1. 4/23/2015
BANKING CRISES AND INSTRUMENTS TO DEAL WITH THEM
Bank Intervention and the Resolution of Weak Banks
Albino John Ajack
albinoajack@gmail.com

2. 1
Banking Crises and Instruments to Deal with Them: Bank Intervention and the
Resolution of Weak Banks
1. Introduction
This paper is going to discuss banking crises, which lead to a reduction of the banks’ capital
below regulatory minimum capital requirements, and how countries can deal with them
through the common options, using practical instruments for dealing with weak banks. We will
explain also how these common options differ in terms of allocations of losses to the banks’
original owners, depositors, other creditors of the bank, and the government.
The paper is going to discuss the practice of dealing with different types of options and
allocations. A detailed explanation will be given about why governments might recapitalize a
commercial bank, when the macroeconomic situation does not allow weak commercial banks
to raise new private capital.
Therefore, we will go through major effects that arise when countries can restructure the
financial institutions in resolving the bankrupt banks after a major banking crises and some
post-crisis stabilization of the banking system. The resolution of weak banks can be led by the
banking system representatives, regulatory agencies, monetary authorities, and the government
depending on the laws plus regulations in the country, and the timing of government
intervention.
This paper is organized as follows. Section 2 discusses the pros and cons of losses in loans
crisis and other assets crises, then balance sheet analysis. Section 3 discusses the main options
for dealing with weak banks. Section 4 discusses how the options for dealing with weak banks
differ in terms of allocation of losses to the banks’ original owners, depositors, other creditors
of the bank, and the government/taxpayers Section 5 discusses the economic and political
issues in each option/allocation. Section 6 answer the question of what is negative capital
means. Section 7 discusses recapitalization when banks cannot raise new capital. Section 8
presents the conclusion.

3. 2
2. Pros and Cons of Losses in Loans Crisis and Other Assets Crises - Balance Sheet
Analysis
One interesting aspect regarding the main difference between the bankruptcy of a
commercial bank and the bankruptcy of other businesses is that when one bank collapses, is
bad news for the other banks, but a firm collapses that is good news for other firms because
they can get more profits due to the reduction in the competition in the market since it will be
less firms competing in the market. For banks bankruptcy of one bank is bad news because,
depositors will take their money out of the banking system thinking that this phenomena will
expand to other banks. The same occurs for financial crisis in one country in one region will
make investors skeptical of investing in that country and also other neighboring countries
especially those who have more financial linkages and transactions with that country, as was
the case of, the Thailand and Asian crises.
Systemic crisis makes creditors and depositors run from the solvent and insolvent banks.
Creditors are no longer getting loans from banks, and depositors withdraw their money out of
the banking system of the country. Then they can keep it in cash or in banks abroad
especially banks in other countries that don’t have crisis.
This action will lead to a reduction in credit flows, and a devastation of the country’s
financial assets. Loss of creditor confidence can lead to significant banking system
weaknesses, and at the same time, foreign investors may stop their investments in a country
with such a banking crisis.
Fiscal cost can accrue in the banking crisis, when the authorities responded via paying the
depositors in the case of closing banks, cash support, issuance of government bond, payments
of guarantees on deposits, costs of recapitalization, and the purchase of nonperforming loans
for the weak banks.
However, fiscal cost is not the only cost of the crisis, since other costs are triggered through
macroeconomic instability, which in turn lead to reduction of economic growth for the
private sector in terms of equity value reduction.

