Weak banks: to close or not to close . . .

• Pages: 175-176

Page 175

One way to deal with problem banks is to close them. Yet, to avoid disruption, country authorities often take extraordinary measures, such as injecting public funds, to prop up nonviable banks. In a recent IMF Working Paper, "What Happens After Supervisory Intervention? Considering Bank Closure Options," Michael Andrews and Mats Josefsson argue that wellplanned and implemented bank closures (which can include sale of all or part of the bank) can preserve essential functions performed by failing banks, mitigating disruption.

Whether dealing with a weak bank in normal times or systemic banking problems in crises, economies in all stages of development have opted to close banks.

Citing a study of the measures used in 24 countries-20 of which were developing or transition economies-Andrews and Josefsson note that 80 percent of the countries that made substantial progress in resolving financial crises used bank closures as part of their strategy. In the 1990s, 12 transition economies in the Baltic States, Eastern Europe, and the Commonwealth of Independent States closed hundreds of banks, largely without contagion, high costs, or social problems.

Why, then, do supervisors often appear reluctant to close weak banks? Supervisors hesitate for many reasons: concerns about potential disruption to depositors, borrowers, creditors, and the payment system; the possibility that closure might trigger runs at other banks; and reluctance to impose losses on depositors, especially in the absence of deposit insurance or a government guarantee. But all these concerns, according to Andrews and Josefsson, can be mitigated by timely, well-planned bank closures. Extraordinary measures to avoid closure may be used in a systemic crisis to preserve some portion of a widely insolvent banking sector, but there are significant risks. The use of public funds, the authors caution, can distort the market and create perverse incentives, ultimately weakening rather than strengthening the banking sector.

Dealing with a weak bank

Bank closure is not meant to punish shareholders or the bank, nor is the decision to close a bank generally an isolated or sudden event. Although serious problems can surface without warning, the decision to close a weak bank is usually the culmination of efforts over time to remedy its problems.

When dealing with an individual weak bank...