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The use of the Act with Dunfermline Building Society has highlighted the importance of some guidance being developed to assist a bank or building society that ...

University of Warwick School of Law

Legal Studies Research Paper No. 2010-27

The UK Banking Act 2009, Pre-Insolvency and Early Intervention: Policy and Practice Dalvinder Singh


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The UK Banking Act 2009, Pre-Insolvency and Early Intervention: Policy and Practice Dalvinder Singh The Banking Act 2009 has introduced a special regime to deal with failing banks in the UK. A feature of the legislation is the regulator’s power to trigger the regime by determining whether or not a bank is likely to fail. The use of the Act with Dunfermline Building Society has highlighted the importance of some guidance being developed to assist a bank or building society that is faced with such a situation on how best to work out its position with the regulator, and ultimately with the Bank of England and the Treasury. This paper looks at the key features of the Canadian and US models of early intervention, which could be described as discretionary and rules-based approaches, respectively. It evaluates these two models in comparison with the UK model to assess whether any lessons could be learned from them. It asks whether early intervention alone is the panacea that regulatory authorities are looking for to reduce the likelihood of bank failure. Introduction The recent financial crisis has generated a considerable amount of debate about the reform of financial regulation and supervision. 1 The area of banks experiencing financial difficulties has specifically featured in this debate. The Banking Act 2009 deals with banks experiencing financial problems by capturing the complex set of risks of a bank in distress, in order to minimise the consequences of a bank failure for the financial system as a whole and to compensate depositors as efficiently and quickly as possible. There are a number of reasons 

Dr Dalvinder Singh, Associate Professor of Law, University of Warwick, UK. This paper was partly presented at the University of Warwick School of Law symposium, Financial Crisis Management and Bank Resolution, 13 April 2009; Conference, Bank Insolvency in the Caribbean – Law and Best Practice (Detecting and Managing Banking Crises: Assessment of the Global Financial Crisis of 2007–2009), Principal Sponsor CARTAC, Rose Hall Resort, Montego Bay, Jamaica, 24–26 March 2010 and at the University of Warwick, Symposium on Managing Systemic Risk, 7–9 April 2010; The Heyman Centre, Benjamin N Cardozo School of Law, Conference on International Financial and Monetary Law, 3–4 June 2010, New York. I am grateful for the discussion and comments at those events. I would specifically like to thank John Raymond LaBrosse, the principal architect of the Canadian Guide to Intervention for Federally Regulated Deposit-Taking Institutions, Richard Osterman, General Legal Counsel, FDIC, USA, Gillian GH Garcia, formerly at the IMF, and Prof Art Wilmarth, George Washington University, Maria Nieto, Bank of Spain, and comments from those that wish to remain anonymous. All errors and views remain my responsibility. 1 Treasury Select Committee, Banking Crisis, April 2009. For an analysis of the crisis and the role of Lender of Last Resort see A Campbell and RM Lastra, ‗Revisiting the Lender of Last Resort‘, Banking and Finance Law Review (2009), 24, p. 453; for an analysis of the mechanism used to contain the UK crisis see also D Singh, ‗UK Approach to Financial Crisis Management‘, 19 Fall, Transnational Law and Contemporary Problems, (2010) p. 101– 155 (forthcoming).


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why a bank failure should be treated differently from a normal corporate failure and the policy of early intervention is inextricably linked to bank resolution regimes.2 A significant policy dilemma is the area of early intervention during the pre-insolvency stage. The issue of early intervention is being deliberated both internationally at the Basel Committee and regionally within the EU. 3 While the former is indicating the need for early intervention, the latter is exploring what early intervention should look like. This paper explores primarily the UK model and reflects on it by looking at the Canadian and US models of early intervention. The new UK Coalition Government has announced major reforms to the regulatory structure which include the transformation of the FSA to become a new prudential supervisor for banks, investment businesses and insurance companies, and the introduction of a separate regulator for consumer protection, conduct of business and markets. 4 The proposed changes are intended to improve the link between financial stability and the supervision of banks by reconfiguring the relationship between the Bank of England and the new FSA. 5 In many respects the Banking Act 2009 vividly establishes the need for a close relationship between central bank and regulator in some quarters such as financial stability. A key component of maintaining financial stability is to intervene in banks in distress bef ore they fail. This paper explores the powers of the FSA, the Bank of England and HM Treasury (the Authorities) in dealing with a failing bank. 6 It specifically focuses on the pre-insolvency RM Lastra, Legal Foundations of International Monetary Stability, (Oxford: Oxford University Press, 2006), pp. 128–137. TMC Asser, Legal Aspects of Regulatory Treatment of Banks in Distress, (Washington DC: IMF, 2001). 3 Report and Recommendations of the Cross-border Bank Resolution Group – final report, 18 March 2010, p. 23. This report recommends that national authorities implement a system of early intervention and that there should be convergence on ‗threshold conditions across borders‘, p. 23 and 27. 4 Speech by the Chancellor of the Exchequer, Rt Hon George Osborne MP, at Mansion House, 16 June 2010, available at Mervyn King, Mansion House speech, at the Lord Mayor‘s Banquet for Bankers and Merchants of the City of London at the Mansion House on 16 June 2010, available at 5 It is beyond the scope of this paper to critique the proposed changes. This paper will therefore analyse the Banking Act 2009 with the FSA, in its current form, at the table with the individual banks, and the Bank of England and HM Treasury. 6 This paper will explore the powers of the FSA under the Banking Act 2009 which will eventually be transferred to the new prudential supervisor.. 2


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arrangements of the new regime, namely the trigger to decide whether a bank is failing and the various stabilisation options, before the bank administration or insolvency proceedings. It analyses legislation and guidance provided so far to assist a bank to determine what it should expect during this phase of ‗heightened supervision‘. It argues that the law as it stands is rather ambiguous and requires clarity to assist banks to better determine their fate. The Dunfermline Building Society provides an interesting case study, highlighting the trade-offs that occur with an early intervention model and the need for guidance. The paper evaluates whether the Authorities should provide some guidelines on the policy of early intervention referred to as heightened supervision, as is the practice in other jurisdictions, namely Canada and the USA. Canada and the USA are useful comparators as well because the models they adopt are, respectively, discretion based and rules based. Finally, the paper explores the limits of early intervention as a policy tool to reduce bank failures or closures. The Banking Act 2009 The UK Authorities recognised the importance of a special resolution regime for banks soon after the Northern Rock debacle.7 The existing insolvency regime was considered inadequate to deal with a bank in distress, albeit that it has been used on a number of occasions with relative success. 8 However, post-Northern Rock the political climate changed in the UK and a move towards a special resolution regime was initiated.9 The principal problem associated with the existing insolvency regime was the impact of a moratorium on depositors‘ rights to access their funds for a period of time. 10 This delay in receiving compensation would cause considerable panic in the market. The other reasons for not using existing insolvency law were the implications of a firesale of bank assets. The reforms introduced by the Enterprise Act 2002 to the Insolvency Act 1986 tried to prevent the firesale of assets by protecting the need to rescue the company as a going concern, and creditors‘ interests as a whole. But this has to be put in context as the special administration regime introduced by the 2002 Act was Banking Reform – Protecting Depositors: A Discussion Paper (11 October 2007); Financial Stability and Depositor Protection: further consultation and special resolution regime, 1 July 2008; Special Resolution Regime: Safeguards. This would replace the temporary Banking (Special Provisions) Act 2008. 8 A Campbell and P Cartwright, Banks in Crisis: A Legal Response, (Aldershot: Ashgate, 2002). 9 For a wide ranging international study, see EHG Hupkes, The Legal Aspects of Bank Insolvency, A Comparative Analysis of Western Europe, The United States and Canada, (The Hague: Kluwer Law International, 2000); DG Mayes, L Halme and A Liuksila, Who Pays for Bank Insolvency?, (Basingstoke: Palgrave Macmillan, 2003). 10FSA, ‗Consumer Awareness of the Financial Services Compensation Scheme‘, Consumer Research 75, (2009) p. 12 and p. 14 respectively. 7


