

The Impact of Bank Runs on Society

A bank run, also known as a run on the capital of the bank, is a situation in which many customers of a financial institution withdraw their deposits simultaneously, due to concerns about the institution’s solvency or financial stability. It is a self-fulfilling prophecy, in which customers anticipate that the institution will become insolvent and withdraw their funds in order to protect their assets.

Maturity transformation, characterized by the mismanagement of liquid deposits and illiquid assets, is common practice in banking. It provides liquidity to the market but also exacerbates the impact of bank runs on society in times of financial distress. A sudden withdrawal of large quantities of liquidity by many different creditors may force the financial institution to liquidate its long term assets at a loss and fail. Furthermore, the interconnectedness of financial institutions may have a contagious effect, which would magnify institution-specific losses and potentially lead to a systemic and international financial crisis. As a result, a bank run decreases liquidity provision for households and businesses and thus leads to a reduction in production.

The purpose of bank regulation is to prevent a disruption of the payment system. This is driven by the fear that such a disruption may result in the need of public stimulus at the expense of the tax payer and a slowdown of the economy. Global regulators therefore use capital models to monitor and predict credit, market and liquidity risk. Bank risk modelling however uses historical data to predict a crisis. Such a model can never be fully compatible and is merely an indicator of future events.

Early Intervention to Maintain the Critical Functions of a Failed Bank

The value and viability of a financial institution is determined by its credibility, functionality and profitability. Account holders and investors are essential for a bank. Regulators have an active duty to maintain confidence in the financial system, protect the stability of supervised financial institutions and avoid tax payer losses. This is an imminent duty that starts when levels of regulatory capital rapidly decrease towards critical levels, or when the public interest requires intervention. Tools used during early intervention include deposit insurance, suspension of withdrawals, lender of last resort, and blanket guarantees to preserve the critical functions of the institution whilst avoiding irreparable bank panic. Compulsory administration is often imposed in collaboration with the management of the troubled financial institution to safeguard stakeholder interests.

Banking is based on trust. In the event of a drop in public confidence, households, businesses, and investors are prompted to evaluate their financial decisions and risk appetite and take appropriate action to protect their investments. The future of a troubled financial institution is in the early days uncertain. As such, regulators and bank management seek ways to rapidly restart the operations by recapitalization, restructuring, or reorganizing the capital base or activities and avoid massive customer outflows. Unless the institution is considered a threat to the financial system, the continuation of its activities remains preferable.

Statutory Administration and the Public Interest Doctrine

Credit and liquidity provision supports the real economy and benefits society. Having a sound banking system and stable financial markets benefits society in general, its administrative systems and its taxpayers. Public welfare and economic stability are therefore considered to be in the public interest.

Financial institutions and banks in particular have certain privileges and in return are considered gatekeepers to police and protect the financial system. In this regard, there are a number of rules, codes, and regulations that must be followed by financial institutions. This complex framework is maintained and enforced by regulators, public authorities, trade organizations and task forces. Financial institutions, bank management and boards can be disciplined by any of these institutions for wrongdoing and conspiracy.

Economic and administrative sanctions lead to corrective or punitive action. A proportionate European response focuses on a change in behavior by the wrongdoer or a financial compensation for victims. By claiming jurisdiction over every USD transaction conducted in the United States and internationally, the Bank Secrecy Act and Section 311 of the US Patriot Act bring the protection of the financial system to an unprecedented level. The US Treasury leverages commercial isolation of uncooperative jurisdictions and rogue foreign financial institutions by designating them as a primary money laundering concern in an effort to enforce a change in policies and behavior. A logical next step is to exclude the wrongdoer from direct and indirect access to USD transactions, and to prohibit third parties from providing them with financial services.

The efforts of local authorities to prevent bank panic, a run on the capital of a bank, and eventually a forced bankruptcy may initiate compulsory administration. Compulsory administration includes a replacement of bank management and a moratorium on outgoing payments. A short cooling down period often enables the bank to restructure, reorganize or recapitalize. Unless a solution can be found, the bank will lose its license and gets liquidated.

