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FEDERAL RESERVE BANK of ATLANTA

WORKING PAPER SERIES

FEDERAL RESERVE BANK o f ATLANTA

WORKING PAPER SERIES

Preconditions for a Successful Implementation of
Supervisors’ Prompt Corrective Action: Is There a Case
for a Banking Standard in the European Union?
María J. Nieto and Larry D. Wall
Working Paper 2006-27
December 2006
Abstract: Over the past years, several countries around the world have adopted a system of prudential
prompt corrective action (PCA). The European Union countries are being encouraged to adopt PCA by
policy analysts who explicitly call for its adoption. To date, most of the discussion on PCA has focused on
its overall merits. This paper focuses on the preconditions needed for the adoption of an effective PCA.
These preconditions include conceptual elements such as a prudential supervisory focus on minimizing
deposit insurance losses and mandating supervisory action as capital declines. These preconditions also
include institutional aspects such as greater supervisory independence and authority, more effective
resolution mechanisms, and better methods of measuring capital.
JEL classification: G28, K23, F20
Key words: bank, supervision, European Union, PCA

The authors thank George Benston, Robert Eisenbeis, Gillian Garcia, Eva Hüpkes, and David Mayes for helpful comments on an
earlier draft as well as C.A.E. Goodhart and Rosa M. Lastra. They also thank the participants in the seminar held at the LSE
Financial Markets Group in London in March 2006. The views expressed here are the authors’ and not necessarily those of the
Banco de España, the Federal Reserve Bank of Atlanta, or the Federal Reserve System. Any remaining errors are the authors’
responsibility.
Please address questions regarding content to María J. Nieto, Banco de España, Alcalá 48, 28014 Madrid (Spain),
maria.nieto@bde.es, or Larry D. Wall, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E.,
Atlanta, GA, 30309-4470, larry.wall@atl.frb.org.
Federal Reserve Bank of Atlanta working papers, including revised versions, are available on the Atlanta Fed’s Web site at
www.frbatlanta.org. Click “Publications” and then “Working Papers.” Use the WebScriber Service (at www.frbatlanta.org) to
receive e-mail notifications about new papers.

Preconditions for a successful implementation of supervisors´ Prompt Corrective
Action: Is there a case for a banking standard in the EU?
Introduction
Over the past years, Japan, Korea and, more recently Mexico have adopted a system of
predetermined capital/asset ratios that trigger structured actions by the supervisor inspired by
Benston and Kaufman’s (1988) proposal for structured early intervention and resolution (SEIR),
a version of which was adopted by the US as prompt corrective action (PCA) in the 1991 Federal
Deposit Insurance Corporation Improvement Act (FDICIA).1 In all these countries, authorities
must resolve the bank through sale, merger or liquidation at a predetermined minimum
regulatory capital ratio. The positive effect of FDICIA in creating the appropriate incentives for
banks, the deposit insurer and the prudential supervisor is reflected in the increasing number of
recommendations to introduce PCA type provisions in other countries.

Goldstein (1997)

presents a case for an international banking standard in which one of the key operational issues is
an incentive compatible safety net and prudential supervision whose principles are inspired in
FDCIA-like features to combat moral hazard and supervisory forbearance.2

In emerging

economies, Goldstein and Turner (1996) propose PCA as a policy aimed at improving incentives
for bank owners, managers and creditors as well as bank supervisors.3
Against the background of the launching of the Euro and the expectation of a gradual
increase in cross border banking activity in the EU, the European Shadow Financial Regulatory
Committee (ESFRC) made a proposal aimed at dealing with problem banks.4 One of the
recommendations in their proposal was to establish a SEIR regime that call for predictable
supervisory action in cases of excessive risk taking. More recently, the ESFRC argues that
implementation of PCA in each individual Member State would contribute to host country
supervisors´ trust in home country supervisors.5 Benink and Benston (2005) also propose SEIR

2
as a mechanism to protect deposit insurance funds and tax payers from losses in the EU as part of
a more broad based regulatory reform.6 Along similar lines, Mayes (2005) proposes intervention
at prescribed benchmarks (ideally above economic insolvency) as a measure to have plausible
bank exit policies for systemic risk banks in the EU.7
The literature and the proposals to implement SEIR/PCA have mainly focused on certain
aspects of its economic rationality and little attention has been paid to the preconditions for its
successful implementation. However, the institutional framework at the time of the adoption of
PCA in the US was very different from the institutional framework of prudential supervision and
deposit insurance in other countries. PCA was adopted in order to make bank supervision more
effective in reducing deposit insurance losses. Before PCA can be successfully adopted, policy
makers need to evaluate the merits of several important characteristics of the US bank
supervisory system in addition to evaluating the merits of PCA within a US style supervision
system.
The purpose of this article is two-fold: (1) to identify and evaluate key conceptual
approaches and institutional structures needed for PCA to be effective, and (2) identify the
changes needed to adopt an effective version of PCA in general and, in particular, in Europe. In
order to better understand what is required for an effective PCA, the first part of this paper
considers PCA’s roots, especially focusing on the origins of PCA in the US, the reasons why the
US adopted PCA and the US experience under PCA. The second part considers the major
conceptual changes that PCA brought to US bank supervision and the extent to which these
would represent changes for European bank supervision. The next section focuses on the
institutional preconditions for a successful implementation of PCA. The last part provides

3
summary remarks. As the paper's objective is to stimulate discussion, it focuses on presenting the
economic arguments.
1.

The US Experience

1.1 Prompt Corrective Action: Creating the conditions for passage
Prompt corrective action (PCA) was part of package of measures adopted with the 1991
passage of FDICIA. The problems that lead to FDICIA were revealed in the late 1970s-early
1980s as US monetary policy tightened to slow the rate of price inflation, and the resulting high
interest rates and reduced inflation produced large losses at thrifts and many banks. These losses
caused economic insolvencies at the so-called “zombie” thrifts that were not resolved until the
late 1980s.8 Throughout most of the 1980s, the US thrift supervisors and Congress compounded
the inability of historic cost accounting to recognize interest–rate-related losses with changes in
regulations that gave an additional artificial boost to thrifts’ supervisory capital ratios as well as
reducing the required levels of those ratios.
The bank supervisors’ response to large banks’ already low capital ratios and the further
losses on less developed countries (LDCs) loans was mixed. On the one hand, the supervisors
did not require and in some cases even discouraged recognition of the losses on LDCs loans. On
the other hand, they implemented numerical capital adequacy requirements that forced many of
the largest banks to issue new capital.9 Moreover, the bank supervisors effectively nationalized
one of the largest banks, Continental Illinois, in response to domestic loan losses and resolved
hundreds of smaller banks that became insolvent, primarily in energy producing and agricultural
areas.10
After years of supervisory and congressional and administration denial of thrift
insolvency problems, Congress moved to address the problem, appropriating $10.875 billion in

4
1987 and additional $132 billion in 1989.11 Shortly thereafter, new problems emerged in the
credit quality of many large commercial banks’ loan portfolios, especially their loans to the
commercial real estate sector. By the early 1990s, the combination of a depleted insurance fund
due to past failed bank resolutions and the threat of additional losses due to new insolvencies led
some to predict that Congress would be required to make another large appropriation of funds.12
In 1991 the Congress moved to limit taxpayer exposure to losses at failed banks with the passage
of FDICIA. The PCA provisions of FDICIA create a structured system of supervisory responses
to declines in bank capital, culminating in the bank being forced into receivership within 90 days
after its tangible equity capital dropped below two percent of total assets.13

1.1

Intellectual history
The US has a long history with the basics required to implement PCA: binding capital

adequacy standards and the ability to take substantial actions against banks that failed to meet the
standards. The supervisors had the authority to adopt many of the provisions of PCA using their
pre-existing powers if they had so chosen.14 However, the experience of the 1980s had clearly
indicated that US supervisors valued discretionary responses targeted at keeping some banks
(especially thrifts and large banks) in operation after they had became financially distressed.
Benston and Kaufman (1988) developed a system of mandatory responses to changes in
capital with a proposal they came to call structured early intervention and resolution (SEIR).15
One way that this proposal could work is illustrated in Table 2 of Benston and Kaufman (1988,
p. 64) in which they propose that banks be placed in one of four categories or tranches: 1) “No
problem,” 2) “Potential problems” that would be subject to more intensive supervision and
regulation, 3)

“Problem intensive” that would face even more intensive supervision and

regulation with mandatory suspension of dividends and 4) “Reorganization mandatory” with

5
ownership of these banks automatically transferred to the deposit insurer. Although the deposit
insurer would assume control of the bank, Benston and Kaufman (1988, p. 68) ordinarily would
have the bank continue in operation under the temporary control of the FDIC, or be sold to
another bank with liquidation only as a “last resort.” The deposit insurer would remain at risk
under SEIR, but only to the extent of covering losses to insured depositors. However, Benston
and Kaufman did not expect such a takeover to be necessary, except when a bank’s capital was
depleted before the supervisors could act, perhaps as a result of a massive undetected fraud.
Because the bank’s owners would realize that the supervisors were mandated to take over a bank
while it was solvent (3 percent market value of capital-to-asset ratio), the owners had strong
incentives to recapitalize, sell, or liquidate the bank rather than put it to the FDIC.16
1.2

Adoption in FDICIA
Congress adopted a variant of SEIR in 1991 with the inclusion of the PCA provisions in

the FDICIA.17 PCA creates five capital categories for banks: well capitalized, adequately
capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.18
Congress ordered the supervisory agencies to set minimum requirements for a bank to be
classified in each of the top four capital categories, with the constraint that a bank must be
classified as critically undercapitalized if it has a tangible accounting equity-capital-to-asset ratio
of less than 2 percent. Congress further required that the minimum requirements for each
category must include both minimum leverage requirement and a minimum risk-based capital
requirement. Unlike the Benston and Kaufman´s (1988) proposal, the supervisory standards
include both minimum tier one (equity capital) and total capital (including subordinated debt)
requirements for each category. The original SEIR proposal would only have set a minimum

6
total capital requirement for each category but SEIR would have required higher levels of
capital.
Unlike SEIR, PCA distinguishes between well capitalized and adequately capitalized
banks, albeit the difference in supervisory treatment is small. However, the set of supervisory
actions under PCA, both mandatory and discretionary, is substantially greater than that sketched
out in SEIR. No bank may make a capital distribution (dividend or stock repurchase) if after the
payment the bank would fall in any of the three undercapitalized categories unless the bank has
prior supervisory approval. All undercapitalized banks must submit a capital restoration plan
and that plan must be approved by the bank’s supervisor. All undercapitalized banks also face
growth restrictions. Significantly undercapitalized banks must restrict bonuses and raises to
management. Critically undercapitalized banks must be placed in receivership within 90 days
unless some other action would better minimize the long-run losses to the deposit insurance
fund. Supervisors are also given a variety of discretionary actions they may take. For example,
the supervisors may dismiss any director or senior officer at a significantly undercapitalized bank
and may further require that their successor be approved by the supervisory agency.
1.3