not intended to apply to building societies – s. 249(e). 11 This position was not put forward by the Authorities, which meant that reforms were still needed. In the light of the number of building societies that have experienced problems, such as Bradford and Bingley, and the wave of building societies that merged during the period, the move to introduce new legislation was sensible. Another stumbling block that has been highlighted was the inability of the FSA to take control of Northern Rock from its shareholders while it was still solvent. 12 Most special bank regimes try to deal with the failing bank as a business unit, thereby providing better value for the assets, which is one of the underlying functions of the Banking Act 2009. Moreover, one of the key objectives of the new regime is to ensure that depositors are paid as quickly and efficiently as possible and are not left without banking services. This is achieved through a number of options: private sector takeover, the setting up of a bridge bank, temporary nationalisation, bank insolvency procedures or the bank administration procedure. 13 The Special Resolution Regime and Objectives The special resolution regime (SRR) is to be used when a bank or part of a bank‘s business ‗has encountered, or is likely to encounter, financial difficulties‘. 14 The idea of financial difficulties is relatively wideranging and is not synonymous with insolvency; hence, it enables the Authorities to deal with a bank well before issues of insolvency arise, giving them and the bank the time to work out the problems that the individual institution faces. 15 The Authorities are able to use one of the three stabilisation options, or exercise the bank insolvency procedure or administration procedure with banks. 16 The definition of a bank P Brierley, ‗The UK Special Resolution Regime for failing banks in an international context‘, Financial Stability Paper No. 5 – July (2009), p. 5. See also E. Avgouleas, ‗Banking supervision and the special resolution regime of the Banking Act 2009: the unfinished reform‘, (2009) 4(2) Capital Markets Law Journal 2011; R Tomasic, ‗The Rescue of Northern Rock: Nationalization in the Shadow of Insolvency‘, Corporate Rescue and Insolvency, (2008) Vol.1 (4), p. 109. 13 Banking Act 2009, s. 1(1) (2) & (3) [Hereinafter the Act]; For a review of the Act see G Walker, ‗Bank Crisis Resolution: The Banking Act 2009‘, in JR LaBrosse, R Olivares-Caminal and D Singh (eds), Financial Crisis Management and Bank Resolution, (London: Informa Law, Lloyds Commercial Law Library, 2009), pp. 187–202. 14 The Act, s. 1(1). 15 T Huertas, ‗The rationale for and limits of bank supervision‘, London Financial Regulation Seminar, 19 January 2009. available at 16 Ibid. s. 1(2). 11 12


refers to deposit-taking institutions incorporated and regulated by the FSA. 17 The political will at the time was devoted to concentrating efforts to put in place a special resolution regime for deposit-taking institutions and the protection of, inter alia, depositor interests. Widening the scope of the regime to include investment banks was, at the time, simply too much to do all at once. 18 However, after the Lehman Brothers bankruptcy it became apparent that there was a need for some avenue to deal with investment banks in light of the complexity of managing the fallout. 19 Therefore SRR enables the Authorities to deal with a range of financial institutions. The Authorities are required to take into account the objectives set out in s. 4 of the Act when deciding the fate of a bank.20 Objective 1 is to protect and enhance the stability of the financial systems of the UK. 21 This requires the Authorities to judge, inter alia, whether ‗the failing bank‘ could have an adverse impact on the financial or banking systems. Objective 2 is to protect and enhance public confidence in the stability of the banking systems of the UK.22 This is interpreted to mean that the Authorities need to ensure that the stability and efficiency of the financial and banking system are not undermined by a bank failure. Objective 3 is to protect depositors. 23 This requires the Authorities to safeguard the interests of depositors while dealing with a failing bank by ensuring a fast payout to depositors and the continuity of banking services. Objective 4 is to protect public funds. 24 This requires the Treasury primarily to safeguard taxpayers‘ interests, if it is providing financial assistance to a bank. Objective 5 is to avoid interfering with property rights in contravention of the Convention Right (within the meaning of the Human Rights Act 1998). 25 This requires the Authorities to minimise the extent to which they interfere with property rights so as to satisfy the public interest.26 The Authorities are required to establish a scheme to determine

s. 2(1) in accordance with s. 22 of Financial Services and Markets Act 2000 [Hereinafter FSMA 2000]. The Act also applies to Building Societies, s. 84 of the Act. 18 Cass Business School, Workshop on the new UK regime for resolution of banking problems, London, 7 April 2008. 19 The Act s. 232–233 and powers of review s. 236. 20 The Act, s. 4(2). 21 The Act, s. 4(4). 22 The Act, s. 4(5). 23 The Act, s. 4(6). 24 The Act, s. 4(7). 25 The Act, s. 4(8). 26 HC, Banking Bill, 312-313, 4 November 2008. 17


any compensation due to shareholders.27 The new regime invariably means that creditors and shareholders will need to maintain a significant level of vigilance regarding what the banks are doing, in order to ensure that their interests are safeguarded. The objectives set out in the SRR are clarified further in the Code of Practice published alongside the Act. 28 The objectives provide some degree of clarity as to how the Authorities intend to interpret and apply their new tools in individual cases. While they are explained in the Code of Practice, the government considered that ‗[t]he concepts at issue are too complex to be reduced to hard-edged statutory definitions. The applications of the objectives may well change over time.‘ 29 While the objectives are listed 1 to 5, no specific priority or order of importance is attached to them.30 Moreover, some considered the list to be rather narrow, and felt that protecting competition and the enterprise value of the bank and ensuring continuity of business services all deserved to be listed as objectives.31 However, the objectives were thought to be sufficiently broad to capture those concerns as well. The objectives are not mutually exclusive, but rather are very much interdependent and interrelated with one another. Mr Hoban, the Shadow Treasury Minister at the time, pointed out during the passage of the bill that there was ‗a tension between the objectives and where the trade-offs between them are.‘ 32 The need to protect in full UK depositors of the Icelandic banks put a specific strain on the public purse, even though the government had only just increased the coverage level to £50,000 from £35,000. This would possibly place objectives 3, depositor interests, and 4, public funds, at loggerheads with one another, since the additional costs will more than likely be absorbed by the taxpayer. While the objectives seem neutral on the surface, they are implicitly capable of achieving political objectives as well, namely the desire to avoid consumers losing any money at the expense of moral hazard,

The Act, s. 49(1) & (2). See specifically, SRM Global Master Fund LP et al v. The Commissioner of HM Treasury [2009] B.C.C. 251 (Divisional Court) (U.K.). 28 HM Treasury, Banking Act 2009, Special Resolution Regime: Code of Practice, February 2009. 29 HC, Banking Bill, Ian Pearson, p. 314, 4 November 2008. It is explicitly provided in s. 4(10): ‗the order in which the objectives are listed in this section is not significant; they are to be balanced as appropriate in each case.‘ 30 HC, Banking Bill, Ian Pearson, p. 296, 4 November 2008. 31 The Act s. 4(9) qualifies s. 4(4) to include continuity of banking services. 32 HC, Banking Bill, Mr Hoban, p. 296, 4 November 2008. 27


as suggested by the decision to rescue Northern Rock. 33 The coverage level during the Icelandic crisis was technically more than sufficient to protect over 98 per cent of bank customers, which was the case with the £35,000 coverage limit.34 This demonstrates that coverage levels of deposit insurance can only be judged robust if they stave off a panic i n a small-scale crisis of one or two medium-size bank failures and not during a state of potential panic, as was the case in the latter part of 2008. This invariably means that the regulatory requirements and coverage limits could be set to one side if political expediency desires that all depositors are to be saved through a bank rescue which is a political rather than a regulatory commitment. What is a Failing Bank? The 2009 Act confers responsibility on the FSA to intervene and then trigger the special regime before a bank reaches the point of insolvency – the pre-insolvency period.35 The trigger is pulled once the FSA considers the bank to be ‗failing or likely to fail to meet its threshold condition‘36 and, in the circumstances, ‗is not reasonably likely to turn its fortunes around so that it meets the threshold conditions‘.37 The terms ‗failing‘ and ‗fail‘ used in s. 7(2) are not defined literally, and respectively connote a wide spectrum of positions a bank could find itself in: ‗a fault or shortcoming‘, ‗shortcoming‘, a ‗weakness‘, ‗in default‘ on the one hand, and ‗unsuccessful‘, ‗neglect to‘, ‗become insufficient‘, ‗become weaker‘ on the other. 38 The normative interpretation of a failing bank reflects the wide spectrum of problems and financial difficulties a bank could experience between solvency and insolvency. This wide interpretation of failing is not unfettered, as will be shown below, as it is linked to the Threshold Conditions to which a bank is required to continuously adhere. In the literal sense it could be quite difficult for a bank to predict how it will be judged by the FSA in the circumstances.