Regulatory Resolution Tools

Financial institutions are privately owned enterprises or joint stock companies regulated by competent authorities. Like any other company, banks have a duty to promote the success of the company. This starts with the financial position of the bank in adverse scenarios and stressful events. An important part of the regulatory framework is given to recovery plans drafted by the bank itself and resolution tools available to regulator. These plans and tools allow for a solid and timely escalation process to mitigate risk at the troubled institution and society at large.

As cross-border capital flows increase, bank regulation has taken on a global character. Financial regulation and resolution procedures for the banking sector are developed on a post-hoc basis. In the aftermath of an impactful event or financial crisis, rules are tightened. It is generally argued that bank regulation prevents harmful conduct and avoids harmful consequences. In order to prepare for a swift and tailored solution for the troubled institution and prevent systemic crises, recovery plans and resolution tools are available to the respective regulator. The most common regulatory resolution tools include, but are not limited to, the bail-in tool, the sale of the business tool, the asset separation tool and the bridge institution tool. Through these tools, losses are absorbed by shareholders and creditors while critical functions of the institution remain operational.

Regulatory resolution tools may bypass shareholder rights, including economic and control or governance rights. Unless there is a public mandate or majority shareholder approval, intervention cannot be justified. This includes compulsory administration to safeguard the creditor rights. The court may be asked via a judicial review procedure to consider whether the regulator acted within the limits of the powers granted by its government. Judicial review may then invalidate the actions of the regulator and thus prevent regulatory intervention.

The Point of No Return: Non-viability and Bank Liquidation

In the early stages of recovery and resolution planning, the goal is to ensure that the critical functions of payments, settlements, and deposit taking are maintained. This is to avoid unnecessary destruction of value and protect insured investors and depositors. To achieve their objectives, regulators identify appropriate ways to end the situation. Measures include the sale of the business, a bridge institution, asset separation and winding up or restructuring via a bail-in mechanism.

The impact of systemically important financial institutions on a domestic and global economy is substantial. Smaller banks, typically privately owned niche players, operate in a different environment. In contrast, failures of organizations that fall within the latter category are viewed as internal and isolated events that do not affect financial stability and do not require rescue missions with tax payer input. These insolvent financial institutions are subject to domestic insolvency procedures to ensure that the troubled organization exits the market in an orderly manner.

In general, financial institutions in distress require a market-based solution. Regulatory intervention aims to mitigate risk for all stakeholders involved. The unavailability of market solutions drive the bank into dissolution and eventually liquidation. At this stage, the banking license is removed and the organizational structure returns to the traditional limited liability company. Preparations are then made to wind up the bank and the total loss-absorbent capital is converted into liquidity to cover institutional losses. Secured creditors and insured account balances are repaid while the positions of the bank are unwound and the assets are sold to interested parties.

Who Gets Paid: Creditor and Insolvency Hierarchies

Depending on the structure of the liquidation, an official receiver or liquidator is appointed by the court to oversee the bank liquidation process. Their duties include managing the liquidation process, making sure that creditors are paid according to their legal rights, and ensuring that assets are sold for the best possible price. Due to their position, a receiver or liquidator also investigates irregular activities of the bank and may where necessary pursue legal action against wrongdoers and bank management.

Nowadays, banking involves cross-border activities and establishments in different countries. Complicated organizational structures, special purpose vehicles and foreign ownership require regulators to approach troubled financial institutions via a single point or multiple points of entry. Although bank liquidation is governed by harmonized resolution plans or by local insolvency laws, the collection of assets held abroad remains a challenge.

Creditors must submit their proof of claim within reasonable time while the official receiver or liquidator starts the collection of domestic and foreign assets, the sale of the essential and functioning parts of the bank, and a transfer of the bad assets to an asset management vehicle. Not all assets can be returned instantly and most sales processes take time. The main challenge for the sale of assets is the difference between their book value and realistic value. This is paramount where assets must be sold back to the marketplace promptly and often at a discounted value. Other difficulties arise where counterparts and correspondent banks are subject to restructuring or bankruptcy proceedings themselves.