Analysis of the US PCA

On first appearances, the adoption of PCA in the US appears to have been extremely successful.
Predictions that US bank failures would force the US Congress to appropriate additional money
so that the FDIC could resolve failing banks were not borne out. Instead, the US bank failure
rate fell dramatically during the 1990s, with, for example, only one bank failing in 1997. Indeed,
not only did bank failures not drain the fund, but banks paid sufficient insurance premiums to
rebuild the insurance fund and over the same period raise their capital adequacy ratios to the

7
point where almost all banks (including virtually all large banks) are currently classified as well
capitalized.19
Although the banking industry’s performance was very impressive during the 1990s, a
closer reading of the record reveals that a variety of factors are responsible for the improvement
Another clearly important factor in the turnaround was the relatively strong economic conditions
that prevailed in the US during the 1990s. Moreover, in some important respects one could
argue that PCA has not yet been adequately tested. In particular, none of the largest US banks
suffered sufficiently large losses to the point where the bank should have been classified as
undercapitalized.
Although the performance of the banking industry may not be sufficient to clarify the
impact of PCA, its likely long-run impact may be evaluated by looking at two issues: (1) would
PCA have prevented some of the mistakes in the 1980s and (2) are the supervisors implementing
PCA in a way that suggests supervisors will behave differently next time the US banking system
is under stress? The extent to which PCA would have reduced the problems in the 1980s is
unclear. The supervisors took a variety of measures designed to make failing depositories look
better and to allow supervisory forbearance including failing to include interest rate risk losses in
their measures of regulatory capital, failing to require large banks to recognize loan losses to
LDCs, and, lowering thrift capital standards and changing accounting policy to allow thrifts to
report higher capital, PCA would not have forced the supervisors into more timely recognition
of interest rate or credit risk problems. Further, PCA would have had only a limited impact on
the lowering of capital standards, as the supervisors have discretion over all of the capital
requirements except for the two percent tangible equity to assets ratio used to classify banks as
critically undercapitalized.

Where PCA would unquestionably have been effective is in

8
preventing the thrift regulators from adopting regulatory accounting principles that were weaker
than generally accepted accounting principles (GAAP) used for financial reporting by US
nonfinancial firms, albeit PCA could not have prevented Congress from adopting measures that
weaken GAAP as it did with net worth certificates.20
The difficult part to judge of FDICIA is its provisions to discourage supervisory
forbearance. PCA requires that the inspector general of the appropriate supervisory agency
prepare a report whenever a bank failure results in material losses. The report addresses why the
loss occurred and what should be done to prevent such losses in the future. A copy of the report
is to be provided to the Comptroller General and to any member of Congress requesting the
report.21 FDICIA also provides for public release of the reports upon request, but such requests
are generally unnecessary as these reports are typically posted on agencies’ web site.22

One

effect of such a report would be to subject the supervisory agency to additional "ex post"
Congressional, media, banks and academic scrutiny.23 Also, the reports often contain
recommendations to avoid future losses, recommendations that both provide the supervisors with
a chance to learn from their mistakes and create the potential for increased accountability after
future failures if the supervisors fail to implement appropriate changes.
The effect of the change in incentives may be seen by looking at the implementation of
FDICIA, both how the Act was implemented at small banks that did fail and in the preparation
for dealing with large banks when one of them becomes distressed. The good news in the
implementation of FDICIA is that the FDIC is enforcing least cost resolution and that the
inspector generals of the respective agencies are carrying through on their responsibility to
review material loss cases. The bad news is that the bank supervisory agencies do not appear to
have worked to implement the intent of PCA. PCA encouraged (and SEIR would require)

9
market value accounting which the US supervisors have not sought to implement. Moreover, if
PCA was being faithfully implemented, any losses on recent bank failures would have been
small. Yet Eisenbeis and Wall (2002) find that the losses at the banks that have failed after
FDICIA are still substantially larger than should have occurred if the bank supervisors had
followed the spirit of PCA.24
2.

Conceptual Issues in Adopting PCA
SEIR and PCA are based on a clear philosophy of the role of bank supervisors that of

minimizing deposit insurance losses. This philosophy is in many ways different from that which
guided the establishment of most bank supervisory authorities in general and in Europe in
particular.

An effective system of PCA may be established without accepting all of the

philosophy underlying SEIR; for example one can view bank supervision as having legitimate
functions beyond protecting the deposit insurer, unlike Benston and Kaufman (1988). However,
in order to have a fully effective system of PCA, the banking supervisory system has to
incorporate some key elements of the SEIR/PCA philosophy. The following subsections analyze
three key elements of that philosophy.
The first of those elements, that bank prudential supervisor’s primary focus should be on
protecting the deposit insurance fund and minimizing government losses is discussed in the first
section. The second core element, that supervisors should have a clear set of required actions to
be taken as a bank becomes progressively more undercapitalized, is discussed in the second
section. A controversial third part of SEIR/PCA, that undercapitalized banks should be closed
before the economic value of their capital becomes negative, flows from the two core elements
but is sufficiently controversial to merit discussion in the third subsection.

10
2.1

Should supervisor’s goal be to minimize government losses?
Both SEIR and PCA give prudential supervisors a single goal in carrying out their

provisions, to limit government losses, rather than a list of public policy concerns to be
addressed as a part of their prudential supervision (i.e. efficiency and competitiveness of the
financial system).25 The rational for this choice is two-fold. The standard motivation for
focusing on limiting losses is that bank failures have imposed large losses on taxpayers in
systems that have not followed SEIR. However, a more compelling motivation is to reduce the
misallocation of resources that arises from banks facing the dual problems of having distorted
incentives for managers and owners, and being run by inefficient managers.26 This approach
contrasts with the rational for adopting PCA in other countries where PCA is aimed at restoring
prudential supervisors’ institutional credibility by ensuring strict enforcement of prudential
requirements (see the case of Mexico in Table 1).27
Hüpkes, Quintyn, and Taylor (2005) note that bank prudential supervisors are often given
multiple goals, and indeed, the single goal given to US supervisors in PCA only applies to
carrying out PCA’s provisions.28 However, most other goals of prudential supervision could be
pursued in ways that do not significantly raise expected losses to the deposit insurer. The one
other goal that, according to some authors, might be in conflict is that of limiting the damage to
the real economy from bank failure. PCA can result in the resolution of a bank that if given
sufficient time might recover, thereby avoiding any failure related costs to the real economy.
Benston and Kaufman (1995) argue that the failure of a bank in a system with multiple
substitutes is no more costly than the failure of many other types of firms, such as the failure of
firms that supply proprietary information technology that is widely used.29 This argument is
perhaps partially qualified by several papers that have found evidence that the failure of a bank

11
imposes costs on the bank’s borrowers.30 There are two hypotheses as to which types of bank
borrowers are adversely impacted: (1) the customers suffering the harm were good borrowers
who were paying a market rate for their loans (the rate that a good bank would have charged if it
had had a relationship with the borrower), and (2) the customers suffering harm were borrowers
that were receiving credit at a below market rate (including bad customers that should not have
received loans) because the failed bank was not demanding adequate compensation for the risk
that it was taking. The existing studies do not distinguish between these hypotheses, albeit
structuring a test that could distinguish between the hypotheses is likely to be difficult and
perhaps impossible.
A longstanding concern is that the failure of a bank could lead to deposit runs at healthy
banks, which would fall like dominoes, and lead to the collapse of the banking system. A more
recent concern is that the failure of some very large banks or a large number of banks on the
payment system markets would have a substantial adverse impact on the operation of the real
economy. A narrow focus on limiting deposit insurance losses may not be appropriate if such a
focused policy were to risk a systemic crisis.
Although a case may be made that systemic concerns should override limiting the losses
of the deposit insurer, that case has several weaknesses. First, the analysis of systemic concerns
typically takes the risk of bank failure as independent of bank supervisory policies. However,
bank supervisory policies that try to prevent bank failure by exercising forbearance towards
failing banks and their creditors reduces the cost of risk-taking to a bank and its owners. The
resulting market prices for debt and equity are likely to create moral hazard by encouraging bank
managers to take additional risk. Moreover, PCA provides for early intervention to reduce the
probability of failure in a variety of ways, including optional authority for the supervisors to

12
remove ineffective bank officers and directors, and a mandatory requirement that the bank
develops a capital restoration plan.
Second, the argument that bank failures are likely to lead to systemic crisis is often
overstated. The historic case for deposit runs has been overstated, at least in the US, with the
bulk of the runs occurring at insolvent banks according to Kaufman (1988).31

Moreover,

concerns about runs at healthy banks may be mitigated by an active lender of last resort.32
Third, allowing insolvent banks to continue in operation runs the risk that they will
accumulate even larger losses leading to even greater market disruption when the bank’s
continued operation is no longer tenable. In contrast, if a bank is required to be closed before its
losses exceed the bank’s equity and subordinated debt then depositors and other creditors should
not be exposed to any loss. Moreover, prompt resolution reduces the probability that more than
one systemically important bank will be insolvent at the same time.33 In sum, a supervisory
focus on limiting deposit insurance costs is unlikely to result in significantly higher expected
losses due to systemic financial problems and may well result in lower expected costs.
In Europe, the European Shadow Financial Regulatory Committee (ESFRC) proposal of
SEIR to deal with problem banks implicitly recognizes the importance of supervisor's goal being
to minimize deposit insurance losses.34 Nonetheless, although policy makers have not explicitly
addressed the relative importance of minimizing deposit insurance losses, the relevant Directive
on deposit insurance is fully compatible with such a focus. Directive 94/19/EC of the European
Parliament and of the Council of 30th May, 1994 (Official Journal of the European Communities
L 135, 31st May, 1994) on deposit guarantee schemes harmonizes minimum deposit insurance
coverage, but also in its Preamble discourages governments from providing funding to their
deposit insurer:35 “ … the cost of financing such schemes must be borne, in principle, by credit

13
institutions themselves ….” At the same time, there are limitations, imposed by the EC Treaty,
on the ECB and/or the Euro area national central banks´ lending to governments or institutions
(article 101), which limit the possibility of central bank financing of deposit insurance schemes.
There are also limitations on the EU Community’s ability to "bail out" governments and/or
public entities (article 103).