See G Wood, ‗Towards a Coherent Crisis Resolution Mandate‘, in JR LaBrosse, R Olivares-Caminal and D Singh, Financial Crisis Management, above n 13, at p. 65. 34 See HM Treasury, Financial Stability And Depositor Protection: Strengthening The Framework, 2008, CM 7308, p. 69 (explaining the original increase covered almost 98 per cent of depositors). 35 The Act, s. 7. 36 The Act, s. 7(2). 37 The Act, s. 7(3). 38 Oxford, Oxford Compact English Dictionary, p. 350. 33


The primary threshold condition that would trigger the SRR is adequate resources, albeit that five threshold conditions exist. 39 ‗Adequate resources‘ relates to both financial and managerial resources.40 It could either be mismanagement per se or failure to comply with liquidity and capital requirements that form the basis of the decision. Thus the FSA is likely to intervene when an institution is faced with circumstances in the market which mean that it is likely to fail. This is similar to its existing powers under FSMA 2000. The context of the new responsibility, however, elevates its importance and separates it by referring to it as a pre-insolvency measure. A bank will generally be technically insolvent if its liabilities exceed its assets (balance sheet insolvency), or if it is unable to meet its creditors‘ obligations as they fall due (cash flow insolvency). 41 A bank will be required to meet capital requirements continuously, which means that it could be insolvent from a regulatory viewpoint before the other two forms of insolvency arise. 42 The objective of this authority is to reduce the likelihood of this point materialising. The FSA has extensive powers to vary,43 restrict,44 or indeed revoke the permission of a bank to undertake deposit-taking business if the authorised body is ‗failing or likely to fail‘ to satisfy the threshold conditions. 45 These powers would primarily be exercised when an institution is considered insolvent or near to insolvency. The factors the FSA takes into account could be both internal and external to the individual institution, namely fraud or mismanagement, and/or changing market conditions that could weaken the institution‘s ability to raise further funds, as has been seen in the current crisis. These powers can be exercised by the FSA if it is of the view that this is desirable because existing or potential depositors are at risk if the bank continues to operate. This is primarily to achieve the objective stated in s. 2(2) of FSMA 2000: protecting consumers. For example, the FSA could require a firm to stop accepting deposits from existing and new customers, as it did with London and Scottish Bank plc. 46 More specifically, the FSA can assess compliance of the

S. 41 and Schedule 6, (1)-(5) FSMA 2000. Prominence Technology Ltd v. Financial Services Authority (2005) FSMT 023. 41 S. 123 Insolvency Act 1986. 42 E Hupkes, above n 8, p. 12–14. 43 FSMA 2000, s. 45(1)(a). 44 FSMA 2000, s. 48. 45 FSMA 2000, s. 45(1)(a). 46 FSA, London and Scottish Bank plc, First Supervisory Notice, 30 November 2008. 39 40


bank with threshold condition 4.47 This could be triggered because the bank either is not fulfilling its Tier 1 capital requirement (balance sheet insolvency) or is experiencing a liquidity problem which puts it in contravention of the liquidity rules (cash flow insolvency).48 This was the case with Heritable Bank plc, where the FSA deemed the bank to be failing to meet the requirements imposed by its part IV permission to protect actual and potential consumers. 49 In the case of Kaupthing Singer & Friedlander, its liquidity position was so acute that the FSA considered there was no realistic likelihood of it improving. 50 This decision requires the FSA to take into account whether a bank‘s position is likely to improve within a reasonable amount of time. In such circumstances the FSA can exercise a variety of powers on its ‗own initiative‘ and therefore intervene immediately if it sees a threat. 51 While the decision to determine whether a bank is ‗failing or likely to fail‘ has this history, in its new context it will be determined by the FSA much earlier, hence it being classed as a preinsolvency decision. Heightened Supervision and Early Intervention Financial markets are protected with a parameter of regulation to control entry, but this on its own is not sufficient to ensure that those given authorisation will continuously comply and that they will not experience considerable difficulties. Intervention in the form of supervision is very much part and parcel of undertaking the business of financial services. Supervision of banks gives rise to a set of rights and obligations to ensure that they undertake their business prudentially. It invariably leads to an opportunity to intervene in the affairs of a bank at regular points in time through inspections carried out either onsite or offsite by the regulators, or by third parties, namely appointed external auditors. 52 The FSA introduced heightened supervision as an intermediate stage between supervision and the SRR. Hector Sants, CEO at the FSA, suggested that the industry needed to ‗be frightened‘ about the new intensity of supervision the FSA was about to adopt.53 It seems this would FSMA 2000, Part 1 of Schedule 6. GENPRU 1.2.26R. 49 Heritable Bank plc, First Supervisory Notice, 7 October 2008. 50 Kaupthing Singer & Friedlander Ltd, First Supervisory Notice, 8 October 2008. See also Landsbanki hf, First Supervisory Notice, 10 October 2008. 51 SUP 7.3.4G. 52 D Singh, Banking Regulation of UK and US Financial Markets, (Aldershot: Ashgate, 2007). 53 Telegraph, ‗Hector Sants says bankers should be ―very frightened‖ by the FSA‘, 12 Mar 2009, available at 48


equally apply to the area of banks experiencing distress, with the introduction of the Banking Act 2009, as this policy shift is also acutely apparent here, and will remain so under the new Coalition regime. 54 The powers of the FSA, like those of the regulators in the USA and Canada, are wide and varied, and the powers associated with early intervention should be viewed as a sub-set of the normal powers of supervision, investigation and enforcement. As Nieto and Wall highlighted, not all regulators have the same range of powers and it is important that this issue is remedied before simply introducing the power of early intervention.55 The idea of heightened supervision 56 goes some way towards introducing the policy of structured early regulatory intervention into the UK regulatory model, without the prescription of prompt corrective action, its USA counterpart. 57 The FSA approach is in many respects an opaque, discretion-based approach to early intervention, limiting it to what it can already do, but fashioning it into a new form, as ‗heightened supervision‘. The FSA model of early intervention is to all intents and purposes simply a clarification of what it could do if a bank was about to breach the threshold conditions. In those instances it iterates that it could, inter alia, increase the number of visits, or change the type of information it needs to be reported as part of a period of heightened supervision. In this respect the new approach places a functional obligation on the FSA to some extent to act to reduce the likelihood of bank failures. 58

should-be-very-frightened-of-the-FSA.html. Under the new regime Hector Sants will be Deputy Governor of the Bank of England with responsibility over the new regulator, at least until it is set up. 54 Speech by Hector Sants, Chief Executive, FSA, ‗FSA Annual Public Meeting‘, 24 June 2010, available at 55 MJ Nieto and L Wall, ‗Preconditions for a successful implementation of supervisor‘s prompt corrective action: Is there a case for a banking standard in the EU?‘, Vol.3/4, (2006), Journal of Banking Regulation, 191, p. 209. 56 FSA, Consultation Paper: ‗Financial stability and depositor protection: FSA responsibilities‘, 08/23, December 2008. 57 This is explored in further detail below. 58 H Sants, CEO, FSA, ‗Dialogue on Financial Stability: How is bank risk to be managed‘, Associate Parliamentary Group on Business Finance & Accountancy Banking Reform, 14 October 2008.


The demise of a bank is primarily a result of mismanagement over a period of time.59 Market volatility may ultimately trigger the final curtain for the bank, but it is the sustained mismanagement of risks that prevent it from absorbing those shocks. The objective of structured early intervention is to ensure that banks are not left unchecked. Appropriate enforcement action needs to take place to keep in check the breaches of rules and the levels of risk before they escalate to a point where the bank is vulnerable to failure. This strategy emulates Shavell‘s second rationale for legal intervention, which is to take the initiative with ‗middle range‘ enforcement measures to prevent the harm from occurring. 60 In this scenario the regulators seek to prevent a disorderly bank failure by taking action before this point is reached. The question for the FSA and the other two Authorities is what is a reasonable amount of time to give the bank before the decision is made to initiate the stabilisation powers? At this juncture a bank is not insolvent, but circumstances are such that there is a likelihood of insolvency. The bank would need to convince the FSA that it can avoid insolvency. In practice it is likely that the decision to continue the business to try to work it out will not lie with the directors but with the FSA. Thus, any discretion the management have will be eliminated. There are good reasons for this curtailment. For instance, a delay could mean the bank collapses and threatens the viability of other banks, or indeed depositors‘ interests. More importantly, a delay could mean that the position of a bank deteriorates to a point where the losses are greater than if the bank was taken out of the system in its current form, before this point of no return. The FSA will act as judge over a very critical matter – a matter the courts find difficult. 61 The bank will to all accounts be primarily responsible for its financial position, and it will ultimately bear the consequences of its own demise. The FSA could also face criticism from a range of stakeholders – not just directors and shareholders, but also the government – if the institution failed for want of better supervision or early

