Chapter

III Regulatory Intervention: Common Issues

Author(s):
T. Asser
Published Date:
April 2001
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1. Categories and Objectives of Regulatory Intervention

Regulatory intervention includes all action taken by the bank regulator with respect to a bank in response to continuing violations of prudential law (banking law, implementing regulations, etc.) on the part of that bank. Thereby, the bank regulator intervenes directly or indirectly in the bank’s management and operations.

The ultimate objective of regulatory intervention is the same as that of all prudential regulation of banks, namely, to promote an efficient and sound banking system. Its immediate objective is to return a wayward bank to compliance with prudential law or to conserve the value of its assets for its creditors followed by the bank’s sale or liquidation.

Regulatory intervention consists of three categories of measures: enforcement action, corrective action, and taking control of a bank through provisional administration or receivership. Distinctions should be drawn between these three levels of regulatory involvement because they differ as to their objectives.

Enforcement of prudential banking law aims at prevention by calling on banks to correct weaknesses before they cause serious banking problems. An example of an enforcement action is a direction or order given by the regulator to a bank engaging in an unsafe or unsound practice in conducting its banking business requiring the bank to cease and desist from the same, without necessarily instructing the bank to take certain specified corrective measures.83

Corrective action is damage repair designed to save the bank and to return it to regulatory health. For example, if it must be feared that a bank, receiving a cease and desist order of the regulator to end an unsafe or unsound banking practice, will fail to take adequate corrective action, the order may prescribe the measures that the bank must take.84

In several countries, if the corrective measures ordered are not carried out or fail to have their intended effect or would come too late to be successful, the regulator may take control of the bank and replace the bank’s management with one or more provisional administrators whose task is to save the bank by managing it back to compliance with prudential regulations or to prepare the bank for a sale to or merger with another institution. Normally, the corrective treatment of a bank requires the bank’s continuing operation. This exposes the creditors of the bank to the risk that, notwithstanding attempts to save the bank, the bank’s condition would worsen to a point where the probability of success of continued corrective action becomes too low to justify the risk of further erosion of the value of the bank’s assets. As this risk grows, the bank regulator must shift the focus of its objectives to minimizing the systemic effects of the bank’s failure and maximizing the value of the bank’s assets for its creditors. In such circumstances, when the regulator decides that it is unlikely that the bank can be saved or sold, a receivership may be imposed for closure including liquidation of the bank under receivership. Thus, unsuccessful corrective action tends to resolve itself through bank closure.

For banks in distress, there would ideally be a gradual progression from enforcement of prudential requirements to corrective action that, if unsuccessful, gives way to taking control of the bank through provisional administration or receivership. In reality, however, the various regulatory actions cannot always be taken sequentially and progressively. For instance, the regulator may not have the time to follow a gradual approach and may have to decide on corrective action through a receiver, for instance, to displace crooked owners and directors when bank supervisors uncover serious banking deficiencies that had been fraudulently concealed. The bank regulator must have the freedom to be selective and apply different regulatory measures in response to different banking problems: in extreme cases, this may require an extreme regulatory response.

2. Discretion of Regulators Under the Law

Most banking laws authorize the bank regulator to order a bank in distress to take corrective measures, or to take control of the bank through provisional administration or a receivership.

As a rule, the scope of the powers of a public agency such as the bank regulator are limited by the statutory provisions (the banking law) granting those powers. Sometimes, the law prescribes more or less precisely when and how a certain authority is to be exercised. More often, however, the law grants the regulator a measure of discretion in deciding when and how a certain power is to be exercised. Discretion in this context means that the decision whether or not to take action and the choice of corrective measures to be imposed on a bank depend to a greater or lesser extent on the judgment of the bank regulator.