4. 3
This crisis eventually benefits the banking system by letting the market evaluate the solvency
of the commercial banks, and encouraging monetary authorities to keep more efforts in
developing regulations, especially regulations that help both recovery from the crisis and
facing the crisis. Banking crises make some firms and banks to fire bad managers and replace
them with good managers, which will lead banks and firms to be more profitable in the
future.1
3. Main Options for Dealing with Weak Banks
(a) Regulatory Forbearance
When a bank is in crisis and its capital falls below the regulatory minimum, then regulators,
may adopt an attitude of regulatory forbearance: regulatory forbearance means that
regulators intentionally don’t use their regulatory rights to close the bank which is insolvent,
by letting those banks continue business without closing them. While doing these regulators
would adopt irregular regulatory accounting principles that in effect of lowered capital
requirements. They could allow saving and loans banks to include in their capital
calculations a high value of intangible capital, called a good well.2
Regulatory forbearance is a popular and easy political decision by governments, but it is not
a great way to deal with banking crises. To get the idea right we can have a look at a simple
balance sheet for a bank in crisis:
Simple Balance Sheet for Bank in Crisis
Assets In Millions of $ Liabilities In Millions of $
Good loans 70 Deposits 94
Bad loans 30 Capital 6
Total 100 100
1
Panagiotis Liargovas and Spyridon Repousist, IS A "BAD BANK" Solution for a Possible Future Greek Banking
Crisis (2012)
2
Et al Panagiotis Liargovas (2012)

5. 4
The above balance sheet can represent the commercial bank balance sheet for a weak bank,
and we can call it weak bank balance sheet because the capital is less than the bad loans, the
banking practice says that bad loans eat the capital of the bank, and a capital of $6 Million is
not able to cover the bad loans which are $30 Million. Therefore, the bank should increase its
capital, to meet the regulatory capital requirements. The basic reason is that the only
incentive for the bank owners to not gamble is their small capital; if they have no capital,
then they have no incentive to avoid gambling because when they have zero capital that
means they have nothing to lose.
There are three reasons why regulatory authorities are forced to use regulatory forbearance.
First, bureaucrats may not want to show that their institutions are in trouble especially when
the banks in crisis are owned by the government. Second, sometimes to serve a certain issue
in the society like agricultural or savings and loans industry in the country, the governments
will not be willing to close the bank. Third, regulatory authorities may have insufficient
funds in their insurance fund to close insolvent banks and pay the insured deposits.3
The risk of regulatory forbearance in a simple commercial bank balance sheet is shown
below:
Simple Balance Sheet for Bank in Crisis
Assets In Millions of $ Liabilities In Millions of $
Good loans 60 Deposits 95
Bad loans 20 Capital (15)
Total 80 80
In this balance sheet we have a negative capital, and if a bank is in this position, and the
monetary authorities, provide them with regulatory forbearance, the authorities are
essentially telling the bank to go and make money to recover its losses, and they will be
willing to take high risk for gaining money.
3
ESMT website, An Old Bank in a New Country (Reference no. ESMT-212-0131-1, September 6, 2012)

6. 5
Regulatory forbearance adoption will increases moral hazard, because an operating bank with
capital below minimum capital regulatory requirement, or a bank with zero or negative
capital has nothing to lose by taking such a high risk, so when the regulatory authorities use
forbearance it is like saying to the bank go and gamble in Las Vegas.4 If the bank is lucky
then the gains from their risky investment will get them out from insolvency. This strategy is
like the “long bomb” strategy in football. When a team is hopelessly behind and time is
running out the team may go for a risky play by playing a long passes to try to score. Of
course, the long bomb is unlikely to be successful, but there is always a small chance that it
will work, and if it does not work the team will lose nothing.
For the government there is the option of liquidity support, when the government gives cash
to the commercial bank to continue business, especially if the bank have a severe liquidity
problem. But still it might be wise to exert some management to protect the liquidity support
there is still no incentive to avoid gambling. And, the bank may use the liquidity support to
pay off favored depositors or make loans to favored borrowers.5
Finally, regulatory forbearance will make zombie banks attract deposits from the healthy
banks by offering higher interest rate. For example, there were many zombie banks in Texas
because they were willing to pay higher than the market rate in deposits, and take below
market interest rate which in turn creates an excessive competition for good banks.6
(b) Raising New Capital
One of the tasks of regulatory agencies after a crisis is to identify the size and distribution of
bank losses, and to classify the banks in to three categories on uniform valuation criteria:
1. Viable and meeting regulatory requirements.
2. Nonviable and insolvent.
3. Viable but undercapitalized.
4
J. Caprio, Finance and Development class ( April 13, 2015)
5
J. Hanson, International Financial Institutions Course, Williams College CDE (April 23, 2015)
6
Liargovas et at (2012)