P Jackson, ‗Deposit Protection and Bank Failures in the United Kingdom,‘ 1 (1996) Financial Stability Review 38, pp. 41–43. As noted by Jackson in her previous study, in many of these cases corporate mismanagement tends to be a significant ingredient when emergency liquidity support is sought. In her research paper, mismanagement was present in eighteen of the twenty-two banks that experienced problems over the 1990s and ‗poor strategy‘ accounted for eleven of the eighteen banks examined in that piece of research (p. 43). 60 S Shavell, ‗The Optimal Structure of Law Enforcement‘, 36 (1993), Journal of Law and Economics, pp. 257–258. 61 Re Continental Assurance Co of London plc [2001] All ER 229, the dilemma directors face is that they stand to be accused by ‗creditors to have taken the coward‘s way out and closed the business too soon‘ (para 281). 59


enough intervention. In practice some institutions are able to turn their affairs around and return some shareholder value. The test to determine whether a bank is placed in the SRR has drawn particular criticism for not being onerous enough for the regulators to discharge to give a bank sufficient time to turn matters round. The test of ‗highly unlikely‘ was suggested to replace ‗reasonably likely‘.62 Ian Pearson, Economic Secretary to the Treasury at the time, explained: ‗The purpose of the [section] is to make it absolutely clear that the authorities will not – indeed, cannot – use the stabilisation powers until it is clear that a bank is failing and that voluntary or regulatory action is no longer appropriate to resolve the situation.‘ 63 Baroness Noakes, Shadow Minister for the Treasury at the time, objected to the position, observing, ‗Nanny knows best!‘64 The implications of having the higher standard would mean the FSA would have to give the failing bank a longer period of time to work out its problems, and if unsuccessful this could mean greater losses. With the standard set as it is, the FSA needs to satisfy itself on a balance of probabilities that a bank is unable to turn its affairs around. 65 However, this cannot be taken at face value. On a formal level a balance of probabilities seems a low threshold in such serious matters, while the courts would expect a sufficient amount of evidence before such an order is made. Although the civil standard is based on a preponderance of probability, Denning LJ (as he then was) suggested that there are degrees of probability. For example, a fraud case naturally requires a higher degree of probability than if one were establishing negligence. Notwithstanding this, Denning LJ (as he then was) qualified his statement by indicating that the degree of probability would not be as high as that expected in a criminal court. 66 This principle was observed more cautiously by Denning in the case of Hornal, where his Lordship decided that when a civil case consists of an allegation of criminality, the standard should still be based on a balance of probabilities, otherwise it would bring the civil process

This was proposed by the Opposition Party in both Houses of Parliament: HC, Banking Bill, 342–434, 6 November 2008; HL, Baroness Noakes, p. 1200, 13 January 2009. 63 HC, Banking Bill, Ian Pearson, p. 344, 6 November 2008. 64 HL, Banking Bill, Baroness Noakes, p. 1203, 13 January 2009. 65 HL, Banking Bill, Lord Myners, p. 1204, 13 January 2009. 66 Bater v Bater 2 All ER, [1950] 458 at p. 460. 62


into contempt.67 According to Coleman J in Heinl, when dishonesty is alleged, the standard of proof to establish it should involve a high level of probability, albeit not as high as the criminal standard. 68 The seriousness of the decision will inevitably require an appropriate amount of evidence should the FSA decide to pull the trigger; this will not necessarily be beyond reasonable doubt, but will be close enough so that the decision to pull the trigger is made with the appropriate level of confidence. The FSA have provided guidance on assessing the conditions to determine the fate of the bank.69 In many respects the factors are unsurprising given the FSA‘s level of discretion and the range of sanctions it has at its disposal. In relation to Condition 1 a breach of the threshold condition could give cause for a range of enforcement actions to be taken which could be used ‗at any time, and so may be used before or in conjunction with the stabilisation tools provided by the Banking Act‘.70 As will be seen below with Dunfermline, before the stabilisation options the FSA and the building society tried to workout the best solution, such as a private takeover. These efforts suggest the FSA does see the stabilisation options as a last resort rather than the first resort, as some opposition members seemed to intimate during the passage of the Banking Bill. The guidance highlights matters relating to the time a bank could be reasonably given to turn its affairs around. 71 It states that the time provided will essentially depend on a non-exhaustive list of factors, such as the extent or risk of a loss and the impact of such a loss on potential consumers, the seriousness of the breach, the risk to the financial system and confidence, and the likely success of any remedial action.72 Some of the other circumstances the FSA could take into account are divided into liquidity and capital concerns. This is sensible because it is these which could trigger a failure as well as fraud. The FSA can take into account the availability of market funding, whether the Hornal v Neuberger Products Ltd [1957] 1 QB 247 at p. 254. Followed in Noble Resources SA, Noble Resources Limited v Philip Seth Gross, Noble Europe Limited [2009] EWHC 1435 (Comm). 68 Heinl and Others v Jyske Bank (Gibraltar) Ltd, The Times Law Reports 28 September [1999] 661, at p. 662; Re A Solicitor [1993] 1 QB 69 at p. 82: emphasis was given to a number of Commonwealth decisions, in particular Bhandari v Advocates Committee [1956] 1 WLR 1442 at p. 1452 at p. 81; R v Milk Marketing Board, ex parte Austin, The Times Law Reports, 21 March (1983) 202 at p. 202. 69 Cond 3: Banking Act 2009, June 2010. 70 Ibid., 3.1.4G Assessing Condition 1. 71 Ibid., 3.1.6G Timing. 72 Ibid., 3.1.6G (1) (2) (3) (4). 67


funding structure is viable and still available, whether the liquidity problem poses doubts about its capital, and the credit rating. 73 For instance, the funding structure of Northern Rock, with its over-reliance on whole funding, would be a concern for the regulator in such deliberations. In respect of capital, the FSA could take into account the availability of capital, the sources and terms of capital, the success of raising capital and the interest shown by institutional investors. Assessing the prospects of a takeover of all or part of the bank will be circumstances that the FSA will take into account. In such circumstances the FSA could take into account the status of the negotiations, the interest expressed and the credibility of potential counterparty, shareholder approval and the need thereof, and the suitability of the potential bidder. The circumstances expressed here are complex issues individually, and ultimately it will be a difficult judgement to call by the FSA. The type of action varies considerably in seriousness, and it would be useful to delineate when during the period of heightened supervision these actions might be exercised. The Stabilisation Options Once the decision is made by the FSA that a bank is not able to fulfil the threshold conditions, the next step is to decide which technique the Bank of England, in consultation with the Treasury and FSA, will adopt to deal with the failing bank. The Act refers to these as stabilisation powers: they broadly enable the Bank of England to decide the fate of the bank and its various operations depending on their financial difficulties. The Bank of England has three options it can use for deposit-taking institutions (in addition to the power simply to close the bank and place it in administration and liquidation), namely transferring to a private buyer, setting up a bridge bank to which it can be transferred, or placing the bank in temporary public ownership. 74 All three options have been utilised in the current period of crisis: the takeover by Lloyds TSB of HBOS, and in the case of Northern Rock and Bradford and Bingley, being placed in temporary public ownership, albeit in the latter case only part of it. 75 The takeover by Lloyds TSB of HBOS is not entirely a true illustration of the first option because the shareholders of Lloyds TSB and HBOS still needed to agree to it, whereas under the legislation the Bank of England would make a decision on the form Ibid., 3.1.8G (1) (a) (b) (c) (d) (e). The Act, s. 11, s. 12 & s. 13. 75 C Bates, K Gibbons, R Gray, J Machin, H Motani and T Plews, ‗Bradford and Bingley plc: Break up under the Banking (Special Provisions) Act 2008‘, (2008) 11.9, Financial Regulation International, 1. 73 74