Against this background, the case for minimizing the deposit

insurers’ losses is even stronger in Europe, as recognized by the European Shadow Financial
Regulatory Committee's (ESFRC) in its proposal to deal with problem banks.36
Nonetheless, governments´ continue to bail out depositors, and even shareholders, remain
as shown in a recent survey on forms of intervention by European deposit insurance schemes,
which shows that nineteen percent of interventions involved transfers of assets or other type of
assistance in addition to depositors pay-off in the period 1993 to 2003 (De Cesare, 2005).37 As a
result, the moral hazard problem remains as shown in the cases of Banco di Napoli and Sicilcasa,
which involved the use of public funds of approximately half a percent of Italy’s year-2000
GDP.38
Although a compelling case may be made for restructuring deposit insurance in the EU,
the potential weaknesses in the structure could be mitigated by a supervisory focus on
minimizing deposit insurance and ultimately taxpayers´ losses. The weaknesses in the provision
and funding of deposit insurance would become less important if banks were resolved before
they could impose significant losses on the insurer.
2.2

Should prudential supervisors’ discretion to exercise forbearance be
reduced?
A key component of any regulatory and supervisory arrangement is the nature, timing

and form of intervention (Llewellyn 2002).39 Any supervisory system must determine what
discretionary measures may be taken by the supervisors and who has authority to authorize those

14
measures. It must also determine (at least implicitly) whether supervisors should be required to
intervene in a prespecified manner at a predetermined point. PCA accepts long-standing US
policy that gives the supervisors broad powers to intervene at their own discretion. The key
innovation of PCA is that it recommends a reduction of supervisory discretion to exercise
forbearance by proposing a series of capital adequacy tranches with a set of mandatory
supervisory actions for each of the undercapitalized tranches. Mandatory supervisory actions are
intended to override the incentives supervisors would otherwise have to engage in forbearance.
In the US, the greatest opposition to PCA came from bank supervisors, who perceived it
as a reduction in their power, visibility and freedom to control banks (Horvitz, 1995).40 This
opposition could not prevent the passage of PCA, however, in large part because the supervisors´
credibility had been weakened greatly by the large thrift crisis and was further weakened by the
perception that additional costly failures were also likely in the banking industry.
One argument against mandating supervisory actions in certain circumstances as is done
in PCA is that retaining supervisory discretion to exercise forbearance increases the probability
that a distressed bank will be able to recover without being forced into resolution. This lack of
discretion is particularly criticized with respect to mandatory reorganization which eliminates
any prospect that banks with very low capital will recover. The problem with this analysis, as
noted above, is that implicitly assumes that PCA will have no affect on the probability that a
bank will become financially distressed.
The general concept that supervisors should intervene promptly is reflected in three of the
four principles in Pillar II of the new Capital Accord. Principle 2 of Pillar II calls for supervisory
evaluation of bank’s internal procedures for maintaining adequate capital and take appropriate
supervisory action if they are not satisfied. Principle 3 states that supervisors should expect

15
banks to operate above the minimum regulatory capital ratios and should have the ability to
require banks to operate above the minimum. Principle 4 establishes that supervisors should
intervene at an early stage to prevent individual bank’s capital from falling below the minimum
requirements and require rapid remedial action. These principles were largely enacted in the
PCA provisions of FDICIA in the US, although PCA goes well beyond them because it
establishes leverage ratios that require minimum supervisory action. Moreover, Pillar II contains
neither mandatory nor discretionary provisions to replenish capital and turn trouble institutions
around before insolvency. Also, it does not contain a closure rule.
The new Capital Accord has been adopted by the EU and that would require the
transposition to national regulations/legislations of the Recasting of Directive 2000/12/EC of the
EU Parliament and the Council of March 2000 relating to the taking up and pursuit of the
business of credit institutions and Council Directive 93/6/EC of 15 March 1993 on the capital
adequacy of investment firms and credit institutions; referred to as “Capital Requirements
Directive" (CRD).41 Principles 3 and 4 of Basle's Pillar II are broadly dealt with in article 124 of
the CRD.42 This article is developed in the so called Supervisory Review Process (SRP).43 SRP
requires a review and evaluation of the banks´ risk profile and management system and calls for
prudential measures to be applied promptly.44 Those prudential measures include setting a
capital requirement above the Pillar 1 (own funds or Tier 1) although the Guidelines emphasize
that they "should not be interpreted as resulting in automatic capital add-ons". Other measures
contemplated in the Guidelines are: Requiring an improvement of the institution internal and
risk management controls; applying specific provisioning policy or treatment of risk assets in
terms of regulatory capital requirements; restricting the business operations and/or reducing the
risk profile of its activities. The specific own funds requirement is envisaged only if the above

16
mentioned imbalances cannot be remedied by other prudential measures within an appropriate
time frame. These remedial actions establish the principle of early intervention, but do not
significantly reduce supervisory discretion as to when to intervene or establish minimum
supervisory actions.
The SRP as well as the Article 124 of the CRD constitute a step in the right direction to
reduce forbearance and bring about timely corrective action by supervisors when banks fail to
meet prudential requirements. Nonetheless, in line with the new Capital Accord, they fall short
of a structured early intervention mechanism in the EU as envisaged by the European Shadow
Financial Regulatory Committee (ESFRC). The present proposal may succeed in reducing the
moral hazard behavior by banks, which should expect supervisory reaction to their excess risk
taking.

However, a more structured prudential performance benchmark would make the

imposition of sanctions more credible, further discouraging poor agent behavior of prudential
supervisors. In this context, market discipline should play even a more important role in putting
a backstop to prudential supervisory action in the EU.
2.3

Should banks be closed with positive regulatory capital?
Both SEIR and PCA call for timely resolution, which is a policy where banks with

sufficiently low, but still positive, equity capital are forced into resolution. In the US context,
resolution is understood to include: (1) the government assuming control of the failed bank,
firing the senior managers and removing equity holders from any governance role, and (2) the
government returning the bank’s assets to private control through some combination of sale to a
healthy bank or banks, new equity issue, or liquidation.45
Timely resolution provides two important benefits. First, forcing a bank into resolution
while it still has positive regulatory capital truncates if not eliminates the value of the deposit

17
insurance put option, reducing the incentive of the bank’s shareholders to support excess risk
taking. Second, timely resolution is critical to limiting deposit insurance losses. If insolvent
banks are allowed to continue in operation then the potential losses from failure can be very
large.
Timely resolution in the US was perceived by some authors as the government taking
private property (Horvitz, 1995).46 The key argument against the claim that timely resolution
involves taking shareholders’ property is that PCA provides the shareholders with an opportunity
to recapitalize the bank before the bank is forced into resolution. If the shareholders are
unwilling to recapitalize the bank and unable to sell it to a healthy bank, that suggests that the
owners and other banks agree the bank is no longer financially viable. The timely resolution
provision of PCA has been employed by the FDIC and has not been found to be contrary to the
US constitution.
In Europe, as highlighted by Mayes, Halme and Liuksila (2001), with only limited
exceptions and contrary to the case in the US, supervisors have often limited legal powers to
intervene if a bank becomes critically undercapitalized or its net worth turns negative.47 In these
authors´ opinion, which is shared by Hadjiemmanuil (2004) as well as the authors of this article,
what is often missing is a delegation of legislative authority to the prudential supervisor as
parliament's designated agent to reorganize and liquidate banks. 48
3.

Institutional preconditions for a successful PCA
The primary effect of PCA was not to give US supervisors new powers but rather to limit

their ability to forbear in using the powers that they largely already had been given.

The

Member States of the EU have developed a variety of bank supervisory systems reflecting their
individual political systems; the needs of their banking system; and their legal traditions. In

18
order to effectively implement PCA, many of the bank supervisory systems will need to provide
their supervisors with additional authorities and resources. This section considers a number of
important prerequisites for PCA to be an effective policy. Our goals are two-fold, first to explain
why the authority or resource is necessary and second to show that those preconditions are, in
most instances, already called for by the Core Principles of Banking Supervision issued by the
Basel Committee, although none of the Core Principles for Effective Bank Supervision prescribe
PCA.
3.1

Supervisory independence and accountability
PCA retained US bank supervisors’ authority to intervene in a variety of ways if the bank

was violating a specific statute or regulation, or if the supervisors concluded it was being
operated in an unsafe or unsound manner. The US supervisors did not need political or judicial
approval prior to PCA to intervene at a troubled bank or to force an insolvent bank into
resolution.49 The major change in supervisory practice resulting from PCA is that after PCA the
supervisors were required to intervene as a bank’s supervisory capital ratios deteriorated.
The independence of supervisory action provided to supervisors before PCA is critical to
the effective operation of PCA.

A system that requires the prior approval of political

authorities creates the potential for delay and forbearance in supervisory intervention to the
extent that the political authorities do not follow the supervisors´ recommendations. Moreover,
if this condition is not met, the requirement of prior political approval reduces the effectiveness
of PCA in discouraging banks from taking excessive risk.
Similarly, requiring prior judicial approval would limit the effectiveness of PCA. A court
could be asked to certify that a bank is undercapitalized and remedial action is appropriate, but
the determination of whether a bank is undercapitalized is likely either: (1) trivial in that the

19
court merely uses available data to verify the supervisors arithmetic, or (2) calls for the court to
undertake actions outside its qualifications, such as determining the correct value of the bank’s
capital or evaluating whether the supervisor has chosen the appropriate discretionary actions to
help the bank recover.
The requirement for supervisory independence does not imply that supervisors should be
free to operate outside the political and legal system in a representative democracy. SEIR does
not challenge the principal that the supervisory agencies should be accountable for their actions
and, as discussed above, PCA sought to strengthen that accountability. The key is that the
supervisors should be accountable after supervisory intervention to the judicial system for the
legality of their actions and to the political authorities for the appropriateness of their actions.
The Basel Committee on Banking Supervision recognized the importance of supervisory
independence by making independence part of its first “Core Principle for Effective Bank
Supervision:” 51
Basel Core Principle 1: "An effective system of banking supervision will have clear
responsibilities and objectives for each agency involved in the supervision of banks. Each
such agency should possess operational independence and adequate resources …"
European countries broadly comply with this principle since the political independence of
the banking supervisors is generally adequate in spite of the fact that, in some countries, the
presence of the government representatives on their supervisory boards could potentially raise
the issue of independence from the government. Moreover, in Germany, although the
supervisory authority is independent in its operations, BaFin is subject to the legal and
supervisory control of the Minister of Finance.

In Switzerland, there appears to be a lack of

20
administrative independence with regard to the supervisory authority ´s budget, which is
incorporated into the Finance Ministry's Budget.
The extent to which the supervisors are able to act independent of the judiciary varies by
country. In some countries, such as France, the prudential supervisor is an administrative
judiciary authority when imposing sanctions and its decisions and sanctions can only be
challenged before the highest administrative judicial authority. However, in other countries,
such as Austria, the legal system puts in some cases the burden of the proof on the supervisors
before they can take remedial action, which is likely to delay prompt corrective action. The legal
protection of supervisors for their actions taken in good faith in their office varies from country
to country. In Italy, the law does not provide such legal protection to its supervisors against
court proceedings. See Table 1 for a description of objectives, autonomy and remedial measures
of prudential supervisors in the EU and selected countries outside the EU.
The European Shadow Financial Regulatory Committee (ESFRC) recognized the importance
of complying with the requirement that supervisors have operational independence.