Orderly liquidation of a bank requires shareholders and creditors to bear the losses where capital is insufficient. Creditors of a bank that is liquidated due to capital and liquidity shortages can expect a larger write-down of assets and similar haircut on deposits than creditors of a bank that has been closed as a result of alleged regulatory violations. Bank deposit insurance via the domestic deposit guarantee scheme therefore provides a first line of defense for account holders to prioritize their claim against the bank up to the insured maximum.

The applicable insolvency or creditor hierarchy dictates how assets are distributed to creditors. Before any distributions to subordinated creditors are made, senior liabilities, collateralized charges, and other secured claims are paid in full. Subordinated creditors include depositors, unsecured senior liabilities and subordinated debt holders. Bank owners and shareholders are left with a residual monetary claim against the estate of the bank. Following the insolvency or creditor hierarchy, claimants must share proceeds and bear losses equally according to their position. This leads to the following schematic representation:

  • First position: costs of the liquidation, DGS advance payments, and the operational costs of the financial institution.
  • Second position: Senior debt, secured claims and liabilities.
  • Third position: Subordinated debt, claims and liabilities such as bank deposits.
  • Fourth position: Unsecured investments and fixed deposits.
  • Fifth position: Bank owners, shareholder equity, tier 1 and tier 2 debt.

The creditor and insolvency hierarchy in bank liquidation reveals that bank account holders are only reimbursed after the first and second positions have been paid in full. There is no guarantee that there is sufficient capital to repay any of the positions in full. This makes deposit insurance a critical part of the recovery for bank account holders.

Bank Resolution in a Practical Setting

Despite the efforts of global regulators to streamline the resolution process, widespread practical challenges remain. Early intervention potentially violates shareholder and property rights and must therefore be sufficiently justified. Consequently, regulators and other public authorities must act within their lawful powers and maintain natural justice. They do not get away with vague assumptions and unfounded allegations. Regulatory decisions may then be challenged in court or through judicial review by bank shareholders and others with standing.

Early intervention is primarily intended to preserve the critical functions and value of a financial institution in distress. It allows for the institution, together with the regulator, to restructure or reorganize the institution and continue its activities under a different management or even a new ownership. In the event of irreparable and fundamental challenges, institutions may need to be dissolved, wound up, or liquidated.

Voluntary bank liquidation takes place outside the jurisdiction of the courts, is managed by the members of the failed institution and is cost- and time efficient. Voluntary winding up may miss the point to restore public confidence and can negatively impact creditors as a result of a lack of oversight and control. Compulsory winding up however requires a court order triggered by the company, its directors, contributories, creditors or a public supervisor. Directors are dismissed, the banking license surrendered and a liquidator is appointed. The liquidator, acting as an agent to the company, owes duties to the company and not to individual contributories or creditors. A liquidator is responsible for winding up the affairs of the bank, collecting in and realizing its assets, and making distributions to creditors in accordance with the applicable creditor hierarchy, with any surplus being returned to shareholders. To secure a fair process, liquidators have extensive powers to inquire into the dealings of the bank and its staff members. Fraud against the bank is passed on the public prosecutor for further investigation and possible prosecution.

Upon the sale of a failed bank to another financial institution, some or all of the assets and liabilities of the failed bank are acquired by the buyer. The Asset Purchase Agreement between the parties define the exact parameters of the acquisition. The majority of bank account balances are protected by deposit insurance schemes. However, the remaining balances may be subject to loss-sharing, bail-in or another form of mandatory write-down.