and terms it would take. The second option, the bridge bank, is rather unfamiliar in UK regulatory quarters, notwithstanding that it is utilised in the USA and numerous other countries. It was used with the Dunfermline Building Society, a case that is explored separately in this paper. The decision to exercise these options is primarily to ensure that the key functions – ‗critical functions‘, as coined by Hupkes – such as deposit-taking business, have continuity.76 The critical function is protected by a private purchase, the setting up of a bridge bank or temporary public ownership. Once the general conditions set out in s. 7 are fulfilled, another set of specific conditions needs to be satisfied before the stabilisation options are used. The specific conditions need to be met at the same time as the general conditions are determined. The conditions articulate what the public interest means when deciding between the stabilisation options, providing a ‗higher test than a public interest test framed in wholly general terms‘. 77 The Bank of England is required to use a private sector purchaser and a bridge bank if Condition A is fulfilled: 78 this is for the stability of the UK financial systems, the maintenance of public confidence or the protection of depositors.79 However, if the failing bank has sought financial assistance from the Treasury then the public interest objective is satisfied if Condition B is fulfilled:80 namely the Treasury has recommended that the Bank of England exercise the stabilisation power and in the Bank‘s opinion the exercise of that power is the way to protect the public interest. 81 This is only a recommendation. The Bank could decide that insolvency or administration rather than a stabilisation option are a better route. The presumption here is that if financial assistance is given to a bank, the Treasury will decide which stabilisation option is needed to safeguard the public funds. It is implicit rather than expressly stated here that the role of the Treasury is to influence which stabilisation power is used in order to ensure that public funds are sufficiently protected, in E Hupkes, ‗Too Big to Save – Towards a Functional Approach to Resolving Crises in Global Financial Institutions‘, in D Evanoff and G Kaufman, Systemic Financial Crises: Resolving Large Bank Insolvencies, (Hackensack: World Scientific, 2005), p 193. 77 HC, Banking Bill, 352, Ian Pearson, 6 November 2008. 78 The Act, s. 8, Specific conditions: private sector purchaser and bridge bank and s. 9, Specific conditions: temporary public ownership. 79 The Act, s. 8(2)(a) (b) or (c). 80 The Act, s. 8(4). 81 The Act, s. 8(5)(a) & (b). 76


consultation with the Bank of England. The provision does not include consultation with the FSA, which seems a little inconsistent with Condition A, and indeed the criteria for temporary public ownership as outlined below. The Treasury is given responsibility to determine whether it is in the public interest to place the bank in temporary public ownership. 82 A separate set of conditions are attached to temporary public ownership.83 The Treasury is required take into account either Condition A or Condition B, namely whether it is necessary to ‗resolve or reduce a serious threat to the stability of the financial systems of the UK‘, or ‗the Treasury have provided financial assistance‘, in the public interest.84 The Treasury is required to discuss with the FSA and the Bank whether the two conditions are satisfied.85 The decision to decide whether temporary public ownership is necessary is based on whether the time and complexity of the threat to the UK is such that nationalisation is the most efficient option to mitigate the risk indicated in Condition A or B. This is possibly due to the implicit protection that temporary public ownership would provide in those two areas. The striking issue is the change in approach from objectives to conditions, even though the set of conditions that need to be taken into account are almost identical to the objectives. But not all the objectives of the SRR are represented, leading to the argument that some of the general objectives are of greater importance than others. For instance, stability of the financial system and protecting the financial assistance are elevated to conditions, whereas the rights of shareholders and creditors and even depositor protection are not. 86 It is suggested that these issues will implicitly be considered by the Bank of England, or indeed the Treasury, when deciding on the stabilisation option. The risk posed to banks, persons with whom banks do business and the financial markets by such a decision is certainly evident. The message to both creditors and shareholders is that they are both likely to

The Act, s .9(1). The Act, s. 9. 84 The Act, s. 9(2) & (3). 85 The Act, s. 9(4). 86 Hoban explains: ‗Whenever we debate what the Bill seeks to achieve it appears that the interests of investors and creditors rank pretty low down the list of priorities. That is reinforced by this clause, which enables the Bank to disrupt traditional property rights because it gives the Bank the power eventually to have partial transfers.‘ HC, Banking Bill, Mr Hoban, 353, 6 November 2008. 82 83


experience some loss, even depositors who have balances over and above the coverage limit, albeit that for the time being that is considered to be politically unacceptable. The Options for Dealing with a Failing Bank The first stabilisation option is a private sector purchase of the bank, either in its entirety or with a part of it being sold to another party.87 The Authorities view a private market-based solution to the problems as the option of ‗first resort‘. The private takeover is orchestrated by the Bank and executed through its power to transfer shares and property either fully or partially to the prospective buyer. 88 It is not handled by the bank itself, as it would be in a ‗normal‘ takeover such as the Lloyds TSB takeover of HBOS, which was principally a private takeover and not one orchestrated by the Bank of England, albeit that the government did set aside competition rules to allow the merger to go ahead. 89 The Bank of England will be able to decide which part of the bank it wants to sell off to execute the sale and possibly make it as attractive as possible to a prospective buyer. It is not entirely clear what incentives the Bank might negotiate with a private purchaser to effect the takeover. The bank taking over the failed bank must itself be in a sufficiently good position to be able to acquire the failed institution. This would be assessed as a supervisory issue. The second resolution technique the Act provides is the bridge bank. 90 The option of setting up a bridge bank was first introduced in the USA,91 and although it has received considerable attention of late, it is an option that is rarely used. 92 Notwithstanding this limited use, it certainly provides the authorities with another option for dealing with a ban k in distress. A bridge bank in the USA is a newly chartered bank to which all or some of the business operations of the distressed bank are transferred. The newly created bank is not a permanent solution: it is to all intents and purposes a temporary one that gives the Authorities time to

The Act, s. 11(1). The Act, s. 11(2). 89 I Kokkoris, in JR LaBrosse et al, above n 13, pp. 237–256. 90 The Act, s. 12(1). 91 DG Mayes, ‗Bridge Banks and Too Big to Fail: Systemic Risk Exemption‘, in DG Evanoff, GG Kaufman and JR LaBrosse, International Financial Instability: Global Banking and National Regulation, (Hackensack: World Scientific, 2007), p. 331. 92 JR LaBrosse, ‗International Experience and Policy Issues in the Growing use of Bridge Banks‘, in JR LaBrosse et al, above n 13, pp. 217–236. 87 88


orchestrate a buyer for the failing bank. 93 The bridge bank gives prospective purchasers time to undertake the necessary due diligence. The Act simply enables the setting up of a company, whereas in the USA a new bank is set up with a separate charter. The bridge bank is not an institution designed simply to house bad assets, but will run the business as a going concern. In some instances a new bank will be set up, despite the ambiguity of the provision. So it will need permission to operate like any other prospective financial services firm. The underlying presumption is explained by Mayes: ‗A crucial distinction between the ―bridge bank‖ concept and some of the alternatives is that the existing bank is terminated and its banking license withdrawn, and a new institution is created.‘ 94 The flexibility of the UK option means that other regulated activities which are not necessarily accepting deposits could also be transferred to a bridge bank.95 The existing shareholders and management of the failed bank would be removed and replaced in either of these options. The governance of the bridge bank throws up some dilemmas. For example, to whom do the directors owe their duty – the Bank of England or the company? As in all companies, the duty would presumably be owed to the company as a whole, and in this case it would invariably mean that the management would need to seek advice from the Bank as to the running of the institution in order to fulfil the legislative objectives and conditions attached to this measure. The company would have to factor the reasons for its existence into its objects and strategy: a temporary life to resolve the position of the business for which it has assumed responsibility. The permission granted to the new firm would have restrictions attached to it by the FSA and it would be supervised for the duration of its existence. The final resolution technique, temporary nationalisation, is deemed a ‗last resort‘ when all other options have failed, or are likely to fail, to provide the best overall solution. In this The FDIC was named Conservator for IndyMac Bank, F.S.B., Pasadena, CA in July 2008 after it was closed by its supervisor, the Office of Thrift Supervision (OTS). In its role as conservator, the FDIC transferred all insured deposit accounts, inter alia, of IndyMac Bank, F.S.B., to IndyMac Federal Bank, a newly FDICchartered institution: 94 DG Mayes, in DG Evanoff, GG Kaufman and JR LaBrosse, above n 90, at pp. 344–345. 95 The Act, s. 12(1). 93


