Pitfalls in Managing Closures of Financial Institutions

Abstract

INTRODUCTION Closure of a financial institution is essential when it is no longer viable. Unviable financial institutions lead to accrual of losses that eventually will have to be borne by various stakeholders. If allowed to operate, they undermine healthy market competition and create moral hazard by giving owners and managers incentives to gamble for recovery and opportunities for asset looting and criminal “end games.” Their continued presence may over time undermine the soundness of an entire financial system. Owners and managers of financial institutions are typically required by law to close an institution once it becomes insolvent and cannot be recapitalized. But numbers can be manipulated and closures or other forms of market exit tend to be delayed and often take place only at supervisors' insistence. Closures of financial institutions are seldom the routine supervisory actions they should be. Closures are typically preceded by other corrective supervisory actions. Closure should be the ultimate sanction for breaching licensing agreements and prudential rules and be part of supervisors' “toolbox” of corrective measures. Reasons for closures could be lack of financial viability, breaches of prudential requirements, licensing agreements or corrective action plans, or criminal activity, fraud, or gross malfeasance. Clean closures causing little disturbance to the financial system should be viewed as a sign of effective supervision. Closures often are delayed by supervisors, who are reluctant to take actions that may be seen by the public and politicians as a failure of supervision rather than a failure of an institutions' owners and managers.

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