The

Committee argued that for SEIR to be credible the political independence of the supervisory
agencies should be strengthened.53
3.2

Adequate authority
PCA requires that the prudential supervisors be given authority to intervene in

undercapitalized banks, both as a deterrent to risk taking by healthy banks and to try to rebuild
capital at undercapitalized banks. If a bank’s capital drops below minimal acceptable levels,
PCA requires that the bank be placed in resolution.

21
The need for adequate authority is also recognized by the Basel Committee on Banking
Supervision:
Basle Core Principle 22: "Banking supervisors must have at their disposal adequate
supervisory measures to bring about timely corrective action when banks fail to meet
prudential requirements (such as minimum capital adequacy ratios), when there are
regulatory violations, or where depositors are threatened in any other way. In extreme
circumstances, this would include the ability to revoke the banking license or recommend
its revocation"

The PCA policy applied in the US goes beyond Basel Core Principle 22 only in that
supervisors have direct authority to revoke the license, whereas the Core Principle allows for the
possibility that the supervisor may only be able to recommend revocation. This difference is
crucial to the extent that political authorities may not follow supervisors´ recommendations.
As shown in Table 1, European countries´ degree of compliance with this Principle varies
country to country. 54

In a number of countries, the banking law provides supervisors with a

wide range of possible corrective actions depending on the severity of the situation. Moreover, if
the prudential supervisor does not take immediate action, firms and/or individuals may raise this
in a proceeding against them under the general jurisdiction of the courts and Tribunal. In some
other countries, such as Finland, Sweden and Iceland, prudential supervisory powers do not
contemplate provisions for approval of new acquisitions, the ability to restrict asset transfer or to
suspend payments to shareholder and/or to purchase banks own shares. In still other countries,
such as Italy, Austria, and Sweden, legislators do not provide prudential supervisors with
authority to bar appointment of individuals from banking once the person has been hired and

22
passed the initial fit and proper test. Although, the decision to revoke a bank license corresponds
to the supervisory authority, in a number of countries the government must formally approve the
license withdrawal or adoption of specific crisis procedures. Last but not least, in some of the
recent entrants in the EU, the ability of the supervisor to address safety and soundness issues in
banks is significantly encumbered by its institutional capacity and resources.
3.3

Adequate resolution procedures
Confidence in the resolution procedure is critical if bank prudential supervisors are to enforce

the timely resolution embedded in PCA. Bank supervisors are likely to resist forcing a bank into
resolution if they know it will result in major disruption, such as when the deposit insurer lacked
adequate funds to honor its commitments or the resolution procedures were likely to result in
severe market disruption. Supervisors would resist both because of concerns about the costs that
the closure would impose on society and on the likely parliamentary response to a bank closure
that severely disrupted the economy. One example of the resistance to timely action is that of the
US thrift industry, where even after the supervisors accepted the need to resolve many failed
thrifts, they did not do so because they lacked adequate resources to honor the deposit insurance
commitments.
In the US, the bank insolvency procedure is administered by the Federal Deposit Insurance
Corporation. FDICIA built upon previously developed US procedures for handling failing banks
with a goal of providing supervisors with sufficient tools to allow timely closure of banks at
minimal cost to the deposit insurance fund. If a private sector resolution cannot be worked out
without government intervention, the FDIC has several options under US law including: (1) act
as a conservator and operate the bank under its existing charter, or (2) ask the chartering
authority to revoke the charter and appoint the FDIC as receiver.55 In practice the FDIC’s

23
intervention has taken the form of receivership. As receiver the FDIC can limit creditors’ ability
to withdraw funds and can allocate losses in excess of equity to the uninsured creditors.
Once the FDIC is appointed receiver of a failed bank, the agency has three options. First, the
FDIC may provide assistance to a healthy bank that purchases most or all of the failed bank’s
assets and assumes the failed bank’s insured deposits and some uninsured liabilities. Second, the
FDIC may decide to liquidate the bank. Third, it may create a new bank which it temporarily
manages pending the sale of part or the entire bank to a healthy bank and liquidates whatever is
not sold. Regardless of which option the FDIC chooses, the agency typically provides insured
depositors with immediate access to their funds and uninsured depositors at domestic offices
with access to at least part of their funds.56 The FDIC’s ability to act expeditiously in resolving a
failed bank outside the bankruptcy courts reduces the period of uncertainty for the bank’s
creditors, borrowers and other customers and may help to reduce the impact of the failure on the
financial system.
In Europe, although there is considerable variation across countries, European prudential
supervisors have, in principle, a more limited set of options in dealing with a distressed bank,
which, generally, are defined by the banking and/or bankruptcy laws. Hüpkes (2003) discusses
two alternatives for resolving bank problems in Europe, neither of which are in some aspects as
flexible as those available in the US, primarily because of the limited range of supervisory
measures to bring about early resolution without applying to the courts and the rigidities imposed
by the general insolvency procedures applied to banks.57
As described in section 3.2, bank supervisors are empowered to different degrees to employ a
range of measures, some of which can be very intrusive, in order to take remedial action. In
contrast to the US, some European prudential supervisors (Germany, Italy and Switzerland),

24
have the power to impose a moratorium against debt enforcement prior to the bank being
declared insolvent and placed into bankruptcy. However, not all supervisors have this power and
in countries, such as the United Kingdom, France, Spain and Luxembourg, bank supervisors
have to apply to the courts. Such measures are typically accompanied with some form of direct
or indirect control via by a provisional administrator on bank's management. Hüpkes (2003)
describes the suspension and appointment of a provisional administrator as a “quasi-insolvency”
procedure, which gives the provisional administrator wide ranging powers to bring about a
resolution, including the sale of new stock and the transfer of ownership.
If a bank cannot be made viable under a payments suspension and the appointment of
provisional administrator, the alternative is liquidation.

Hüpkes (2003) notes that the

administration of bank insolvency proceedings is regarded as a judicial function in most
European jurisdictions. In some countries such as the United Kingdom, the courts rely entirely
on general corporate bankruptcy procedures; whereas in other countries, such as Austria,
Belgium, Germany, Italy, Luxemburg, the Netherlands and Portugal, special rules or exemptions
to the general bankruptcy law are established in the banking law.

These approaches are

consistent with a "marked trend toward providing the supervisor with wider powers and to either
complement or replace powers previously exercised by judicial authorities" (Hüpkes, 2003 p.8).
Some countries, such as France, allow for the coexistence of administrative proceedings
controlled by the prudential supervisors and court judicial proceedings. The court allows the
bank to continue operating, while trying to rehabilitate it, or to simply liquidate. Hüpkes (2003,
p. 23) notes that a bank reaching this point is likely to be liquidated as “all corrective measures
available under the banking law as well as mediation attempts will have already been
exhausted.”

25
Hüpkes (2003) analysis suggests that the existing legal framework offers European
prudential supervisors two suboptimal options for addressing an insolvent bank: (1) limited
provisional administration, which may not be sufficient to bring about efficient resolution, or (2)
turning the problem over to a bankruptcy court, which in some jurisdictions is an administered
bankruptcy proceeding under the banking law. These options are unlikely to fully benefit from
the supervisors’ understanding of the banking system and, in some instances, risk conflict
between judicial and supervisory authorities arising from disparate assessments and
recommendations.
Not only are failed banks typically resolved through regular corporate bankruptcy
proceedings, but the Directive 94/19/EC on deposit guarantee schemes does not require that
depositors will have immediate access to their funds. Estonia, Hungary, Poland and Slovenia are
the only European countries whose legislators have set more ambitious timing for the receipt of
compensation (Garcia and Nieto, 2005).58 The potential delay in providing depositors with
access to their funds may have macroeconomic consequences that would encourage authorities
with responsibility for macroeconomic conditions to strongly encourage supervisory forbearance.
Dermine (1996, p. 680) stated that:
The issue is not so much the fear of a domino effect where the failure of a large bank would
create the failure of many smaller ones; strict analysis of counterparty exposures has reduced
substantially the risk of a domino effect. The fear is rather that the need to close a bank for
several months to value its illiquid assets would freeze a large part of deposit and savings,
causing a significant negative effect on national consumption.59

Although resolution policy has largely been left to its Member States, the EU has
addressed some of the potential problems with reorganizing and winding up credit institutions
that operate across member boundaries. The Reorganization and Winding up Directive for EU
Credit Institutions (Directive 2001/24/EC of the European Parliament and of the Council of 4

26
April)60, which only applies to cross-border banking crisis, has harmonized the rules of private
international law applicable to bank collective proceedings with the aim of ensuring the mutual
recognition by Member States of the national measures relating to the reorganization and
administrative or court-based liquidation of EU banks which have branches in other Member
States.61 Hence, the Directive has not harmonized the national banking and bankruptcy laws on
those aspects dealing with banks´ reorganization and liquidation procedures.62 The Directive
recognizes intervention into third party rights by administrative or judicial authorities as valid
reorganization measures. In fact, it defines "reorganization measures" (Title II) as measures
which are intended to preserve or restore the financial situation of a credit institution and which
could affect third parties´ pre-existing rights, including measures involving the possibility of a
suspension of payments, suspension of enforcement measures or reduction of claims.
The Directive’s provision recognizing the powers of administrative and judicial procedures
to intervene in third party rights may have important implications for quasi-judicial procedures.
Hüpkes (2003) points out that the European Court of Justice may have limited the ability of
quasi-insolvency procedures to bring about effective resolution in EU Member States as a result
of its 1996 opinion in Panagis Pafitis and other v. Trapeza Kentrikis Ellados AE and others
(“Pafitis case”).63 This view is shared by Mayes, Halme and Liuksila (2001) who argue that the
Pafitis case made intervention at positive benchmarks impossible in Europe.64 However, the
wording in the 2001 Directive appears to endorse quasi-insolvency proceedings raises the
possibility that the Court might now reach a different conclusion were it to be presented with a
similar case.
Although the Directive will provide some minimum basis for resolution after a bank is
declared insolvent, it does little to create a common framework for determining when a bank will

27
be forced into resolution. In particular, the Directive fell short of creating a framework of
commonly accepted standards of bank resolution practice, including a common definition of
bank insolvency and a fully-fledged single legal framework or common decision-making
structures across Member States, which adds complexity to the notification among Member
States´ authorities.
3.4

Accurate and timely financial information
Arguably, the biggest weakness of PCA is its reliance on regulatory capital measures of a

bank’s capital, measures which may significantly deviate from the bank’s economic capital.
Banks that are threatened by PCA mandated supervisory actions have a strong incentive to report
inflated estimates of the value of their portfolios. The extent to which banks are allowed to
overestimate their capital under PCA depends in part on the accounting rules and in part on the
enforcement of the rules. Thus, if bank prudential supervisors want to preserve their discretion
despite the requirements for mandatory actions in PCA, supervisors need only accept a troubled
bank’s inflated estimates of its regulatory capital adequacy ratio.
In the US, PCA is vulnerable to problems both in the accounting principles and their
enforcement.

The weakness in the principles is that US generally accepted accounting

principles (US GAAP) generally do not permit the revaluation of assets and liabilities for
changes in market interest rates, the exception being securities held in a trading account or
available for sale if they are traded on a recognized exchange.