instance the Treasury, on behalf of the state, takes on the burden as the owner. Moreover, the state will have a vested interest in such an institution, as the bank is very likely to have obtained financial assistance in order to ensure that it does not fail for want of liquidity, but has not been able to resolve its affairs. For example, Northern Rock and parts of Bradford and Bingley were nationalised under the 2008 Act. In the case of Northern Rock the depositors were given a 100 per cent guarantee. In the Bradford and Bingley case, Santander (via its subsidiary Abbey National plc) bought the savings business and branch network, and the government put the mortgage and loans business into temporary public ownership.96 In this case the continuity of the banking services was maintained by the takeover, so customers did not lose access to their bank accounts. What this highlights is that not all parts of the bank will need to be nationalised, although more of the bad than the good assets may well be brought into public ownership, which is burdensome on the state. The government‘s interests are managed by UK Financial Investments (UKFI) in Northern Rock and Bradford and Bingley, including the recapitalised RBS and Lloyds TSB and HBOS (Lloyds Banking Group).97 This creates a distance, an arm‘s length relationship, between the public interest and the private interests in the banks. The assistance provided to RBS and Lloyds Banking Group could broadly be referred to as open bank assistance, which includes support through loans or the purchase of troubled assets. It is not technically deemed a resolution technique, so it does not feature as such in the legislation. The Act does make provision for the possibility of financial assistance from the government either directly or via the Bank of England. The Act sets out how Parliament needs to be informed about the use of public funds, in s. 231. This provision requires disclosure of assistance after the fact, at specific intervals, rather than prior to the decision as suggested by the Treasury Select Committee. Prior to the Act, the Bank had covertly provided emergency liquidity support to both RBS and HBOS, indemnified by the Treasury, in late 2008. 98 The indemnity provided by HM Treasury came under particular criticism from the Treasury Committee, which considered that guidance on such matters had been Explanatory Memorandum to the Bradford and Bingley plc Transfer of Securities and Property etc. Order 2008, S I 2008/2546. 97 For further analysis of UKFI see for example, D Singh, ‗Crisis Management‘, above n 1, at pp. 147–149. 98 House of Commons, Treasury, Reporting Contingent Liabilities to Parliament, Fifth Report of Session 2009– 10, at p. 3. 96


breached by not disclosing the assistance at least orally to the chairmen of the Public Accounts Committee and Treasury Committee, ‗whatever the circumstance‘. 99 By this time the Northern Rock leak debacle must have resonated in the minds of the Authorities and was something they needed to avoid, so they did not reveal the assistance until it was satisfied that disclosure would not give rise to systemic disturbance, which was decided to be unsatisfactory.100 While there is provision for disclosure of such matters, it nevertheless falls short of what those responsible for overseeing public finances would expect.

Dunfermline Building Society: A Case Study The Dunfermline Building Society was formed in 1869 and grew to become the largest building society in Scotland, ranked 12 in Britain. 101 It is a useful case study for exploring the workings of the Banking Act 2009, as it was the first institution to be dealt with under the new regime. 102 This section of the paper seeks to explore how this decision was reached by the FSA. The difficulty of the decision is acutely apparent. It highlights the weak position that the bank or building society is in: it needs to set out a strategy to turn its affairs around and avoid being put in the hands of the SRR. It highlights how the FSA is equally exposed in this process, since questions are immediately asked about what it knew and when, before the decision was made to investigate the bank as ‗failing‘. The demise of Dunfermline arose from its commercial real estate division and losses associated with the introduction of a new business to provide back-office support to other banks and building societies.103 The FSA considered Dunfermline to be in a position where it was not able to continue in light of ‗future possible solvency under stress conditions‘. 104 This decision was made after Dunfermline underwent further stress tests on its capital levels during the turmoil in the markets in 2008. The Authorities envisaged the banks and building

Ibid., p. 8. Ibid., p. 3. 101 House of Commons, Scottish Affairs Committee, ‗Dunfermline Building Society‘, Firth Report of Session 2008–09, July 2009. 102 Ibid. 103 Ibid. The exposure to commercial property was increased with the acquisition of mortgages from GMAC and Lehman Brothers totalling £410m and £57m respectively (p. 6). 104 Ibid. 99



societies to be in need of a large capital cushion to sustain the losses they were likely to incur in light of market circumstances at the time. Once it was considered a candidate as a failing building society, Dunfermline had to assess its options. Its own position was ideally to stay independent rather than being taken over or have its fate decided by the Bank of England. The Authorities considered that this option was only viable if Dunfermline could obtain new capital in the region of £60m or more. This was not the sort of figure Dunfermline had calculated that it needed to survive; it considered itself to need approximately £30m to retain its independent status. The fresh investment would have served to ensure that Dunfermline complied with the adequate resources threshold set by the FSA. However, the moves to secure Dunfermline‘s future, such as the FSA‘s efforts to try and organise a merger with another building society, did not succeed. The Building Societies Association‘s decision to assist with an investment of £30m in the building society to match public funds of £30m did not materialise. The Authorities thought it would be virtually impossible for Dunfermline to service a loan of £60m from its profits, especially if a penalty rate of interest was to be applied – which is generally the case for emergency liquidity support.105 However, once the £60m had not materialised, the Board of Dunfermline decided that it could no longer continue as a going concern, which then led to the FSA concluding that it was likely to fail to satisfy the threshold conditions. 106 While the FSA communicated with Dunfermline, Dunfermline considered itself to be in the dark about the views of the Authorities as a whole, to the extent that it felt that this situation was ‗deliberate‘. 107 However, any Treasury involvement in the decision at that time would invariably have given rise to concerns that political motives swayed any decision, rather than the decision being based on independent regulatory assessments, given the location of the building society. The sale of parts of Dunfermline to Nationwide by the Bank took place during the weekend of 28–29 March. Nationwide purchased the retail and the wholesale deposits, the branches, the head office and the residential mortgage book. A part of the business relating to social 105 Ibid.,

p. 14; see generally RM Lastra, above n 1, pp. 113–124, for an analysis of Lender of Last Resort. Letter from the Chairman Lord Turner, to The Rt Hon Alistair Darling MP, 17 April 2009, p. 7. This letter sets out how the FSA supervised Dunfermline Building Society. 107 Ibid., p. 18. 106


housing was transferred to a bridge bank, called DBS Ltd. The parts of the business which were performing poorly were put into the bank administration procedure. The Nationwide retained the Dunfermline name and brand, in light of the value it still has in the communities in which it operates. Moreover, the takeover provided security against compulsory redundancies at Dunfermline for a minimum of three years. The FSA came under criticism over its supervision and communication with Dunfermline and the weight attached to its correspondence via supervisory visits and the sort of changes it had expected the building society to make in its business. The Scottish Affairs Committee concluded in its first report: ‗In the years running up to the transfer, the Financial Services Authority failed to provide the necessary level of supervision over the Dunfermline Building Society and to issue clear and specific warnings.‘ 108 An overestimation on the part of the FSA and underestimation on the part of banks and building societies regarding the weight that should be attached to the various communications between the parties is certainly evident. An expectations gap exists on both sides. This is particularly the case with communication which is indirect, such as speeches and CEO letters. It certainly highlights the fact that the FSA needs to set out more explicitly the seriousness of the communication it puts out and the need for financial firms to take it on board, as would be the case with a direction from a specific visit or meeting. Notwithstanding these criticisms, the primary concern highlighted by the Scottish Affairs Committee was the need for a bank in such a position to be aware of what it should expect: ‗the Authorities must consider whether it is necessary to hold the banking institution at arm‘s length, or whether a more beneficial outcome might be achieved if all parties are fully aware of the standards expected to be met‘. 109 This need for standards is explored in the next section in light of international experience. Structuring Early Intervention: Some Lessons from the USA and Canada The argument for formal structured intervention is that it avoids the risk of the authorities hesitating when circumstances arise in which a decision about a bank in trouble needs to be made. As Kane explained, regulators tend to have conflicting interests to satisfy, namely those of the government and the taxpayer, as well as the industry on a day-to-day basis. In 108 109

Dunfermline Building Society, above n 100, at p. 26. Ibid., p. 26.


light of these conflicting interests, an incentive arises to forbear from taking regulatory decisions.110 The consequence is that the institution‘s financial position deteriorates further, and this paradoxically increases the burden on the taxpayer.


Hupkes echoes this,

highlighting that ‗experience in various countries has shown that regulators tend to intervene too late rather than too early‘. 112 Moreover, even when they do intervene early, as with Dunfermline, regulators are still exposed to accusations that they did not warn the banks of their impending disaster. Can regulators ever get it right?! This part of the paper suggests that the FSA might like to consider structuring and providing guidance on its heightened supervision regime, in light of the Scottish Affairs Committee report and its criticism. It is proposed that the UK could learn lessons from the Canadian or US models of early intervention. In a broader context the debate between the two in some respects centres on whether the model adopted is like a rules-based or discretion-based model. But this division may be rather too simplistic, as is demonstrated below.