In analyzing the law as to the discretion that it grants to the bank regulator, a distinction must be drawn between the legal authority to take regulatory action, the grounds on which that authority may be exercised, and the choice of regulatory action that may be taken pursuant to that authority. This distinction may be illustrated by reference to the following banking law provision:

When a bank has failed to follow sound banking practices, the bank regulator, after having afforded the bank’s managers an opportunity to explain such failure, may issue a warning to them.85

In this provision, the legal authority to take corrective action is granted by the provision that the bank regulator may issue a warning. The ground for exercising that authority is that the bank has failed to follow sound banking practices. The choice of action authorized by the law is limited to the issue of a warning to the bank’s managers.

Legal Authority to Take Regulatory Action

In the foregoing example, the legal authority to take corrective action is couched in permissive language: the provision says may issue a warning. This means that the bank regulator has discretion in deciding whether or not to exercise his authority under the provision. If, in contrast, the provision had used mandatory language and had said shall issue a warning, the regulator would have no discretion in the exercise of his authority: whenever the regulator would determine that a bank had failed to follow sound banking practices, the regulator would be required to take the action prescribed by the law. Of course, even when the provision had used mandatory language, the regulator would have had a fair degree of discretion in determining what are sound banking practices.

The permissive approach raises a serious issue. Assuming that all provisions of the banking law that authorize the bank regulator to take corrective action against a wayward bank are couched in such discretionary language (as is the case in many countries), would then the regulator be permitted not to take any corrective action at all against such bank? As, strictly speaking, the answer must be affirmative, the issue is whether this state of affairs is acceptable. Should the bank regulator not be required by law to address every infraction of the banking law?

Without opening a discussion of regulatory forbearance,86 the supporters of permissive treatment generally respond that there are circumstances in which discretion is needed. The exercise of remedial authority on the part of the regulator would make little sense, for instance, when the violation at issue is insignificant or has been corrected already by the bank. To exclude extreme cases of regulatory abstention, the law may impose sanctions on regulators who are derelict in carrying out their duties or may permit bank creditors to bring a claim for damages suffered as a result of gross negligence on the part of the regulator.87

There are provisions of banking law which leave the regulator no choice in the exercise of its authority and require it to take regulatory action. In Switzerland, for example, the banking law contains the following provision:

When the bank regulator discovers violations of the law or other irregularities, it shall take the measures necessary to restore the rule of law and to remove the irregularities.88

The provision requires the regulator to do whatever is necessary to remedy the situation; if the provision would have used permissive language and would have said may take the measures, it would have permitted the regulator to abstain from corrective action altogether. The exercise of regulatory authority to take regulatory action is made mandatory. However, the meaning of “other irregularities” is uncertain and the choice of regulatory action is discretionary. This means that the provision is not strictly mandatory. It would be strictly mandatory if the provision would precisely define the irregularities and measures referred to in the provision.

Strictly mandatory provisions of banking law are fairly rare. They are usually reserved for special situations, where it concerns a particular regulatory act to be done in narrowly defined circumstances. For instance, in England, the banking law requires the bank regulator to revoke a bank’s banking license when a winding-up order has been made against the bank.89

The banking law may curtail the discretion of the bank regulator in exercising authority granted by the banking law by prescribing review procedures whereby the bank is notified of impending regulatory action and is afforded an opportunity to present its views to the regulator in a hearing before action is taken by the regulator. Such procedures have the effect of delaying a regulatory response to banking problems and thereby restricting the discretion of the regulator in determining the timing of the response. For cases where a delay in regulatory action caused by such procedures would have serious adverse effects on the bank concerned or even the banking system as a whole, the law often permits the regulator to act without prior notification or hearing, pending completion of the review procedures.90