7. 6
For the undercapitalized banks additional assessment will be needed to address the ability of
shareholders to raise new capital within an acceptable period which is three months in the
practice of different countries.7
Moreover, raising new capital will require a viable but insolvent bank, and the government will
ask them to raise capital through a private fund by existing or new shareholders. If the banks’
shareholders don’t have funds, then the government can help by giving them enough funds, and
this requires the government to make the bank management or make the shareholders legally
responsible for the loan. The government in most cases provides capital in terms of securities
because it is profitable, with zero risk domestically, and the bank can sell them at any time and
convert them to cash needed if there is an active government debt market in the country.
However, in few cases, the government can provide cash to the weak commercial banks,
especially if they have severe liquidity problems. However, when the government gives capital
to commercial banks it will also, at a minimum, require them to publish more financial reports,
which enabling regulators to watch the banks closely.
Furthermore, regulatory authorities can work with commercial banks to improve their balance
sheets. There are three ways to improve a banks’ balance sheet: inject new capital, shrink
liabilities, and rehabilitate assets to reverse the losses.8
(c) Closure and Paying off the Depositors
In the case of banking crisis insolvent banks can be closed at early stages of the crises to
stabilize the market. If the credit blanket guarantee is in the country then early closer would not
affect the confidence of the public, and also the closure will have a small effect if the public
knows that only insolvent banks are closed. Additionally, the authorities may take
administrative measures to avoid losing monetary control.
We can look at the system of banking closure in the USA as one of the best systems in the world
for dealing with banking crises. The Federal Deposit Insurance Corporation (FDIC) was created
in 1933, and it is core concern was the financial impact of the bank failure on a bank’s
7
Et al J. Hanson (April 23, 2015)
8
William Alexander et al, Systemic Bank Restructuring and Macroeconomic Policy IMF paper (1997)

8. 7
depositors. In that time the federal deposit insurance, depositors typically would recover 60
percent of their money from failed banks. And this is payment up to a maximum, so smaller
depositors are fully paid, but large depositors will suffer losses.
Furthermore, the FDIC merge the weak banks into a sound bank and provide the new bank with
some funds to make up for the difference between transferred deposits and the transferred sound
loans; this process saves the FDIC money. Note that the FDIC mostly deals with small banks
(some 6000 in the US for various reasons); the situation is more complex for the larger banks
and the Federal Reserve Bank FED may get involved. Consequently, depositors’ confidence on
the banking system would weaken, and depositor runs became more frequent, which in turn
triggered more banks to close at that time.
Federal deposit insurance was designed to provide better protection to depositors, thereby
enhancing depositors’ confidence in the banking system, which would end up with financial
stability.9 The FDIC’s insurance limit is the maximum insurance coverage available under
applicable insurance regulations. FDIC set the original limit at $2,500 in 1933, and then in 1980
they raised the maximum insurance coverage to $100,000 for all types of accounts. The most
recent increase was during the crisis the minimum coverage become $250,000.10
In the process of closing a failed bank in brief, the institution that is responsible for the closing,
or the FDIC in the USA, determines how many employees are needed for the closing. The FDIC
appoints a closing manager to supervise the process and to plan, manage, and coordinate all the
activities that are related to the closing of the bank. The primary facts needed for determining the
size of closing team are: (1) the asset and deposit size of the institution, (2) number of banks’
branches, and (3) type of resolution.
9
Federal Deposit Insurance Corporation (FDIC), Website.
10
Et al (FDIC), Website.