The Canadian Model In Canada responsibility for bank regulation is divided between the Office of the Superintendent of Financial Institutions (OSFI) and Canada Deposit Insurance Corporation (CDIC) and the Department of Finance. The multiple-authority model has not always worked well, and the need to be better co-ordinated to ensure better consultation and exchange of information has arisen. 113 One area in which it has needed to work is early intervention in the affairs of a bank experiencing problems. The banking system is partly regulated by the ‗objectives‘ of the ‗Guide to Intervention‘.114 Its main objective is to coordinate intervention in a bank as soon as concerns about it arise, to minimise exposure to the deposit insurance system. It is an administrative order managed by OSFI. The rationale for the guide is to ‗promote awareness and enhance transparency of the framework for intervening with federally regulated deposit-taking institutions‘.115 Its aim is to ‗communicate EJ Kane, ‗Changing Incentives Facing Financial-Services Regulators‘, (1989) 2, Journal of Financial Services Research, p. 265. 111 Ibid. 112 Hupkes, above n 74, p. 193. 113 Report of the Auditor General of Canada – October 2000, p. 16–10, para 16.23. Follow up Recommendations of Previous Reports. 114 Government of Canada, Guide to Intervention for Federally Regulated Deposit-Taking Institutions, (2008) p. 2. 115 Ibid. 110


at which stage an action/intervention would typically occur‘. 116 The Canadian system is set out in stages that focus not only on capital but also on management risk and controls. There are pre-stage and staged positions. In the pre-stage position the institution is deemed ‗resilient to most normal adverse business and economic conditions‘. 117 Once an institution is ‗staged‘, there are four levels. Stage 1 is entitled ‗Early warning‘; it identifies the risks and deficiencies that need to be rectified. The level of supervision is increased and the management of the bank are directed to rectify the deficiencies. The levels of monitoring and reporting by the regulator and bank are both increased. It goes without saying that supervision and investigation do intensify in the latter stages. Stage 2 is entitled ‗Risk to financial viability or insolvency‘, and refers to a situation in which ‗the institution poses material safety and soundness concerns and is vulnerable to adverse business and economic conditions‘.118 While these kinds of problem are not deemed an immediate threat to financial viability or solvency, they could deteriorate into such concerns. Stage 3 is entitled ‗Future financial viability in serious doubt‘. The threat to the bank has materialised and places it in a position where it is unlikely to survive unless the measures suggested at Stage 2 are implemented to remedy the situation. In this stage the CDIC will put in place plans to minimise the bank‘s exposure to any potential failure. Stage 4 is entitled ‗Nonviability/insolvency imminent‘: the position of the bank has deteriorated to the point that it has failed to meet regulatory capital requirements and has not put in place an acceptable business plan to turn its fortunes around. In this stage the regulatory authority takes temporary control of the assets, and efforts are made to apply for a winding-up order. The Canadian approach is set out in stages, but this does not necessarily mean the individual decisions are taken in stages. In practice a bank could go from Stage 0 to Stage 4 in one decision if its position is seen as being impossible to turn around, and therefore the bank would effectively be closed by the authorities. For example, this would be likely if a serious liquidity shortage occurred at the bank, putting it in a position where it could not meet its liabilities when they fall due. The idea of stages is deemed fluid enough to allow the

Ibid. Ibid. 118 Ibid., p. 7. 116 117


authorities to manoeuvre to gauge the extent of the problems at the bank, whether related to poor management controls or its capital and liquidity positions, but also to provide an individualised approach to dealing with the problems and ultimately reduce any ‗public costs‘ that a potential failure could cause. A more important feature to emphasise in the ‗Guide to Intervention‘ is the need to set out what the individual authorities would do and when in each stage in any given circumstances – a feature that is acutely apparent for the UK Authorities. This would aid banks and the Authorities to understand and predict what to expect from each other at each stage.

The US Model The Federal Deposit Insurance Corporation Improvement Act 1991 (FDICIA) provides the regulators with the power to insist on ‗prompt corrective action‘ (PCA) to make banks remedy insufficient levels of capital. 119 As Carnell, explains: ‗[a]n institution falling below minimum capital standards faces progressively more stringent regulatory restrictions and requirements. The goal is to correct problems before they metastasize.‘ 120 The US bank regulators are required to use it to ‗resolve the problems of insured depository institutions at the least possible long-term cost to the deposit insurance fund.‘121 In the USA the structuring of regulatory discretion through prompt corrective action was an attempt to limit regulatory forbearance. Nevertheless, the regulator still retains a significant level of discretion to decide capital levels and the action that is judged necessary to mitigate the risk that a bank poses. 122 There is a combination of both quantitative 123 and qualitative measures that the regulator can expect banks to take in order to remedy the problems before the point of insolvency is

HE Jackson and E Symons, Regulation of Financial Institutions, (St Paul, West Group, 1999). RS Carnell, ‗A Partial Antidote to Perverse Incentives: The FDIC Improvement Act of 1991‘, (1993), 12 Annual Review of Banking Law, 317, p. 327. 121 Comptroller of the Currency, Banking Issuance, Prompt Corrective Action, BC 268, Feb, 25 1993, p. 1. 122 RS Carnell, above n 114, p. 349. 123 USC Title 12: Chapter 16—Federal Deposit Insurance Corporation § 1831o. Prompt corrective action: (1) Purpose The purpose of this section is to resolve the problems of insured depository institutions at the least possible long-term loss to the Deposit Insurance Fund. (2) Prompt corrective action required Each appropriate Federal banking agency and the Corporation (acting in the Corporation‘s capacity as the insurer of depository institutions under this chapter) shall carry out the purpose of this section by taking prompt corrective action to resolve the problems of insured depository institutions. 119 120


reached.124 But it is the quantitative measures in the USA that determine the ways in which the regulator would intervene and the action the bank will need to take. The individual regulator can request a number of actions on the part of the bank as the bank‘s capital position deteriorates. If a bank is considered critically undercapitalised, it would for instance need to put in place a plan to explain how it intends to recapitalise, by selling shares, through a merger or by selling part of its assets. Alternatively, the bank could be requested to provide a capital restoration plan which would specifically require it to identify how it plans to restore its Tier 1 capital levels through, inter alia, new forms of capital. 125 The regulator could also impose restrictions on the types of activities the bank can undertake. 126 For example, the bank‘s directors may be required to agree with the regulator any payment of bonuses, commissions, severance or similar remuneration plans. 127 This control on bank bonuses is certainly a power the UK authorities could have done with given the political backlash this caused. The US regulator may require the bank to implement changes within a set period of time. In some instances this could be 30 days to put together a capital restoration plan. Moreover, the US regulators could categorise a bank as undercapitalised if it fails to comply with the broad powers associated with its general safety and soundness, which is equivalent to failing to comply with general prudential supervision requirements. The US model does take a remedial conciliatory approach to bank problems , so engages in an exercise of dialogue on how the bank should resolve its problems rather than simply punishing breaches of rules. 128 The ‗prompt corrective action directives‘ are explicit and prescriptive to remedy the problems at a bank before a bank faces the possibility of failing and imposing costs to the deposit insurance fund. Indeed it is the prescriptive nature of what the regulators can make a bank do that gives the impression that PCA restricts regulatory forbearance by limiting regulatory discretion, which is not necessarily the case. Some Comparative Observations and Lessons

§ 1831o(2) § 1831o(f)(2)(A) 126 § 1831o(f)(2)(B)(C)(D)(E)(F)(G)(H)(I) 127 § 1831o(4). 128 D Singh, Banking Regulation of UK and US Financial Markets, (Aldershot: Ashgate, 2007), pp. 143–150. 124 125


The UK approach is opaque: it is not clear how the FSA‘s decision-making process escalates in intensity. The Canadian approach is set out in stages, but this does not necessarily mean the individual decisions are taken in stages. In practice a bank could go from Stage 0 to 4 in one decision if it is impossible to turn its affairs around. The bank will face the position that it is effectively closed by the authorities. The idea of stages is deemed ambiguous enough to allow the authorities to manoeuvre to gauge the extent of the problems at the bank, whether these are related to poor management controls or its capital and liquidity positions, but also to provide an individualised approach to dealing with its problems and ultimately reduce any ‗public costs‘ to which a potential failure could give rise. The Canadian model, in contrast to the US model, does not confer a significant amount of discretion to the regulator and the banks to be creative with their compliance with capital requirements.129 The UK approach does set out what the individual responsibilities of the Authorities are, but does not set out, as the Canadian model does, how they will work together explicitly in coming up with the solution during the period of determining whether a bank is a failing institution. The decision-making process for the individual options does differ. The Bank of England, in the first instance with the FSA, decides whether the first two options are viable, namely private sector purchase or a bridge bank. If the option chosen is temporary nationalisation, the Treasury is formally involved. Moreover, if financial assistance is sought or is requested then the Treasury will also be involved in the first instance because the option will need to safeguard the public funds. Therefore, it is important for there to be some form of guidance on the individual involvement in the decision-making process as the scrutiny to restructure the business of the bank intensifies. This would aid the bank and the Authorities to understand and predict what to expect from each other in light of the ‗stage‘ reached. The decision to dismantle the FSA and to separate prudential supervision and consumer and market protection will mean that even more parties will need to be involved in the decision-making process, therefore making the process much more complicated. The US approach is more prescriptive than the UK approach, but both these models set out quite explicitly what the respective regulator could do in the circumstances; this is not the case with the Canadian model. Like most models of banking supervision, enforcement and 129