Along similar lines, banking laws sometimes grant authority to take regulatory action by prescribing a graduated two-step approach. The first step usually consists of a guideline, recommendation, or order to the bank to correct a certain deficiency, often within a deadline specified by the regulator, while the second step consists of more rigorous action, such as the application of a sanction or taking control of the bank through provisional administration if the first step is not taken by the bank.91 One would expect that, when a bank fails to comply with a guideline or order of the regulator, the law would require the regulator to follow up with stricter regulatory action. Instead, the banking law typically permits the exercise of the regulator’s authority to respond to this failure and provides accordingly that the second step may be taken.92 As noncompliance with a direction of the bank regulator is a serious matter that should not be disregarded by the regulator, it is difficult to understand why the exercise of the regulator’s authority at the second level would not be mandatory. Flexibility can be built into a mandatory two-step approach by allowing extensions of the deadline for completion of remedial action under the first step, and by making the choice of remedial action imposed as a second step more or less discretionary.

The discretion of the bank regulator in taking action can be restricted by providing that the action may only be taken with judicial concurrence. Typical examples would be taking regulatory control of a bank through a provisional administrator or a receiver to be appointed by court order. Pursuant to such provisions, the regulator may not exercise its authority without judicial approval and regulatory discretion of decision making is shared between the regulator and the court.

The balance of discretionary power between the regulator and the court can be adjusted by statutory provision. For instance, if the law provides that judicial insolvency proceedings may be opened against a bank upon the application of a bank’s creditors after consultation with the bank regulator,93 most of the discretionary decision-making power rests with the court. However, by providing in the law that judicial insolvency proceedings may be opened against a bank only upon a petition from the bank regulator,94 the balance of discretionary power can be tilted somewhat toward the bank regulator. If in this example the law would also provide that the inability to pay or the insolvency of the bank is to be determined exclusively by the bank regulator, the discretionary power of decision making would rest mostly with the regulator. In the last mentioned case, the court would not materially participate in the decision-making process. Its role would be limited to protecting the interests of the bank by reviewing the petition in the light of, inter alia, procedural requirements of the banking law and general principles of administrative law, for instance, to ascertain that the petition is not unreasonable in the circumstances. Even if it lacks discretionary power in the decision-making process, the judiciary can play an important role as watchdog over compliance with the rule of law by the bank regulator.

Grounds for Regulatory Action

Typically, banking law provisions granting authority to take regulatory action specify the concrete circumstances in which that authority may or must be exercised. Broad and vaguely defined grounds for regulatory action leave the regulator greater discretion in deciding whether the circumstances of a particular case before it come within the scope of its authority to act, than do narrow and precisely defined grounds for regulatory action. Thus, the degree of discretion to be granted to the bank regulator to take regulatory action can be more or less controlled through the statutory grounds on which such action may be taken.

Sometimes, broad and narrow grounds are found side by side in the same section of the banking law. For example, the banking law of Australia contains substantially the following provision:

(1) The bank regulator may give a bank a direction of a kind specified in subsection (2) if the regulator considers that the bank has contravened a prudential regulation or a prudential standard, or the direction is necessary in the interests of depositors of the bank.95

The provision specifies two basic grounds for issuing a direction to a bank: (A) the bank has contravened a prudential regulation or a prudential standard; and (B) a direction of a kind specified in subsection (2) is necessary in the interests of depositors of the bank. The ground described under (A) is fairly narrow as there will not be much discretion involved in deciding whether a bank has or has not contravened the law, one would hope. The ground described under (B) is fairly broad and allows the regulator considerable discretion in deciding whether the interests of a bank’s depositors require a direction of a kind specified in subsection (2).

There are banking law provisions that grant authority to the bank regulator to take regulatory action without specifying any ground. For example, the banking law of France includes a provision that in substance reads as follows:

The bank regulator may issue a recommendation to a bank to take appropriate measures to restore or strengthen its financial condition, to improve its management methods or to ensure that its organization is adequate for its activities or development objectives. The bank concerned must respond within two months by describing in detail the measures taken pursuant to that recommendation.96

Although the discretion of the regulator in deciding in what circumstances to issue the recommendation may seem unlimited, in practice, its discretion will be restricted by principles of administrative law dictating that regulatory action as permitted by the provision may not be taken without sufficient cause. In this context, it should be noted that, for obvious reasons, no mandatory provision of banking law was found that authorizes regulatory action without specifying the grounds on which such action must be taken.