This problem was well

understood at the time of the adoption of PCA, which encourages but does not require the
supervisors to adopt market value accounting. However, the supervisors have chosen not to take
up this part of PCA, or even to use the fair value balance sheets that are available in publicly
traded banks.

28
The first line of defense in the US for enforcing compliance with accounting rules,
especially loan loss provisioning rules, are the external auditors of a bank.65 The total impact of
external auditors is hard to judge, as there is rarely any public disclosure when a bank changes its
asset valuation in response to its external auditor’s comments.
Dahl, O’Keefe and Hanweck (1998) find evidence that external auditors on average exerted an
influence over bank loan loss provisioning during the 1987 to 1997 period.66 However, that
study is not designed to indicate whether external auditors were effective in forcing loss
recognition that would result in a bank becoming undercapitalized. There are cases prior to PCA
which raised questions about the effectiveness of external auditors, such as their real estate loan
valuations at many banks in the northeast in the early 1990s that differed substantially from
supervisory valuations. 67 In the post PCA period, reviews of bank failures that caused material
losses to the FDIC by the offices of inspector general of the respective agencies have found
several cases where external auditors did not adequately verify the correctness of asset
valuations.68 The official policies of the supervisory agencies call upon them to review the work
of the external auditor, primarily to streamline the work of the bank examiners but also to assess
the adequacy of the audit.69

To the extent that outside auditors are unable or unwilling to

force banks to recognize losses in their asset portfolios, PCA depends on the effectiveness of
bank examinations by the supervisory agencies. Yet relying on the supervisors to enforce honest
accounting creates a contradiction in PCA. PCA is designed to limit supervisory discretion in
enforcing capital adequacy, yet PCA will only be fully effective if the bank supervisors use their
discretion in conducting on-site examinations to force timely recognition of declines in portfolio
value.

29
The vulnerability in enforcement is highlighted by Eisenbeis and Wall’s (2002) finding
that deposit insurance losses at failed banks in the US did not decrease as a proportion of the
failed bank’s assets after the adoption of PCA as should have happened if the supervisors were
following timely resolution.70

Their findings suggest that bank supervisors do not always

enforce timely recognition of losses. Moreover, these weaknesses in PCA are not limited to the
US. Japan adopted a version of PCA in 1998, but did not impose sanctions on banks widely
thought to be undercapitalized or even insolvent because the banks reported adequate regulatory
capital ratios.71
The EU is addressing the problems in obtaining accurate and timely information.
Although in the EU, Member States have traditionally had different supervisory requirements
and accounting rules, harmonization has taken place in the recent years to comply with the
International Financial Reporting Standards (IFRS).72 Most importantly, IFRS requires fair
value accounting which takes account of changes in portfolio value due to interest rate changes.
In addition, EU bank prudential supervisors aim at streamlining financial reporting under IFRS,
focusing on harmonization of reporting formats and convergence of supervisory reporting
requirements. In the first stage, efforts have been oriented towards the primary reporting formats,
such as balance sheet and profit and loss accounts. Moreover, EU bank supervisors have also
developed a common reporting framework for the implementation of the new solvency ratio
under Basle II.
With very few exceptions, EU banks are required to present audited financial statements.
Most, but not all, EU supervisors also supplement bank auditing with on-site examinations to
verify banks’ reported financial condition.73 The on-site inspections provide supervisors with the
opportunity to enforce timely loan loss recognition, but it is only an opportunity. Losses may not

30
be recognized in a timely manner if the supervisors fail to use their discretion to enforce timely
recognition
One way of reducing the vulnerability of PCA to over-estimates of capital is to
supplement regulatory capital ratios with market data in setting the tripwires between different
PCA categories. Such market signals could be derived from the debt or equity markets for banks
that have (or could issue) actively traded debt or equity obligations. For example, Evanoff and
Wall (2002) propose using the spread between the yield on subordinated debt and other debt
securities of comparable maturity as a trigger for PCA sanctions at the largest US banks.74
Evanoff and Wall’s (2002) analysis found that subordinated debt yield spreads produced more
accurate predictions of upcoming confidential supervisory ratings than did bank’s risk-based
regulatory capital ratios.75 However, because they also found that both risk measures contain
substantial noise, they suggest limiting the use of subordinated debt only as a failsafe mechanism
to identify critically undercapitalized banks.76
In the EU, in spite of the fact that there is a lack of statistical reliable data; according to
the BIS (2003), retail investors seem to play a larger role given the relatively high number of
small banks that issue subordinated debt. To the extent that institutional investors are better
placed to exercise market discipline, this may pose a limitation to market discipline of EU banks.
Furthermore, Benink and Benston (2005) show that the level of subordinated debt over total
assets of EU commercial banks increased little over the period 1999-2003.77

Nonetheless, EU

banks and in particular German, British and Spanish banks are large issuers of subordinated
bonds. Moreover, the concentration of debt issues per most issuing bank is relatively low in the
EU as compared to the USA or Japan.78

31
Sironi (2001) empirically tested the risk sensitivity of subordinated debt spreads of over
400 fixed rate subordinated bonds of EU banks, using publicly available information such as
ratings and market variables. Sironi found that investors appear to rationally discriminate
between the different risk profiles of European banks and that the sensitivity of the subordinated
debt spreads has been increasing overtime "suggesting that implicit guarantees such as TBTF
policies were present in the first half of the nineties and became weaker or vanished during the
second part of the decade."

However, Sironi as well as most other empirical studies of risk

sensitivity of subordinated debt lacked access to confidential supervisory ratings and, thus, was
forced to implicitly assume that publicly available information reflects a bank’s risk profile in a
timely and adequate manner.
4. Conclusions
Prompt corrective supervisory action seeks to minimize expected losses to the deposit insurer
and taxpayer by limiting supervisors’ ability to engage in forbearance. Along with reducing
taxpayer losses, PCA should also reduce banks’ incentive to engage in moral hazard behavior by
reducing or eliminating the subsidy to risk-taking provided by mispriced deposit insurance.
These potential benefits from PCA appear to have been recognized, as reflected in the increasing
number of recommendations to policy makers to introduce PCA type of provisions in their
national legislation. Japan, Korea and, more recently Mexico have adopted this prudential
policy. However, an effective PCA policy requires on one hand the acceptance of key aspects
of the philosophy underlying SEIR/PCA, on the other, an institutional framework supportive of
supervisors’ disciplinary action. This article attempts to identify the changes needed to adopt an
effective PCA in general and, in particular, in Europe.

32
Three aspects of the philosophy underlying SEIR/PCA are critical to its effective
operation. First, the primary goal of prudential supervisors should be to minimize deposit
insurance losses, a goal which is also likely to result in a reduction in the expected social costs of
systemic financial problems. The 94/19/EC Directive on deposit insurance schemes, as well as
the EC Treaty (articles 101 and 103) discourage governments and limit central banks from
providing funding to the deposit insurance.
the SEIR/PCA philosophy.

Hence, this regulation is in line with this element of

A second critical part of their philosophy is that prudential

supervisory discretion to engage in forbearance should be limited. PCA requires mandatory
intervention at an early stage of a bank’s financial problems. Such intervention may prevent
insolvency by (a) contributing to an early recognition by banks’ managers of the banks’
problems; (b) putting pressure on banks’ managers to build capital and avoid excessive risk
taking. Pillar II of the proposed new capital accord contains three principles that require prompt
supervisory intervention. These principles are broadly dealt with in the recently approved CRD.
However, the resemblance to the PCA should not be overstated. The PCA policy applied in the
US goes beyond those three principles of Basle II in that it limits even further supervisory
discretion as to when to forbear from intervening by specifying capital/asset ratios that require
minimum and automatic supervisory action. The third critical part of PCA follows from the first
two parts, banks should be subject to mandatory closure at positive levels of regulatory capital
ratio. This provides an incentive to banks’ managers to recapitalize the bank or look for a
healthy merger partner and, ultimately, contribute to reduce the cost of deposit insurance. In the
EU, contrary to the case in the US, prudential supervisors have a limited range of legal powers to
bring about early resolution without applying the general insolvency procedures to banks.

33
Regarding the second element for an efficient implementation of PCA, an institutional
framework supportive of prudential supervision disciplinary action is based on four
preconditions, which, are in most instances called for by the Core Principles issued by the Basle
Committee on Banking Supervision although they do not prescribe PCA.
First, supervisors must have operational independence from the political and judicial
systems. In the EU, prudential supervisors are either central banks or independent agencies that
have achieved increasing political independence over the past two decades, which, through
accountability, has been reconciled with the demands of democratic legitimacy. However, in
some countries, formal consultation with government is required in matters of internal procedure.
Also, the extent to which the supervisors are able to act independently of the judiciary varies by
country.
Second, supervisors must have access to a broad range of supervisory measures to bring
about timely corrective action is another requirement for an effective PCA. In some countries,
supervisors do not have a full range of corrective actions, such as restricting asset transfers or
suspending dividends. In the recent entrants to the EU, the ability of the supervisor to address
safety and soundness issues in banks is significantly encumbered by its institutional capacity and
resources. Furthermore, in a number of EU countries, government must formally approve the
license withdrawal although the decision corresponds to the supervisor. Hence, the “prompt”
part of the PCA is not present.
Third, the supervisors must be provided with adequate resolution procedures. In the EU,
Member States´ bank resolution procedures generally lack the flexibility of those available in the
US, because of (1) the above mentioned limited range of supervisory measures to bring about
resolution without applying to the courts and (2) the rigidities imposed by the general insolvency

34
procedures applied to banks, which in some jurisdictions are an administered bankruptcy
proceeding under the banking law. In the case of credit institutions with cross-border activity
within the EU, Directive 2001/24/EC on the Reorganization and Winding up addresses some of
the potential problems by enshrining the principles of mutual recognition, unity and universality.
Nonetheless, the Directive falls short of creating a framework of commonly accepted standards
of bank resolution practice and, in particular, a common definition of bank insolvency and a
fully-fledged single legal framework across the EU.
Finally, prudential supervisors must have access to accurate and timely financial
information on banks’ financial condition is also a pre condition for an effective PCA. The
accuracy of banks’ financial information depends on both the accounting principles used to
measure capital and the enforcement of that those principles. The EU is addressing this question
by requiring banks to comply with the IFRS, developing common reporting requirements, and
implementing methods for the data transmission in real time. The more difficult problem to
solve relate to giving the supervisors appropriate incentives to engage in timely action. The U.S.
experience since the adoption of PCA suggests that it may need to strengthen its supervisors’
incentives to demand honest accounting.
In sum, although the existing EU legal framework generally supports the underlying
philosophy of PCA, particularly with regard to limiting deposit insurance losses and mandatory
prudential supervision at an early stage of banks financial problems. However, PCA embeds
some conceptual views about the operation of bank supervision and the mandatory closure at
positive predetermined levels of regulatory capital ratios that have not been adopted by EU
Member States. Moreover, substantial changes would need to be made to the Member States’
institutional framework before the EU could adopt a version of PCA. These institutional

35
changes would be desirable even if the EU does not adopt PCA, but they are critical to the
implementation of a PCA that is as effective as the PCA currently is in the US.