Nieto and Wall above n 54, p. 209.


early intervention, the powers tend to be in a variety of places. The less prescriptive UK model of providing a reasonable level of time is more sensible and may mean that the bank is given 32 days to resolve the matter. Moreover, if the bank is experiencing a liquidity problem it may mean that a shorter period of time is given to the bank to deal with the issues. For instance, the FSA gave the Icelandic bank Kaupthing several days to resolve its liquidity problems before it exercised its powers of administration. 130 Moreover, a key exception to the general PCA powers in the US model is the systemic risk exception where a bank closure could threaten the stability of the financial system. 131 While in the USA this is explicit, in the UK and Canada it would be a judgement exercised by the authorities. During a systemic crisis the appropriate option may well be not to exercise powers attached to early intervention, but to use an alternative mechanism such as recapitalisation to save the bank from its own folly, at least for the duration of the crisis, and deal with the mismanagement after the crisis has subsided. In this respect the discretion conferred on the UK Authorities provides them with the flexibility to avoid moving the bank simply into insolvency and liquidation. The issue of capitalisation and recapitalisation during a time when the bank is experiencing problems is a complex issue. It may not be conducive to have a rules-based approach because of the rigidity, and indeed the false expectations of soundness, that this creates. The Canadian position is that the banks are expected to hold capital over and above the international requirements. 132 In other circumstances, the US model is more explicit on the matters surrounding capital and recapitalisation. In the US a critically undercapitalised bank is ‗simply‘ required to improve its capital level so that it is adequately capitalised, rather than to improve it such that it is well capitalised.133 In contrast to this, the UK Authorities seem have adopted a tougher stance. For instance, RBS was recapitalised such that it is now ‗one of the highest of any big bank‘, with core capital at 11 per cent, having started off with a

The Queen (on the application of Kaupthing Bank hf) vs. H M Treasury [2009] EWHC 2542, para 16–28. RS Carnell, above n 114, p. 367, referring to § 1823(c)(4)(G)(i)(I). In the recent crisis it was exercised to deal with Wachovia Bank: ‗Citigroup Inc. to Acquire Banking Operations of Wachovia – FDIC, Federal Reserve and Treasury Agree to Provide Open Bank Assistance to Protect Depositors‘, available at 132 T Price, ‗Developments in Bank Supervision – a Canadian Perspective‘, available at, at p. 2. 133 I would like to thank Richard Osterman, General Counsel, at FDIC for confirming this observation. 130 131


‗paltry 4 per cent‘ before the crisis, as The Economist notes.134 This raises other implications beyond this paper, such as the government extending itself beyond what was necessary to recapitalise the banks adequately. It might be that the Authorities wanted to ensure the bank was well capitalised ‗beyond reasonable doubt‘ and thus unlikely to fail in the future, so that clear daylight existed between the past and the future: effectively, making it bomb proof! Again, like some of the other decisions mentioned, this comes across as being based more on political than regulatory necessity. But this poses policy implications, as it places a rather onerous task on banks that are potentially failing to recapitalise themselves beyond what might be necessary, as well as on the state finances. The three models provide varying forms of transparency surrounding the decision-making process on closing a bank if it is failing. The UK model is the most opaque and provides the most discretion in comparison to the model in Canada and the USA. On another note, the rules-based approach in the USA is possibly appropriate and more efficient given the large number of bank failures and closures it has recently experienced where a more procedural approach is necessary. 135 The number is huge, but the counter argument may well be that the UK Authorities have not let insolvent banks fail, as the markets would expect. However, once we get over the first hurdle of recognising that there is some assistance to understand the process, the actual decisions at the various points are still extremely difficult because individually they still require an exercise of judgement on the part of the regulator. In these circumstances a considerable level of dialogue between the regulator and the bank is required during the process. Indeed, it is ultimately the experience and judgement of the regulator making the right choices which will determine the success of the outcome. Moreover, this leads back to the importance of better supervision. The policy of early intervention cannot on its own be deemed a panacea for bank failures, as regulators are still prone to act too late. Indeed, supervision per se can be poor, as

The Economist, ‗Reviving Royal Bank of Scotland: Scots on the rocks‘, 27 February 2010, p. 76. From a regulatory perspective this might have been adequate, but not during a crisis as is considered in this paper. 135 See FDIC Failed Bank List, available at Currently it is up to 255 bank failures between 2007 and 2010. 134


acknowledge by the FSA in respect of Northern Rock. 136 According to a recent study by Garcia on prompt corrective action in the USA, despite structured early intervention being in place since 1991, USA regulators still opt to forbear even when legislation provides them with a range of options to deal with the problems at a bank in advance to prevent the subsequent closure. 137 Peek and Rosengren have suggested that the success of PCA is oversold and that more frequent bank examinations are the more appropriate reasons for the small number of closures before the current crisis.138 Moreover, the weaknesses identified relate not to whether early intervention follows a rules- or discretion-based model, but to the fact that the timing of the intervention can still be too late, leaving the regulator open to criticism and subsequently increasing the costs associated with a bank failure. Conclusion This paper has analysed some key features of the Banking Act 2009, specifically those relating to the pre-insolvency area. It has specifically analysed the powers of the FSA to intervene in a failing bank, the stabilisation powers the Bank of England is able to use to deal with a failing bank, and the policy issues associated with these two areas. It has highlighted, using the case of the Dunfermline Building Society, the need for some degree of transparency and structure around the FSA‘s powers. The parameters surrounding the issues of early intervention need to be identified, so that the regulator and the regulated can understand what to do and what to expect, if circumstances arise. Indeed the bank will need to have an appreciation of what steps it will need to take in order to remedy the situation. So while the actions might not be dissimilar to the actions taken if a bank is closed, it is the fact that the decision is being taken before that critical point has been reached and the confidence the regulator has that the bank can turn its affairs around. The time period for such decisions is relative, but the circumstances surrounding the decisions and outcomes expected could be structured. FSA, ‗The Supervision of Northern Rock: Lessons Learned‘, Executive Summary, 9, available at, p. 2 (26 March 2007). 137 G Garcia, ‗Failing prompt corrective action‘, (2010), 11(3) Journal of Banking Regulation, pp. 171–190. 138 J Peek and ES Rosengren, ‗Will Legislated Early Intervention Prevent the Next Banking Crisis?‘, (1997) 64, Southern Economic Journal, 268, p. 270. See also A Campbell, JR LaBrosse, D Mayes and D Singh, ‗A new standard for deposit insurance and government guarantees after the crisis‘, (2009) 17(3) JFRC, 210, pp. 217– 218. 136


An early intervention model needs to place a considerable amount of emphasis on market conditions, and based on these should try and predict the types of institutions that may experience problems. It should not simply be centred on capital levels; it needs to be broader than that, including areas around mismanagement, for instance, that will be a likely cause of poor capital or even liquidity levels. Moreover, conclusions should also be drawn from lapses in compliance which could lead to a view that the institution is managing its risks poorly. If such issues seem endemic then it is reasonable to deduce that further attention needs to be given to the bank – similar to a watchlist. This will also mean the regulator will need to have a better understanding of the business strategy that the bank has adopted and the implications of that strategy to its viability. It is now generally considered to be the case that regulators have given little attention to these matters, which in many respects signal the risk appetite of the bank. For instance, it is generally considered to be the case that RBS‘s acquisition of ABN AMRO was the cause of its need to have extraordinary government support. 139 Some kind of impact assessment of key decisions would be a useful starting point to determine the implications of a decision going sour. It seems that the timing of a decision to prevent a failing bank from collapsing for want of intervention will be judged ‗effective‘ if the supervision that precedes it has done its job properly. Despite the best efforts of the regulator, a bank by its own mismanagement has failed. A transparent set of guidelines is useful and necessary; what form they take, be they in the form of a discretion- or a rules-based model, is something the authorities will need to consider. A clear danger with adopting an early intervention model is still the timing issue, so whether a rules- or a discretion-based approach is taken, its success will depend on its use and the timing, and not necessarily what shape it takes.


See ‘Reviving Royal Bank of Scotland’, above n 131, at p. 75. 32