9. 8
Before the actual date of closing a bank, the closing team learns as much as they can about the
failing bank. Moreover, the closing team has primary sub team as follows: Asset team, deposit
team, accounting team, settlement team, information support team.11
Closing a bank in the case of crisis is a good policy to eliminate vulnerability from the banking
system, and to secure the banking system against zombie banks. Closing a bank requires an
urgent decision by the institution that is responsible for the bank resolution on how to manage
the assets and liabilities of the closed bank. Also that the weak bank is usually closed but the
assets plus covered deposits are transferred to another bank, this is not so easy to do in
developing countries because of the much fewer number of banks in developing countries. In the
US, about 300 banks were closed in 2009-2010 by FDIC.12
Supervision of closures of banks and
other financial institutions were part of the initial measures for stabilizing the banking systems in
Indonesia, Korea, and Thailand.13
Meanwhile, experience suggests that intervention and the closure of weak banks need to be
properly managed, as well as the uncertainty among depositors. Otherwise bank closure can
trigger uncertainty among depositors, like in the case of Indonesia in the late 1997 when the
closing of 16 banks triggered a bank run, and in some other references was mentioned that less
than 16 banks were closed.14
(d) Government Intervention
When the government intervenes in a problematic bank, the task can be given to an agency
which is responsible for bank resolutions. If the decision is to keep the bank open then the
choices are to recapitalize the bank with public fund; to offer it for immediate sale as is,
possibly with government guarantees on certain asset values; or to merge it with another
sound public bank.
11
Et al FDIC, Website.
12
Et al J. Hanson (April 23, 2015)
13
David S. Hoelsher et al, Managing Systemic Banking Crises, IMF paper (2003)
14
Hoelsher et al, IMF paper (2003)

10. 9
Once a decision is made to recapitalize the bank an increase in the paid-in capital (Tier I
capital) is preferred, because it both provides income and improves capital ratios. The
government will not be interested in taking stake in the bank, but it can be interested in first
injecting Tier II capital and holding some shares in the bank. Therefore when the bank fails
the government can take ownership of the bank, therefore legal arrangements are needed
for doing all the process of government intervention.
Moreover, raising new capital by another big foreign bank, will be good also as the case of
Equity bank as one of the foreign banks, that was planning in 2011 to rise a new capital to
Nile commercial bank in South Sudan, but it does not do that because it was fearing that
the government can use some political powers and reduce their ability in making high
profits.15
There are many ways of government intervention. One way is supporting the borrowers by
write-off loans, in this case, the government pays back bad loans or non-performing loans.
This system is one of the financial weaknesses of the communist financial system in Russia
when most of the banks are government banks and in the case of default the bad loans will
be paid by the government using the government funds, which encourages many banks to
take more risks and became not serious in making a proper risk assessments before
providing loans to their customers, since the government is always there to pay back for
their bad loans if they face some crises.16
In practice writing off loans does not mean that banks will forget the loans sometimes these
loans used to be sold to other companies to be responsible for collecting bad loans.
Furthermore, most commercial banks prefer to take bad loans out of their balance sheet. If
the bank leaves those bad loans in the balance sheet, there will be a lot of non-performing
loans and then the bank will be charging the other borrowers higher interest rate to cover its
losses in the balance sheet. Also, when people knows that a bank has a lot of bad loans they
will take their money from that bank and deposit it with another good bank.
15
Bank of South Sudan, banking supervision department reports.
16
Et al J. Caprio ( April 13, 2015)

11. 10
Another intervention by the government is the Asset Management Corporation (AMC),
which is a body formed by the government whose goal is to provide assistance to banks
when they have serious financial problems. The AMC used to buy bad debt from banks,
especially ones that have more bad debts than capital, in order to help them recover from
their problems. If a bank has non-performing loans valued at $30, the AMC can buy them
$15, in the form of government bonds in most cases. They give them less than the $30, to
make the banks still likely need capital and make sure that they put all what they get in
capital, and don’t make new bad loans.17
Furthermore, governments can take over the bank by injecting capital into the bank, as we
mentioned in the previous paragraph, whether by recapitalizing the bank and offering it for
sale, or merging it with another sound public fund.
4. How do the options for dealing with weak banks differ in terms of the allocation of
losses to the banks’ original owners, depositors, other creditors of the bank, and the
government/ taxpayers?
Regulatory forbearance:
In the option of regulatory forbearance, the banks’ original owners will not have losses for a
short period of time, because they will not loss their depositors and they will have a chance to
continue their business. While depositors will be in a risky environment because their money
is not safe, they will have some gains through the high interest rate offered by these zombie
banks. On the other hand borrowers will suffer losses because the interest rate is higher now.
The government will save money since it uses forbearance when it has no money to pay
depositors. Other creditors of the bank will have no change because they can get an extended
time to pay back their loans. However, the situation will worsen very soon if these weak
banks don’t manage to get money and then all parts will loss.
Closure and paying-off the depositors:
Meanwhile, in the closure option, losses shared by the bank’ original owners, depositors,
other creditors, and the government/ taxpayers.
17
Et al Caprio ( April 13, 2015)