Where the grounds for regulatory action set out in the banking law are broad, granting the regulator a broad measure of discretion, the regulator may be required by law to issue regulations that give more precise content to those grounds and better define the circumstances in which regulatory action may be taken.97

Choice of Regulatory Action

Finally, the law may adjust the degree of discretion to be granted to the bank regulator by listing the actions that the regulator may or must take. In doing so, the legislature may limit the choice of regulatory actions available to the regulator. This is a useful legislative technique to correlate certain regulatory measures with certain grounds for taking regulatory action. The technique is also used to specify certain categories of regulatory action that the regulator may take at its discretion, implicitly excluding other categories of measures that are not suitable for such discretionary treatment, such as measures that are so intrusive into the affairs of a bank that they should only be taken by the judiciary.

The degree of statutory specificity in prescribing what regulatory action may be taken differs considerably from country to country, and in some countries from provision to provision of the banking law. At one end of the spectrum are broad provisions that authorize the regulator to take whatever measures are necessary to remedy the infractions referred to in the grounds for exercising the authority.98 At the other end of the spectrum are banking law provisions with exhaustive lists of the kinds of regulatory action that may be taken.99 There are also banking law provisions where the broad approach is combined with an illustrative list of measures.100

Some banking laws cover both ends of the scale in a single provision. Thus, for example, the banking law of Australia lists 14 kinds of direction that the regulator may give to a bank, including, inter alia:

  • (f) a direction not to accept the deposit of any amount;
  • (j) a direction not to pay a dividend on any shares;
  • (n) any other direction as to the way in which the affairs of the bank are to be conducted or not conducted.101

The open-ended kind of direction last listed implicitly recognizes, and cures, the principal disadvantage attached to an exhaustive enumeration of regulatory action: as the legislature cannot foresee all kinds of measures that the bank regulator may need to respond adequately to the violation of evolving prudential standards, writing an exhaustive list of regulatory action into the law risks omitting the very measure that is needed.

Prompt Corrective Action in the United States

Some of the foregoing considerations may be illustrated by reference to the mandatory regulatory response of prompt corrective action that United States law imposes in case a bank fails to meet prudential capital adequacy standards.

The severe banking and savings and loan crises of the 1980s and suspicion that the crises had been worsened by lax banking supervision led the U.S. Congress to adopt the FDIC Improvement Act of 1991. The Act includes under the heading “prompt corrective action” a relatively long and detailed list of violations and corresponding corrective measures that a bank is required to take or the bank regulator is required to order, based on the level of the bank’s capital.102 The provisions were designed to limit regulatory forbearance by requiring intervention that would be more timely and less discretionary, with the objective of reducing the costs of bank failures.103

Notwithstanding the impression of relative inflexibility that it was meant to create, the system of prompt corrective action is less mandatory in practice than its appearance would suggest. One reason is that the measures prescribed by the law have a degree of flexibility built into the text of the prescriptions that is necessary in practice to address the differing circumstances of different banking institutions. Thus, the system of prompt corrective action consists largely of requirements for banks to submit and carry out a capital restoration plan whose content is negotiated with the regulator, leaving considerable room for discretion as to the content of the plan.

Concluding Observations

In determining the scope of discretion to be granted to the bank regulator, balances must be struck in two partly overlapping areas, namely: (a) a balance between protecting the banking system as a whole and protecting the interests of individual banks and their owners through tightly written banking law provisions or judicial involvement; and (b) a balance between protecting the banking system from both regulatory abuse and negligent forbearance and the need to avoid provisions that are so tightly written that they would unduly impair the ability of the regulator to address unexpected conditions or unforeseen innovations in banking services or financial products.