The following are some examples of the difficulties regulators, bank shareholders, and other stakeholders face in actual situations:

  • The Belgian cooperative holding group ARCO is an investment vehicle used by a local workers organisation. One of its primary investments was Dexia Bank, a financial institution that failed as a result of the global financial crisis. In addition to bankrupting ARCO, this investment also resulted in participants losing their investments. Several years later, the Belgian government sought to reimburse ARCO participants under its domestic bank deposit insurance program. This action was disapproved by European regulators since ARCO was not a credit institution and the investment participation was not considered a bank deposit.
  • The Financial Crimes Enforcement Network (FinCEN) issued a Notice of Finding alleging  FBME Bank Ltd. to be a financial institution of money laundering concern in July 2014. The Central Bank of Cyprus and later the Bank of Tanzania placed FBME Bank under resolution. Both the branch and the head office lost their licenses in 2015 and 2017 respectively. Deposit insurance was triggered and bank liquidation proposed. However, the administrative court in Cyprus ruled in 2022 that the resolution authority acted beyond its powers by imposing an administration decree on the bank.
  • In 2015, Banca Privada d’Andorra (BPA) was considered a Primary Institute of Money Laundering Concern by the Financial Crimes Enforcement Network of the US Treasury. The bank was placed under external administration whilst little background information was provided and legitimate creditors and bank account holders had only restricted access to their account and bank facilities. The findings were eventually withdrawn by FinCEN and a bridge bank named Vall Banc obtained the legitimate assets, liabilities and clients of BPA. Meanwhile the shareholders of the bank pursue a hefty claim for compensation against the financial supervisor and the Government of Andorra for unfair and reckless intervention.
  • Choice Bank Limited was placed under enhanced supervision by its regulator, the Central Bank of Belize. Corrective actions remained unanswered, the bank’s card issuer terminated the working relationship and as a result deposit withdrawal was suspended by bank management. The banking license was revoked and a liquidator appointed. The liquidator continues to face a difficult task. So far, the regulator has appointed three different liquidators, and one of the Choice Bank shareholders ran an external prepaid card program issued by the bank. These card users also claimed the estate of Choice Bank in liquidation.
  • St. Vincent based Loyal Bank Limited lost its license in August 2018. Shortly after, joint liquidators were appointed to manage the affairs of the bank, collect the assets and distribute dividends to creditors, and ultimately wind up the organization. Almost three years after the appointment of the liquidators, a first interim dividend distribution of 25% was made available to claimants. Creditor losses are expected to exceed half of their deposits. When creditors waive or otherwise lose their right to claim, reimbursement to identified claimants may be raised.
  • Lucayas Bank, based in the Bahamas, was placed under statutory administration in November 2021. The activities of the bank were frozen and a moratorium on payments was imposed. After the bank was sold to Brittania Bank & Trust, half of the money was returned to account holders and investors. A ‘reserve position’ is maintained for the outstanding balance pending a successful recovery by the statutory administrator of the bank. Meanwhile, Lucayas Bank shareholders, Old Church Financial Investments, still challenge the sale of the business in the Bahamian court.
  • The Malta Financial Services Authority (MFSA) asked the European Central Bank (ECB) to withdraw the authorization of Satabank plc to act as a less significant credit institution in 2020. The General Court of the European Union granted the St. Julian based lender in 2023 access to its file held by the ECB. Access to this file enables Satabank plc and its shareholders to secure their rights of defence and allow for a diligent complaints procedure in a confidential setting.
  • An investigation by the Joint Chiefs of Global Tax Enforcement (J5) into the Puerto Rican Euro Pacific Bank was highlighted and broadcasted by ‘60 Minutes/Australia’. Many customers left the bank after this public announcement. As a full-reserve bank, the bank maintained a stable capital position. The Puerto Rican financial regulator (OCIF), however claimed that the bank was insolvent. By 2022, the license of Euro Pacific Bank to act as an international financial institution in Puerto Rico was suspended. Under voluntary liquidation, the assets of the bank were transferred to Texas-based fintech firm Qenta Inc. The bank shareholder denies wrongdoing and takes legal action against people, entities and public authorities responsible for the bank closure. Meanwhile the UK tax authorities, HMCR, are investigating UK customers of the bank for alleged tax evasion and money laundering.