Table 1. Objectives, autonomy and remedial measures of prudential supervisors: EU and rest of the world (*)
Country
EU
Germany

France

Italy

The
Netherlands

Objectives and autonomy (BCP 1)

Remedial Measures (BCP 22)

Comments

The, Prud. Sup. Authority is independent in its supervisory
operations, albeit accountable to the MoF. The assessment notes
some issues where the scope of the role of the MoF is unclear, for
instance its mandate to issue instructions to the Prud. Sup.
Authority, and the requirement that the Prud. Sup. Authority must
consult the MoF in matters of internal procedures.

The Prud. Sup. Authority has a broad range of remedial
measures at their disposal to counter weaknesses in banks, and
they use these measures frequently. There is an implicit
presumption in the legislation that adequate remedial action is
taken promptly. Authorities are encouraged to make this
presumption more explicit, in particular in severe cases.

Authorities point out that overly
prescriptive rules could be
counterproductive because they
would reduce the room and
incentives for taking
discretionary decisions, which
are better adapted to the specific
circumstances, especially as the
correct use of discretion is
determined by general rules and
legal limits.

Independence of banking supervision is generally adequate
although the presence of the Head of Treasury on the board of the
Prud. Sup. Authority could raise the issue of independence from
the Government. The legal protection of supervisors is a well
recognized tenet of administrative law and is considered
satisfactory.

The Prud. Sup. Authority has the legal power to impose a broad
range of remedial measures that range from recommendation to
withdrawal of the license with or without appointment of a
liquidator. The Prud. Sup. Authority may impose the
withdrawal of the voting rights of certain or all shares, the
prohibition to pay dividends or other form of remunerations to
shareholders and the obligation for the credit institution to
disclose the disciplinary measures. When imposing sanctions,
the Prud. Sup. Authority is an administrative judicial authority,
and its decisions and actions can only be challenged before the
highest administrative authority.
The Prud. Sup. Authority is able to activate a broad range of
measures graduated according the seriousness of the problem
bank's situation. Nonetheless, it lacks specific provision to
require subsequent removal of a director or senior officer who
may have become unfit.

The Prud. Sup. Authority takes the initiative in recommending
regulatory and supervisory policy and it has operational
independence on day-to-day application of supervisory methods.
The enforcement powers of Prud. Sup. Authorities are
satisfactory. The law does not provide legal protection to its
supervisors against court proceedings stemming from measures
adopted in the performance of their functions in good faith.
The Sup. Authority is independent in its supervisory activity and
accountable to the Treasury Minister, and, through them, to
Parliament.

The Bank Act gives the Sup. Authority powers to exercise
supervision of financial institutions in accordance with applicable
legislation. The legislation also provides the Ministry of Finance
powers to exercise certain supervisory measures. The objectives
of the Sup. Authority are only implicitly embedded in the
legislation rather than being explicitly set out and published. The
new legislation will be an opportunity to strengthen this aspect
and make accountability easier to measure.

The Sup. Authority can take remedial action with immediate
effect, using a supervisory notice. The Sup. Authority may
cancel a bank's permission and it has the authority to take
disciplinary action against a bank or an individual, including
fines and public censure. It may also place requirements or
restrictions on banks permission. This power can be used to
require a bank to take (or refrain from taking) specified actions.
Though the legal powers given to the Sup. Authority are wide
ranging and would appear to cover almost all (if not all)
eventualities, more formalized measures are rarely used in
practice. Notwithstanding, there are established procedures on
how to implement such measures if called for. These measures
tend to be persuasive and confidential in nature including the
use of the ‘silent receiver’ in cases of substantial concern. This
system appears to work effectively. It can be questioned

Austria

Sweden

The Prud. Sup. Authority enjoys operational independence, and
have a mandate clearly defined in law. There is legal protection
for individual supervisors discharging their duties in good faith.
Court decisions may find the federal government liable for losses
in a bank failure due to shortcomings of an external auditor
performing supervisory duties prescribed in the banking act.
The Sup. Authority is an independent authority in performing its
regulatory and supervisory functions and it has its own board.
The government yearly issues the Sup. Authority ´s general
objectives after consulting with the Sup. Authority. In order to
achieve the overall objectives, Sup. Authority sets its operational
goals and objectives without having to consult with the
government. Sup. Authority ´s employees can be considered to
have legal protection for their actions taken in good faith in their
office

Finland

The Sup. Authority has limited independence and accountability.
Independence is limited as the responsibility for the licensing and
revocation of a bank remains with the MOF. Accountability is
limited as no authority is explicitly charged with supervising the
Sup. Authority with regards to the effectiveness and
appropriateness of its functions.

Slovenia

The Prud. Sup. Authority must be commended for the actions
undertaken to enhance the regulatory regime and its endeavor to
meet international standards. However, the insufficiency of the
salary must be addressed and the legal protection of the
supervisory staff must be established.

Slovak
Republic

The legal framework for banking supervision is suitable and
provides supervisory independence. The banking Law has
enhanced the supervisor's authority and ability to act, in part
based on certain safety and soundness provisions. However, the
ability of the supervisor to address safety and soundness issues in
banks is significantly encumbered by its institutional capacity.

Hungary

The respective laws fully empower the Prud. Sup. Authority to
address compliance with laws and all significant concerns of
soundness and prudent management. They empower, except for
the extreme sanction of withdrawal of a license, the Prud. Sup.
Authority to take or impose prompt remedial action whenever, in
its judgment, a bank is not complying with laws and regulations

whether ‘penalties’ can be applied to management rather than
just members of the Supervisory and Executive boards.
A broad range of remedial powers is provided by law to the
Sup. Authority, including explicit requirements to take prompt
action in serious cases such as insolvency. The legal system
puts a high burden of proof on the supervisor before action,
which may subsequently be challenged in court.
The supervisor has a limited range of remedial actions
available. In addition to issuing warnings and imposing
conditional fines, the supervisor can revoke the license.
However, the supervisor should be able to take a more
proactive approach with respect to remedial measures. The
supervisor is not empowered to take most of the measures
enumerated in the essential criteria, e.g. restricting the scope of
activities of a bank and suspending the payment of dividends.
There are no laws or regulations that would mitigate against
supervisory forbearance.
The Sup. Authority does not have the powers to require
compliance with safety and soundness measures recommended
by the supervisor; powers to establish criteria for reviewing
acquisitions and investments; powers to assess the adequacy of
loan loss provisions and reserves; powers to require a higher
minimum capital ratio; powers to control connected lending;
and powers to bring about timely remedial action. Although
the. Sup. Authority participates in the resolution process for
problem banks; it lacks powers to take prompt remedial action.
The. Sup. Authority is for the most part focused on ex post
reaction.
The Prud. Sup. Authority has the legal power to restrict bank
activity or a license or to revoke a bank license. Prud. Sup.
Authority has, inter alia, powers to object to potential
controllers or shareholders of banks, and to existing controllers
or shareholders. In practice, the BoS seeks remedial action
through informal means, principally through the use of moral
suasion.
The banking Law provides a range of remedial actions to the
supervisor, which if interpreted properly and affectively
applied, offer the supervisor sufficient leverage and actions to
oversee the banking sector. In order to accomplish this, the
overall practice of supervision must continue to be
strengthened. The willingness and capacity of the Sup.
Authority to identify issues and to take timely and effective
actions must still be demonstrated.
Although the Prud. Sup. Authority has remedial tools at its
disposal; they are not directed at reinforcing the responsibilities
of the board and senior management to prudently oversee the
safe and sound operation of the bank and the consolidated
company. Supervisors cannot remove board members and
senior management. Recourse to remedial actions is predicated

European
non-EU
Switzerland

Norway

or is (at risk of) engaging in any unsafe or unsound practice.
Supervisors enjoy full protection under the civil service acts for
all acts performed in exercising their professional duties. The
MoF is responsible for the licensing and exit policies.

on an institution being in a crisis or pre-crisis mode.

There appears to be a lack of administrative independence with
regard to the Prud. Sup. Authority ´s budget, which is
incorporated into the Finance Ministry's Budget.

The banking Law provides a range of remedial actions,
including the withdrawal of the bank's license. There is no
mechanism for the automatic imposition of administrative or
penal sanctions, as under Swiss law such sanctions require the
conduct of legal proceedings. The proposed amendment to the
banking Law will codify the Prud. Sup Authority ´s current
practices and will explicitly empower it, for instance:
o
To suspend/dismiss managers or directors if bank
solvency is under threat
o
To alter reduce or terminate any activity that poses
excessive risk, or restrict an institution's business
activities; or
o
To impose temporary management and
reorganization measures.
The Prud. Sup. Authority has no explicit legal basis for
publicly disclosing enforcement actions naming institutions and
individuals.
Several remedial tools specifically backed by legal authority
should be added:
o
To force financial institutions to arrange good risk
management practices.
o
To order explicit restrictions on financial institutions. in
unsatisfactory condition withholding approval to open
new offices, expand into new products, or acquire new
businesses
o
To empower Prud. Sup. with authority to set adequate
individual loan loss provisions.

Laws provide a clear framework, objectives and responsibilities
for carrying out bank supervision. However, the institutional
arrangements among MOF and Prud. Sup. Authority need to be
strengthened in order to preserve and increase the actual and
perceived authority and independence of the Prud. Sup.
Authority.

Rest of the
World
Canada

Japan

The banking Law provides legislated authority for the Prud. Sup.
Authority to address compliance with laws and safety and
soundness of banks. Legislation gives Prud. Sup operational
independence. However, the MoF has some formal powers to
overrule the Prud. Sup. Authority on chartering and some
banking policy issues.
Although the removal of responsibility for supervision from the
MoF and the setting up of the unified Sup. Authority was a major
step forward, there appears to be lack of operational
independence. The constitutional framework of the Sup.
Authority -with a minister who effectively has control over the
operations of the supervisor- creates scope for the Sup. Authority
to be subject to political pressures.

Although the Prud. Sup. Authority has a wide array of
sanctions at his disposal; it does not have the authority to bar an
individual from banking once the person has been hired. The
Prud. Sup. Authority is subject to the external control of the
General Accounting Office.
The Sup. Authority is authorized to take an appropriate range
of actions against a bank that requires remedial measures. The
actions range from submission of business improvement plans
to revocation of the license. Sanctions apply also to the board
of directors, auditors and managers for violation of the banking
Law, including failure to observe corrective orders.

Authorities point out that
decisions taken by the MoF will
always be based on a
recommendation from Prud.
Sup. Authority, which always
will be available to an applicant,
and normally will be publicly
available. Thus a decision taken
by the MoF will be much more
transparent than a decision taken
by the Prud. Sup. Authority.