The unprecedented rate of change in the financial markets and the banking industry experienced during the last decades has made it necessary to grant bank regulators greater regulatory discretion than previously was deemed desirable. This development has shifted the burden of providing safeguards against abuse of discretion to administrative law applied by an independent judiciary. Decisions as to the degree of discretion to be granted to the bank regulator may depend on these and other considerations, including the extent of accountability and functional autonomy of the bank regulator.

Regulatory discretion means that for certain measures the legislature relies more or less on the regulator’s judgment. In bank regulation, there are generally good reasons for doing so. The bank regulator must be assumed to have unique expertise and experience with regard to matters falling within its jurisdiction that justify making it solely responsible for decisions on those matters. Generally speaking, laws granting discretion to the bank regulator are testimonials that the legislature has confidence in the regulator, whereas laws that are mandatory or otherwise prescriptive reflect a lack of trust in the regulator.104

While a discretionary regime preserves flexibility for the regulator, it may create uncertainty concerning regulatory action. Moreover, a discretionary regulatory framework may raise concerns about the fairness of regulatory intervention, especially in countries where respect for the rule of administrative law on the part of the regulator is wanting. In contrast, while a mandatory regime is relatively inflexible, it offers greater transparency and certainty about regulatory action than a discretionary regime, and it promotes equality of treatment. As was suggested before, the transparency and predictability of a discretionary regime may be enhanced by issuing definitions of circumstances that would trigger the authority of the regulator to take action.105

The principal weakness of a strictly mandatory system is its methodology of eliminating regulatory discretion and prescribing in its stead uniform measures for all banks that have reached a certain state of noncompliance with the banking law, regardless of whether such measures are appropriate in the light of prevailing circumstances. A prescriptive regime of regulatory action that is too strictly mandatory puts the bank regulator into a straightjacket and may exclude or impede a flexible response. Theoretically, under extreme circumstances, a mandatory corrective system rigidly applied could produce a wholesale closure of the banking system. Such an outcome would violate the elementary objective of prudential banking regulation aiming at the preservation of a functioning banking system. Therefore, a mandatory regime may force the regulator, when faced by conditions unforeseen by the legislature, either to order measures that are not suitable for the problems to be corrected or to avoid taking the action prescribed by the law altogether—for instance, by denying that a statutory ground for the action exists—and thus to break the law. Obviously, this dilemma should be avoided.

Under certain conditions a strictly mandatory regime should be ruled out a priori. For instance, a strictly mandatory regime is generally unsuitable for heterogeneous banking systems, because these banking systems require a fair degree of corrective differentiation by the regulator, owing to differences in the conditions and needs of various categories of banks. Similarly, mandatory banking law provisions whose application depends on a valuation of marketable bank assets should be avoided in countries with less developed or illiquid financial markets that do not produce reliable asset values.

Logic dictates, therefore, that even a mandatory regime normally requires a minimum of discretion for the bank regulator. Such discretion may be provided by the law in the form of exceptions to mandatory provisions in order to address unusual circumstances.106 Exceptions can be made to the regulatory action required, to the grounds on which such action must be taken, or to both. However, where such exceptions undermine the objectives pursued in making the regime mandatory, they would normally be permitted only if the result of the application of the mandatory regime in a particular case would be incompatible with crucial systemic interests or would otherwise be patently unreasonable.

Does a mandatory regime moderated by suitable exceptions produce better results than one that is discretionary? It cannot be denied that discretion can easily turn into permissiveness and lax banking supervision, especially in societies with a club culture. In contrast, a mandatory regime creates an appearance of predictability and equality of treatment and thereby enhances the credibility of the bank regulator.107 Mandatory systems of regulatory action have other advantages. These are chiefly that they require frequent monitoring of the bank and that, even though applying their trigger points may be more an art than a science, they force regulators periodically to collect and analyze evidence concerning the direction in which the bank’s financial condition develops.