12. 11
Banks’ raising a new capital
If capital has been raised by the shareholders private fund, then losses will be allocated to the
banks’ original owners, but the depositors, other creditors of the bank, and the government
will not have any losses.
Government intervention:
In this case the government is responsible for the bank, and must use different resolution or
liquidation options to keep the remaining assets. However, the government will decide
whether to offer the bank in an immediate sale, or to merge it with sound public bank.
Therefore, in both cases the losses will be shared between the government and the old owners
of the bank.
5. The economic and political issues in each option/allocation?
Regarding regulatory forbearance as we discussed earlier in section 2, it is one of the more
popular political options, but it will put the economy at risk of ending up with a high interest
rate and inflation like what happen in the USA in the late 1970s.
The second option is bank raising a new capital. This option is a good economical option
because it helps keep the banking system healthy, and the government is not paying the bank.
Moreover, it can also be costly from a political prospective if the government raises capital
for public banks or the banks that have been made to support social issues. For example in
the USA, the government was not willing to close the saving and loans banks because they
didn’t want to lose the support of the public.
The third option is bank closure, which is good economically, because closure secures the
banking system against zombie banks. However, politically it is not welcome especially if
the failed bank is a public bank, because bureaucrats do not like to show that their own banks
are in trouble.
Forth option, government intervention is a good option economically if it has good timing
and proper and tough regulators, but politically it can be costly, because some time it requires
the government to pay for or buy bad assets, which is not a desirable choice by politicians.

13. 12
6. Negative capital
Negative capital occurs when the current liabilities are greater than current assets, in the balance
sheet of the commercial bank. This situation explains that the bank has a serious problem
because capital is an important for paying for losses in a crisis.18
7. Recapitalization When Banks Cannot Raise New Capital
When a bank cannot raise new capital due to the economic situation in the country, then the
government can recapitalize the bank. Sometimes, when the public sector causes the crisis
that lead these banks to be in this situation, the government can issue bonds to compensate
banks for their losses. The following three points explain how recapitalization of a
commercial bank should be done.
Policymakers often fail to respond effectively to evidence of an impending banking crisis,
especially when allowing banks and their owners to operate with less than the required
capital, hoping that they can sustain. Systemic crisis needs to be faced by a strong financial
system, and proper supervision, but poor countries always failed to have these criteria.
However, intervening early with comprehensive and credible plan can avoid a systemic
crisis, and them minimizing adverse effects and overall losses.19
Experience also suggests that closing weak financial institutions need to be properly
managed, to avoid uncertainty among depositors. Baer and Klingebiel (1995) suggest that, to
avoid uncertainty and limit incentives to run, the policymakers need to deal simultaneously
with insolvent and marginally solvent institutions. Moreover, emerging economies have
weak supervision, and poor data, they need to make their intervention as simple as possible.20
Furthermore, emerging market economies need to strengthen their supervision and establish
institutions that can help the banking system prevent a crisis or reduce its pressure when a
18
Et al J. Hanson (April 23, 2015)
19
Daniela Klingebiel et al, Managing the Real and Fiscal Effect of Banking Crises (January 2002)
20
Klingebiel et al (January 2002)