39
Mexico

Korea

Even though the legal framework establishes the Prud. Sup.
Authority as the single authority responsible for banking
regulation and supervision, in reality the regulatory responsibility
is shared with other institutions. This fragmentation of powers
weakens accountability and enforcement of rules and regulations.
Political interference in decision making and budgetary
constrains undermine the operational independence of the Prud.
Sup. Authority.
The operational independence of the. Authority is embodied in
law, however, in practice some practices such as the MoF
interpretations of regulations, have called that independence into
question. The Sup. Authority and its staff lack of statutory
protection against lawsuits for actions performed while
discharging their duties in good faith.

There is a system of prompt corrective action in place that
would allow the Prud. Sup. Authority to take remedial action
in a timely fashion.

There is a full range of remedial actions that can be taken
against banks. However, there is scope to strengthen and
clarify the. Sup. Authority powers to initiate enforcement
actions. The. Sup. Authority is not empowered to remove
employees of financial institutions.

Authorities point out that the
lack of clarity in the roles of
agencies overseeing the financial
sector promotes an effective
system of checks and balances.

(*) Observance of the Basle Core Principles for Effective Banking Supervision. IMF-WB Assessments available in the web site
(http://www.imf.org/external/ns/search.aspx?filter_val=N&NewQuery=basle+core+principles+banking+supervision&col=SITENG&collection=&lan=eng).
These
institutional arrangements may have changed since the date of the assessment.

Benston, George J. and George G. Kaufman (1998) Risk and Solvency Regulation of Depositor Institutions: Past
Policies and Current Options. New York: Salomon Brothers Center, Graduate School of Business, New York
University.

Goldstein, M. (1997) The case for an International Banking Standard. Policy Analyses in International
Economics N. 47 April.
3

Goldstein, M. and Phillip Turner (1996) Banking crises in emerging economies: origins and policy options. BIS
Economic Papers No 46 October.
4

European Shadow Financial Regulatory Committee Statement No. 1, Dealing with problem banks in Europe.
Center for Economic Policy Studies, 22 June, 1998
5

European Shadow Financial Regulatory Committee Statement No.23, Reforming Banking Supervision in Europe .
21 November 2005.
6

Benink, H. and George J. Benston (2005) The future of banking regulation in developed countries: Lessons from
and for Europe. Mimeo.
7

Mayes, D. (2005) Implications of Basle II for the European Financial System Presentation at the Center for
European Policy Studies.

Kane, Edward J. (1985). The Gathering Crisis in Deposit Insurance. Cambridge, MA: MIT Press. provides an
early discussion of the thrift problem. The banking problems of the 1980s, are summarized with an extensive
literature review in Federal Deposit Insurance Corporation (1997) History of the Eighties: Lessons for the Future.
Volume 1: An Examination of the Banking Crises of the 1980s and Early 1990s. Federal Deposit Insurance
Corporation, Washington D.C. 167-188. Also available at <http://www.fdic.gov/bank/historical/history/vol1.html >.
Chapter 4 of Federal Deposit Insurance Corporation (1997) addresses the thrift problems.

Wall, Larry D. (1989) Capital Requirements for Banks: A Look at the 1981 and 1988 Standards. Economic
Review, Federal Reserve Bank of Atlanta, (March/April) 14-29.
10

Federal Deposit Insurance Corporation (ref. 8 above) discusses Continental Illinois failure in Chapter 7, the
problems of banks that served agricultural areas in Chapter 8 and the problems of banks in the Southwestern U.S.
(the primary energy producing region) in chapter 9.

See Chapters 2 and 4 of Federal Deposit Insurance Corporation (ref. 8 above) for a discussion of the 1987 and
1989 legislative acts.

Note, the US has separate insurance funds for commercial banks and savings associations (thrifts). For discussion
of the condition of the FDIC’s insurance fund in 1991 see: See Garcia, Gillian. (1991). The condition of the Bank
Insurance Fund: a view from Washington. Proceedings of a Conference on Bank Structure and Competition. Federal
Reserve Bank of Chicago. pp. 50-69., Litan, Robert E. (1991). Short and long snapshots of the U.S. banking
industry. Proceedings of a Conference on Bank Structure and Competition. Federal Reserve Bank of Chicago. pp.
70-86. Bartholomew, Philip F. and Thomas J. Lutton. (1991). Assessing the condition of the Bank Insurance Fund.
Proceedings of a Conference on Bank Structure and Competition. Federal Reserve Bank of Chicago. pp. 87-111. and
Bovenzi, John F. (1991). BIF: still solvent after all these years? Proceedings of a Conference on Bank Structure and
Competition. Federal Reserve Bank of Chicago. pp. 112-121.
13

The supervisors can take other actions if such actions would better achieve the goal of the act.

For an argument that supervisors routinely imposed many of the restrictions contained in FDICIA prior to its
adoption see Gilbert, Alton R. (1991). Supervision of undercapitalized banks: is there a case for change? Review,
Federal Reserve Bank of St. Louis. (May) pp. 16-30.
15

See Benston, George J. and George G. Kaufman (1988) in ref. 1 above. For a discussion of the intellectual history
of PCA see Benston, G., and Kaufman, G. (1994) The Intellectual History of the Federal Deposit Insurance
Corporation Improvement Act of 1991. In G. G. Kaufman (ed.) Reforming Financial Institutions and Markets in the
United States, p 1-17. Boston: Kluwer.

Table 2 in Benston and Kaufman (1998) gives “Illustrative Reorganization Rules” with mandatory reorganization
at a 3 percent market value of capital-to-asset ratio. However, the text talks about possibility that this ratio should
be revised up.

The Federal Deposit Insurance Corporation Improvement Act (FDICIA) also includes significant changes in the
way deposit insurance premiums are charged and the way the Federal Deposit Insurance Corporation (FDIC)
resolves failed banks (see Chapter 2 of Federal Deposit Insurance Corporation (1997) for a brief summary of the
deposit insurance reform parts of FDICIA. For a more detailed discussion of least cost resolution—especially as
applied to the largest US banks) see Wall, Larry D. (1993). Too-Big-To-Fail' After FDICIA. Economic Review,
Federal Reserve Bank of Atlanta, (January/February) pp. 1-14.
FDICIA replaced the flat-rate deposit insurance premiums that banks had paid since the FDIC was created with
risk-based premiums. In practice, the risk measure used to set the premiums is crude, but it is nevertheless
substantially more accurate than charging all banks a flat rate on deposits. The change in the way the FDIC resolves
banks was contained in language ordering the agency to resolve banks in the way least costly to the insurance fund.
Prior to FDICIA, the FDIC used a cost test in its bank resolutions but applied the test in a way that had the effect of
almost always providing 100 percent deposit insurance for deposits exceeding the de jure coverage limit of
$100,000. FDICIA ordered a change in the cost test that would restrict coverage to $100,000 in almost all cases.
18

PCA does not apply to the corporate owners of banks or their non-bank affiliates. However, the bank subsidiaries
are the dominant assets of almost all holding companies that own banks. As such, the failure of the banking within
the group is likely to trigger the failure of the holding company.

Moreover, the US supervisors set the requirements to be classified as well capitalized under PCA above the
minimum requirements set by Basel 1. Well capitalized banks must have a Tier 1 risk-based capital ratio of 5 %, a
total risk-based capital ratio of 10% and must also meet a minimum leverage (equity capital to total assets)
requirement.

Section 37 of FDICIA. SEIR would have imposed even stricter requirements on regulatory accounting,
mandating the use of market values in the calculation of capital ratios.

The Comptroller General is the head of the General Accounting Office, the investigative arm of the US Congress.

For example, the FDIC Office of Inspector General’s report on material losses incurred at South Pacific Bank may
be found at < http://www.fdicig.gov/reports03/03-036-508.shtml >. In discussing the role of PCA, the report states:
“However, PCA was not fully effective due to the inadequate provision for loan losses that overstated SPB’s income
and capital for several years.”
23

Canada is the only other country in the OECD where the Office of the Auditor General does have similar
responsibilities regarding the Superintendent of Financial Institutions (see www.oag-bvg.gc.ca).

Eisenbeis, Robert A. and Larry D. Wall (2002). The Major Supervisory Initiatives Post-FCICIA: Are They Based
on the Goals of PCA? Should They Be? Prompt Corrective Action in Banking: 10 Years Later edited by George

Kaufman, pp. 109-142. This book is volume 14 of Research in Financial Services: Private and Public Policy
published by JAI.
25

An almost equivalent way of viewing the problem is that of minimizing deposit insurance losses. The differences
between the two arise from the differential treatment of government expenditures outside the deposit insurance
system. A U.S. example of this is the use of tax credit by NCNB to acquire First RepublicBank Corporation in
Texas in 1988. Another way in which such assistance may be provided is via bailouts of bank borrowers to prevent
a bank from failing due to loan losses.

Stern, Gary H. and Ron J. Feldman (2004) Too Big to Fail: The Hazards of Bank Bailouts, The Brookings
Institution, Washington D.C.
27

Mexico: Financial System Assessment Program. International Monetary Fund October, 2001 page 18
(http://www.imf.org/external/pubs/ft/scr/2001/cr01192.pdf).

Hupkes Eva, Marc Quintyn and Michael W. Taylor (2005), The Accountability of Financial Sector Supervisors:
Principles and Practice, IMF Working Paper, March, n.51.

George J Benston and George G Kaufman (1995), Is the Banking and Payments System Fragile? Journal of
Financial Services Research, December, v. 9, iss. 3-4, pp. 209-240.

A recent paper finding evidence that bank failures reduced the value of their borrowers is Brewer, Elijah III,
Hesna Genay, William Curt Hunter, and George G. Kaufman (2003), The value of banking relationships during a
financial crisis: Evidence from failures of Japanese banks, Journal of .Japanese and International Economies, 17
(September) pp. 233–262.
31

Kaufman, George G. (1988), Bank Runs: Causes, Benefits, and Costs, Cato Journal, Winter. 7, No. 3 (Winte),

Eisenbeis and Wall (2002, ref .24 above) point out that the terrorist events of September 11, 2001 caused severe
disruption to US financial system, including the inability to of some financial to accept or route payments, but that a
potential crisis was averted when the Federal Reserve stepped in to provide adequate liquidity. Eisenbeis and Wall
(2002) also argue that the temporary disruptions resulting from a bank’s failure may be reduced by following
appropriate resolution policies. For example, resolution policies may be structured in a way that transfers the viable
operations, insured deposits and other good liabilities to a healthy bank as soon as possible.

The likelihood that more than one bank would become insolvent at the same time is small unless if the banks were
exposed to and suffered losses due to a single shock, such as excessive exposure to interest rate changes.

European Shadow Financial Regulatory Committee Statement No. 1, (June, 1998). See ref. 4 above.