It may be concluded from the foregoing that a good banking law would generally require the bank regulator promptly to take appropriate action to address violations of prudential standards by a bank, and would empower the regulator to do so by offering a balanced menu of options representing both a discretionary and a moderately mandatory approach, depending on the kinds of circumstance addressed, while generally submitting the most invasive regulatory measures to a prior review by the judiciary. For each country, its sociopolitical character and its experience with banking crises will help determine whether its banking law grants more or less discretion to the bank regulator in addressing banking problems.

3. Gradation of Regulatory Intervention

In considering the degree of discretion to be granted to the bank regulator, it is not unusual to find an inverse relationship between the generality of the grounds for authority to take corrective action and the variety or invasiveness of corrective action allowed to be taken under that authority. It is not uncommon for the law to combine broad grounds of authority with narrowly prescribed corrective actions and narrow grounds of authority with broader arrays of measures. Similarly, some banking laws show a tendency toward more narrowly defined grounds of authority as the action that they authorize becomes more invasive. Examples of these tendencies are found in countries where the banking law grants the regulator discretionary authority to issue orders or restrictions concerning a bank’s activities while requiring a court order for taking control of a bank through a receivership.108

In line with this practice, it has been recommended that countries adopt, implement, and enforce a method of structured early intervention in the banking sector that includes a well-considered set of mechanisms to ensure a consistent, timely, and graduated response by supervisors.109

As a graduated approach to regulatory intervention is a logical extension of the administrative law principle of proportionality, examples of a graduated response can be found in many banking laws.

For instance, regulatory action must be graduated where the banking law requires the regulator to follow a two-step approach, the first step consisting of a guideline, order, or recommendation issued to the bank to correct a certain deficiency within a certain deadline, followed by a second step of more rigorous regulatory action in the event of an inadequate response by the bank to the first step.110

The Banking Act 1959 of Australia offers another example. Regulatory intervention authorized by the Act falls into two categories: the regulator may by notice in writing give “directions” to a bank; or the regulator may appoint an investigator or take direct or indirect control of the business of a bank. The grounds on which these two kinds of action may be taken differ.

A “direction” may be given by the regulator if the regulator considers that the bank has contravened a prudential regulation or a prudential standard, or that the direction is necessary in the interests of depositors of the bank.111 The kinds of directions that may be given are specified by the Act; they include directions to comply with a certain prudential standard, directions to remove, suspend, or replace managers, directions to desist from any borrowing, payment, or transfer, and directions generally to conduct or not to conduct the affairs of the bank in any way.112 Sanctions on noncompliance with a direction include criminal penalties levied against the bank and noncomplying bank officers,113 and publication of the direction.114

If the bank regulator considers that a bank is likely to become unable to meet its obligations or is about to suspend payment or if a bank becomes unable to meet its obligations or suspends payment, the regulator may appoint a person to investigate the affairs of the bank, take control of the bank’s business or appoint an administrator to take control of the bank’s business.115

The difference in grounds is striking: whereas the general ground for giving directions to a bank is its noncompliance with prudential law or regulations, the more intrusive corrective actions of appointment of an investigator and taking control of the bank are reserved for cases where the bank is or is about to become illiquid or insolvent.

One of the problems posed by a graduated approach is that it requires the grading of violations of prudential law and regulatory responses thereto on a single scale of abstract values. Although such grading may be possible for certain broad categories of violation, it is ill-suited to others. For instance, although deficiencies in the financial condition of a bank, such as a bank’s failure to meet capital adequacy requirements, could be scaled because they have effects that can be measured in numerical terms, it will be difficult to bring these financial infractions under a common denominator with other offences, such as money laundering, that cannot be so measured.