14. 13
crisis happens, and supervisors can use early warning indicators to show risks before the
crisis happens.
(a) How is the amount of recapitalization decided and what are the issues in that
decision
The amount of recapitalization should be given as an amount that will not be taken advantage
of by shareholders, and the bank should be closely supervised until it returns to normal life
(when its bank capital meets the capital requirements). Therefore, in the period of
recapitalization the bank will be suspended from distributing earnings to shareholders and at
a minimum; maybe it needs some government members on the board of the bank.
(b) Temporary Nationalization
Nationalizing the bank means the government becomes the main owner of an insolvent
private bank and recapitalizes it. In systemic crises the government always tries to own the
bank temporarily and seeks to privatize it at any early date. The government temporary
nationalizes a bank, to facilitate swift and orderly restructuring.21
Therefore, the government
takes over the bank cleans it up and sell it in rapid order to the private sector.22
While the
government tries to rescue the financial institutions in the country by throwing more money
at the bad dollar, but this policy is not appealing one because the fiscal cost is much larger.
(c) Capital injection
The common form of capital provided by the government is securities, because they
are profitable and secured with zero risk domestically. Commercial banks can also sell
them in case they need some cash.
Furthermore, the government can provide capital in the form of cash or securities,
called capital injection. The most common methods of capital injection the
government provides are the following:
 Cash: Egypt (1991), Mauritania (1991-94), and Philippines (1986).
21
Tunku Varagaraja The Wall Street Journal (February 21, 2009)
22
YouTube Video posted by Columbia Business (February 19, 2009)

15. 14
 Long-term loans or other instruments representing a government claim or
participation: Argentina (1994-95), Azerbaijan (1995), and Mexico (1995).
 Debt transfers (unrequited or in exchange for overvalued problem assets): Chile
(1984), Ghana (1990), and Mauritania (1993).
Usually government assistance takes the form of transferring assets to the bank, with no
claim made on the liability side of the bank’s balance sheet, which increases the banks’
equity. Cash and bonds can be used to recapitalize a bank, while assets (including
government bonds) with low or below market interest rates may not sufficiently improve
bank profitability, but they are less risky.23
8. Conclusion
Banking crises are one of the most sensitive issues and therefore supervisors should
be prepared to face them. In the case of a crisis, time is short and problems have to be
faced immediately. Any delay will worsen the situation and make the solution more
costly for shareholders, depositors, other creditors, and the government/taxpayers.
To avoid weak banks the country should have strong supervision, to help in avoiding
the risks and define, the risks before they become more serious, and regulation
besides willingness to take action that is needed. Prevention is usually better than a
cure; however supervisors should use existing tools, to evaluate their banks, but this
requires the supervisors and the tools which they are using are good enough and
backed by the government. A combination of financial reporting and monitoring, with
on-site and off-site examinations, should be used by regulators, and some cooperation
by commercial banks is also needed by maintaining transparency in presenting their
financial statements.24
23
Alexander et al IMF paper (1997)
24
Basel Committee, Supervisory Guidelines for Dealing with Weak Banks, (June 2014)

16. 15
When banks fail, supervisors should distinguish between the symptoms of weakness
and their underlying causes. Liquidation is often one of the best options, particularly
where deposit insurance is well established.

17. 16
References:
Bank of South Sudan, banking supervision department reports
Basel Committee, Supervisory Guidelines for Dealing with Weak Banks, (June 2014)
Chandia Dziobek, Ceyla Pazarbasiglu and William E. Alexander, Systemic Bank Restructuring
and Macroeconomic Policy IMF paper (1997)
Daniela Klingebiel and Luc Laeven, Managing the Real and Fiscal Effect of Banking Crises
(January 2002)
David S. Hoelscher and Marc Quintyn, Managing Systemic Banking Crises, IMF paper (2003)
ESMT website, An Old Bank in a New Country (Reference no. ESMT-212-0131-1, September
6, 2012)
Federal Deposit Insurance Corporation (FDIC), Website.
J. Caprio, Center for development Economics, Williams College, Finance and Development
class of ( April 13, 2015)
J. Hanson, Center for development Economics, Williams College, International Financial
Institutions Course (April 23, 2015)
Panagiotis Liargovas and Spyridon Repousist, IS A "BAD BANK" Solution for a Possible
Future Greek Banking Crisis (2012)
Tunku Varagaraja The Wall Street Journal (February 21, 2009)
YouTube Video posted by Columbia Business (February 19, 2009)