Directive 94/19/EC was primarily designed with the aim of discouraging credit institutions within the EU from
using protection's different features to compete with each other. To this end, it provides for a minimum harmonized
level of protection of small depositors (€20,000 and transitionally below it in some countries that have recently
joined the EU). See Garcia, G. and María J. Nieto (2005) Banking Crisis Management in the European Union:
Multiple Regulators and Resolution Authorities Journal of Banking Regulation Vol. 6 N 3 pp.215-219 for a
description of the features of the EU countries’ deposit protection schemes.

European Shadow Financial Regulatory Committee Statement No. 1, (June 1998). See ref. 4 above.

The sample includes 32 European countries (24 EU members, 6 CEEC, Norway and Iceland). De Cesare,
Manuela ( 2005). Report on Deposit Insurance: An international Outlook, Working Paper 8. Fondo Interbancario
di Tutela dei Depositi.

Italy: Detailed Assessment of the Compliance of the Basle Core Principles of Banking Supervision. International
Monetary Fund. May 2004 (http://www.imf.org/external/pubs/ft/scr/2004/cr04133.pdf).

Llewelyn, D.T. (2002) "Comment" in Prompt Corrective Action: Ten Years Later. G.G. Kaufman, ed.
Amsterdam, JAI, pp. 321-333 (also published in Mayes, D. and D.T. Llewellyn (2003), The role of market discipline
in handling problem banks, Bank of Finland Discussion Papers 21.) See also Carnell, Richard S., 1993. The
Culture of Ad Hoc Discretion, in G. Kaufman and R. Litan (eds.), Assessing Bank Reform: FDICIA One Year Later.
Washington: The Brookings Institution, pp. 113-121.

Horvitz, P. M. (1995) Banking regulation as a solution to financial fragility, Journal of Financial Services
Research, December, pp.369-380.

The CRD covers Pillar II in Articles 123, 124 and Annex XI as well as Article 22 and Annex V, which deal with
internal governance. Directives are binding as regards the results to be achieved and the forms and methods, in
general national legislation, for its achievement are left to member States.
42

Article 124 of the CRD: "1- [T]he competent authorities shall review the arrangements, strategies, processes and
mechanisms implemented by credit institutions to comply with this Directive and evaluate the risks to which the
credit institutions are or might be exposed.
3- On the basis of the review and evaluation referred to in paragraph 1, the competent authorities shall determine
whether the arrangements, strategies, processes and mechanisms implemented by the credit institutions and the own
funds held ensure a sound management and coverage of their risks. "
43

SRP represents the collective views of EU supervisors on the standards that credit institutions are expected to
observe and the supervisory practices that supervisory authorities will apply (http://www.c-ebs.org/pdfs/GL03.pdf,
see page 37).

Bank liquidation is generally as a last resort in the US because it imposes greater costs on the bank’s customers
and destroys any franchise value created by the failed bank. The FDIC acting as receiver will only liquidate a bank
if doing so reduces the expected cost of resolution to the deposit insurance fund.

See Horvitz, P. M. (1995) ref. 40 above.

Mayes, D. G., L. Halme and A. Liuksila (2001) Improving Banking Supervision, Basingstoke. Palgrave.

Hadjiemmanuil, Ch. (2004) Europe´s Universalist Approach to Cross-Border Bank Resolution Issues, presented
at the Conference on Systemic Financial Crisis: Resolving Large Bank Insolvencies, sponsored by the Federal
Reserve Bank of Chicago.
49

FDICIA does add a new requirement for approval of a political authority, the Secretary of the Treasury in
consultation with the President. However, that requirement applies only if the FDIC wants to resolve a bank in a
way that protects otherwise uninsured creditors of the bank at the expense of the insurance fund (often called the
“systemic risk” exception). The FDIC is not required to obtain political approval for resolutions that are in accord
with the least cost resolution provision of FDICIA.

In theory, a requirement for political or judicial approval might not be a problem for effective PCA provided the
approval was promptly and automatically given. However, there would also be no benefit to such a requirement.

The Core Principles were issued by the Basle Committee in September 1997, and endorsed by the international
financial community during the annual meeting of the IMF and World Bank in Hong Kong in October, 1997
(http://www.bis.org/publ/bcbs30.pdf). Observance of the Basle Core Principles for Effective Banking Supervision.
IMF-WB Assessments are available in the web site

(http://www.imf.org/external/ns/search.aspx?filter_val=N&NewQuery=basle+core+principles+banking+supervision&col=SITE
NG&collection=&lan=eng). The present institutional arrangements may have changed since the date of the assessment.
52

See Germany Financial Stability Assessment, November 2003 (p.52)
http://www.imf.org/external/pubs/ft/scr/2003/cr03343.pdf

European Shadow Financial Regulatory Committee Statement No. 1, ref. 4 above.

Observance of the Basle Core Principles for Effective Banking Supervision. IMF-WB Assessments . See ref. 51
above.

However, these special provisions in the US apply only to chartered banks. The nonbank corporate parent and
nonbank affiliates of a US bank are subject to the corporate bankruptcy provisions of US law.

Kaufman, George G. and Steven A. Selig, (2000), Post-Resolution Treatment of Depositors at Failed Banks:
Implications for the Severity of Banking Crises, Systemic Risk and Too-Big-To Fail, Federal Reserve Bank of
Chicago working paper WP 2000-16.

Hüpkes, E. (2003) Insolvency - why a special regime for banks? in Current Developments in Monetary and
Financial Law, Vol.3. International Monetary Fund, Washington DC.

See Table 4 in Garcia, G. H. and M. J. Nieto (2005) ref. 35 above. The potential for delay in providing depositors
with access to their funds could be even greater in the case of "ex post" funded deposit insurance funds.

Dermine, Jean, (1996) Comment, Swiss Journal of Economics and Statistics, (December), 679-682.

Official Journal of the European Communities L125, 5th May, 2001. At the time of writing this article,
implementation was pending in four Member States: Czech Republic, Greece, Portugal and Sweden.

Financial institutions are excluded from the EU Insolvency Proceedings Regulation (Council Regulation EC N0
1346/2000 of 29 May, 2000 on insolvency proceedings) and the Winding-up Directive parallels in the banking field
that regulation governing general corporate insolvency law. The Winding-up Directive does not apply to the
insurance, securities and UCITS activities of the conglomerate.

This development has been possible because of the pre-existence of a heavily harmonized system of banking
regulation and supervision in the EU. EU Policy makers have traditionally relied on regulatory harmonization to
achieve the integration of financial markets. See Garcia and Nieto ( 2005) pp. 209-210 ref. 35 above.

Panagis Pafitis and other v. Trapeza Kentrikis Ellados AE and others (Case C-441/93), CMLR, 9 July 1996.
Mayes, D. G., L. Halme and A. Liuksila (2001) Improving Banking Supervision, Basingstoke: Palgrave.

Bank regulations do not require audited financial statements of banks with less than $500 million in assets and
some smaller banks are not audited.

Dahl, Drew, John P. O.Keefe, and Gerald A. Hanweck (1998), The Influence of Auditors and Examiners on
Accounting Discretion in the Banking Industry, FDIC Banking Review, (Winter), v. 11, pp. 10-25. However,
another study looking specifically at banks that restated their financial condition suggests that examiners have an
impact after taking account of external auditors (albeit the paper only includes a binary audit variable in its model
and does not focus specifically on restatements by banks that have been audited). See Gunther and Moore (2003)
Loss underreporting and the auditing role of bank exams, , Journal of Financial Intermediation 12 (April) pp. 153–
177.

An example of the differences in valuations between those of the bank supervisors and the values in the financial
statements (which were approved by the bank’s auditors) is given by the United States General Accounting Office
(1991) Bank Supervision: OCC's Oversight of the Bank of New England Was Not Timely or Forceful (GAO/GGD91-128, Sept. 16) < http://archive.gao.gov/d19t9/144822.pdf >.
68

Examples of cases where the relevant inspector general criticized the external auditors’ performance or the
supervisor’s reliance on the outside auditor to catch valuation errors or both include: (a) Federal Deposit Insurance
Corporation Office of Inspector General (2003) Material Loss Review of the Failure of the Connecticut Bank of
Commerce, Stamford, Connecticut (Audit Report No. 03-017) < http://www.fdicig.gov/reports03/03-017.pdf >, (b)
United States Treasury Office of the Inspector General (2002) Material Loss Review of Superior Bank, FSB, (OIG02-040), < http://www.treas.gov/inspector-general/audit-reports/2002/oig02040.pdf >, and (c) United States
Treasury Office of the Inspector General (2000)Material Loss Review of The First National Bank of Keystone, OIG00-067 < http://www.treas.gov/inspector-general/audit-reports/2000/oig00067.pdf >.
69

Office of the Comptroller of the Currency (2003), Internal and External Audits: Comptrollers Handbook (April)
< http://www.ffiec.gov/ffiecinfobase/resources/audit/occ-hb-internal_external_audits-intro.pdf >.

Eisenbeis, Robert A., and Larry D. Wall’s (2002) see ref. 24 above.

Japan: Financial Sector Stability Assessment and supplementary information. International Monetary Fund
September 2003 (< http://www.imf.org/external/pubs/ft/scr/2003/cr03287.pdf >).

Directive 2003/51/CE of the European Parliament and of the Council of 18 June, 2003 (Official Journal of the
European Communities L 178/16).

One exception which has been identified by the IMF Financial System Stability Assessment is Germany. See
http://www.imf.org/external/pubs/ft/scr/2003/cr03343.pdf.

Douglas D. Evanoff and Larry D. Wall, (2002) Subordinated Debt and Prompt Corrective Regulatory Action
Prompt Corrective Action in Banking: 10 Years Later edited by George Kaufman, pp. 53-119. This book is volume
14 of Research in Financial Services: Private and Public Policy published by JAI.
75

Douglas D. Evanoff and Larry D. Wall , Sub-Debt Yield Spreads as Bank Risk Measures. Journal of Banking and
Finance, (May 2002) pp. 989-1009.

However, Evanoff and Wall (2002, se ref. 74 above) they also note that the quality of the signal obtained from
subordinated debt may be improved if large banks were required to issue subordinated debt on an annual or semiannual basis.

Benink, H.and George J. Benston (2005) see ref. 6 above.

Bank for Internacional Settlements, (2003), Markets for Subordinated Debt and Equity in Basle Committee
Member Countries, Basle Committee on Banking Supervision. Working Paper No. 12. Benink, H. and George
J.Benston (2005) see ref. 6 above.

Sironi, A. (2001) Testing for Market Discipline in the European Banking Industry: Evidence from Subordinated
Debt. The Financial Safety Net: Costs, Benefits, and Implications for Regulation. The 37th Annual Conference on
Bank Structure and Competition. Federal Reserve Bank of Chicago, pp. 366 - 384.

Full text of Working Papers (Federal Reserve Bank of Atlanta) : Preconditions for a Successful Implementation of Supervisors' Prompt Corrective Action : Is There a Case for a Banking Standard in the European Union?, Working Paper 2006-27

FRASER