The graduated approach to regulatory action addresses the proportionality between violations of prudential law and regulatory responses thereto. Regulatory action is ratcheted up or down as banking law violations by a bank become more or less serious. This should not be taken to imply that the bank regulator must first exhaust lesser corrective remedies before more intrusive regulatory measures may be taken. Although there are cases where a regimen of measures of increasing severity would clearly be appropriate, there also are situations where the regulator would wish to address simultaneously different types of deficiencies with different types of measures graded at different points on the scale, such as capital inadequacies requiring the bank to recapitalize and managerial incompetence or crookedness requiring the replacement of managers. Also, the fact that a particular measure is more intrusive than another one does not necessarily mean that it should be postponed until a less invasive measure has been tried first; for example, although the appointment of a provisional administrator is relatively invasive, it may be the only action that is appropriate to replace a crooked management until a new management has been appointed by the owners.116

Much more cannot be said about a graduated response than that corrective action should be tailored to the deficiencies encountered and that corrective action should neither go beyond what is necessary to return the bank to full compliance with prudential requirements nor be too weak to achieve its goal.

4. Timeliness of Regulatory Measures

To be effective, corrective regulatory action must be swift and decisive. In contrast, experience would seem to point to a widespread tendency on the part of bank regulators to postpone effective action against wayward banks. The history of prudential regulation of banks is replete with instances of regulatory forbearance with respect to banks that the regulator knew to be in difficulty. Whether it is the savings and loan crisis of the 1980s in the United States, the problems of Crédit Lyonnais, BCCI, or Barings, or the more recent banking crises in Korea, Russia, Thailand, and Indonesia, some of the blame for these events has been laid at the doorstep of the bank regulator.

There are situations, of course, where regulatory forbearance is justified, for instance, when the banking sector is overwhelmed by adverse economic conditions and the regulator must respond by relaxing prudential requirements, provided that this is done explicitly and publicly and applies to all banks alike. Often, however, regulatory forbearance is a serious problem, especially when it consists of negligence of the regulator in its main task, namely, to identify and respond to banking problems before they spin out of control; then, regulatory forbearance can undermine the entire bank regulatory structure. Although some of the causes of regulatory negligence are known—political interference in the regulatory process and a club culture are among them—a thorough analysis (which would go beyond the scope of this book) might show why this phenomenon is so widespread and what should be done to curtail it.

Negligent forbearance by the bank regulator carries significant costs. Not surprisingly, it leads to banking problems, which cause increases in costs for bank creditors in case of bank failures, and for the monetary authorities in case of bank rescue operations. Generally, regulatory negligence is inequitable as it produces unfair competition: banks not complying with prudential regulations are allowed to avoid costs associated with regulatory compliance and are therefore permitted to operate from a lower regulatory cost base than banks that are in compliance. Worse for the banking system is that regulatory negligence breeds a culture of noncompliance with banking law. Compliance with banking law cannot be assured without the voluntary cooperation of bankers; because regulatory negligence permits some banks to disregard the banking law, it creates a powerful incentive for all banks to do likewise, leading eventually to widespread deficiencies in the banking system. In the end, regulatory negligence regarding banks that the public perceives as weak undermines the credibility of the bank regulator, creates uncertainties for the public concerning the financial condition of all banks, and thus heightens systemic risk.

Developments in the business of the banking industry over the last two decades have worsened the risks attending corrective action unduly postponed. Changes in consumer investment preferences have forced many banks to replace their traditional deposit base with money market instruments. Also, the income of banks derives increasingly from financial services requiring transactions with other financial institutions. The financial markets are more sensitive to negative publicity concerning a bank than most depositors were in the past. As a result of the information revolution, news reaches financial market participants faster than before, and their reaction to such news is faster than a traditional run on a bank by depositors would be.

The shortened reaction time of bank counterparties should cause regulators likewise to react to banking irregularities faster than before. The longer corrective action is postponed, the more forceful it generally will be, increasing the risks of a violent market reaction. The provisions of U.S. law requiring banks in distress and the regulator to take prompt corrective action117 have been written with this consideration in mind to promote an early and proportional corrective response to banking deficiencies.

5. Reporting and Disclosure Requirements

Financial reporting is the Achilles’ heel of the bank regulator. Without adequate information about a bank’s noncompliance with prudential standards, the bank regulator will not be able to order corrective action as and when needed. Much touted market discipline in keeping banks on the straight and narrow depends on timely and adequate reports on the financial condition of banks. As a rule, therefore, banks are subject to regular reporting requirements or on-site inspections by the regulator. In addition, banks whose capital shares or debt securities are publicly traded usually must disclose to the public significant changes in their financial condition.

In some countries, the law requires a bank or its management or auditors to alert the bank regulator if it is likely to become unable to meet its obligations or is about to suspend payments,118 or if it becomes insolvent or overindebted.119 For example, in Norway, the law requires the bank, its managers, and auditors to notify the regulator:

if there is reason to fear that:

  • a) the institution may be unable to meet its commitments as they fall due,
  • b) the institution may be unable to meet the minimum requirements as to its own funds or other capital adequacy and prudential requirements set out in law or regulations,
  • c) circumstances have arisen that may entail a serious loss of confidence or losses that will substantially weaken or threaten the institution’s financial position.120

Often, when an instance of noncompliance with prudential requirements is uncovered by the bank regulator there are reasons to fear that what became visible is merely the tip of the proverbial iceberg. For such cases, the law may authorize the regulator to order a special audit of the bank covering not only its financial condition but also its operations and risk management policies and procedures, or to appoint an observer.121

As was noted before, the increasing exposure of banks to financial market risks and the communication revolution have reduced the reaction time of bank counterparties to real or perceived weaknesses in a bank’s financial condition. This requires improved flows of information from the banks to the regulator that permit the regulator to form faster judgments about the current financial condition and risk exposure of the banks. In particular, the time lags implicit in traditional forms of information gathering by bank regulators should be significantly shortened, for instance, by giving the regulator electronic access to accounting data of banks that reflect each bank’s unique risk profile and risk management. Real-time banking supervision would help the regulator to take early and therefore limited action that would not attract undue public attention.

6. Financial Costs of Regulatory Intervention

For the bank regulator, there are financial costs or expenses associated with regulatory intervention. As these activities are often labor intensive and a drain on its staff and other resources, the law may allow the regulator to recoup these costs and expenses.

This is especially important for situations where the intervention costs to the regulator are significant, as they would be when the regulator would take control of a bank through a provisional administrator or a receiver. If the costs of a successful regulatory rescue mission are not recouped, the bank and its owners would enjoy an unfair benefit in comparison with other banks. In order to avoid that such a bank and its owners would become “free riders” at the expense of the regulator, it is important that the bank should bear the financial costs incurred by the regulator on account of the restructuring of the bank. The banking law may make provision for charging the expenses of regulatory intervention to the bank122 and grant to the regulator the powers necessary to enforce its right to reimbursement on account of such expenses, for instance, by granting it a statutory preference in the bank’s liquidation.123

Principal Objectives To Be Pursued by Law

The law should require the bank regulator to respond promptly and adequately to infractions of prudential standards and should grant the bank regulator a degree of discretion of decision making that is commensurate with the need for a proper response to unpredictable conditions in the banking system. Even mandatory regimes prescribing corrective action should afford the regulator sufficient discretion to take account of unforeseen conditions.

Regulatory action to correct banking deficiencies should be broadly gradual, in consonance with the administrative law principle of proportionality. Such action should be taken in a timely fashion so as to avoid that stricter measures would be required later, and so as to maintain a level regulatory playing field for all banks.

Financial reporting by banks to the regulator should be improved so as to give the regulator continuous real-time information about the bank’s financial condition.

Banks should reimburse the regulator for the regulator’s costs and expenses on account of measures taken to correct deficiencies in their compliance with prudential regulations; free ridership of owners of banks benefiting from corrective action should be precluded.

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