Basel Committee on Banking Supervision

Weak banks are a worldwide phenomenon, presenting challenges for bank supervisors and resolution authorities in all countries, regardless of the political structure, financial system and level of economic and technical development. Bank supervisors must be prepared to minimise the occurrence of weak banks and deal with them effectively when they arise.

For supervision to operate effectively, the proper regulatory, accounting and legal framework, as set out in the Basel core principles for effective banking supervision, must be in place. Supervisors must distinguish clearly between symptoms and causes of bank problems. Early intervention is essential when addressing weak banks to prevent the escalation of problems and mitigate potential risks.

Weak banks often face similar challenges. Insights have been drawn by pooling the experiences of supervisors and resolution authorities, especially the specific actions that have proven effective – or ineffective – in various circumstances. The lack of contingency arrangements and understanding of the tools available for dealing with weak banks have, in some cases, resulted in unnecessary delays in supervisory and resolution actions. These delays have been key contributors to the high costs of resolving banking problems. The Committee believes that appropriate guidance could reduce the costs and spillover effects of these problems.

The following terms are used throughout this chapter and have the meaning given below:

1. Contingency plan: involves preparing for major incidents, formulating flexible plans and organising suitable resources that will come into play in the event of major incidents or business disruption. See also recovery plan.
2. Corrective action: refers to an action required by supervisors to deal with deficiencies and change behaviour in a weak bank. It can be implemented by the bank under the supervisor’s informal oversight or, if necessary, through formal supervisory intervention.
3. Early warning system (EWS): is an empirical model that attempts to estimate the likelihood of failure or financial distress of the bank over a fixed time horizon, based on the bank’s current risk profile.
4. Emergency liquidity assistance: see Lender of last resort.
5. Fit and proper test: refers to the evaluation of the competence, integrity and qualifications of major shareholders, directors and management officials in order to assess their banking skills, other business experience, personal integrity, other relevant skills, and ultimately to determine their suitability for office.
6. Lender of last resort: refers to the central bank’s role as a lender whom banks may ask for emergency liquidity after all other alternatives have been exhausted. On a case by case basis, the central bank may consider the discretionary provision of emergency liquidity, in addition to its normal standing facilities, either to individual banks which are assessed to be illiquid but solvent and viable, or to the market as a whole. To minimise moral hazard and the risk of possible losses of public monies, the central bank will maintain ambiguity as to the exact circumstances in which such lending would be made. Such lending is sometimes referred to as emergency liquidity assistance.
7. Private sector solution: refers to a resolution solution that does not impose a cost on taxpayers and introduces the least amount of distortion in the banking sector. This solution may involve the use of one or more resolution tools.
8. Public sector bank: is a bank that is controlled, directly or indirectly, by the government, including banks that provide special or social services at the direction of the government.
9. Recovery plan: is a specific type of contingency plan which is intended to be embedded in a bank’s business-as-usual risk management framework and capital and liquidity management procedures. As the stress increases and reaches the high end of the continuum, these procedures and associated processes come into effect. Some banks, such as those that are systemically important either domestically or globally, have formal requirements to draw up a robust and credible recovery plan that identifies options for restoring financial strength and viability when the bank comes under severe stress. A recovery plan should include three elements: (i) credible options to cope with a range of scenarios, including both idiosyncratic and market-wide stress; (ii) scenarios that address capital shortfall and liquidity pressures; and (iii) processes to ensure timely implementation of recovery options in a range of stress situations.
10. Resolution: refers to the plan to resolve a bank when a firm is no longer viable or likely to be no longer viable, and has no reasonable prospect of becoming so, typically involving some change to the legal structure and ownership of the bank. The resolution regime should provide for timely and early entry into resolution before a firm is balance sheet insolvent and before all equity has been fully wiped out. There should be clear standards or suitable indicators of non- viability to help guide decisions on whether firms meet the conditions for entry into resolution. Systemically important banks are subject to a resolution planning requirement consistent with the FSB Key Attributes.1
11. Risk-based supervision: refers to supervision based on an assessment of risks. The supervisor assesses the various business areas of the bank and the associated quality of management and internal controls to identify the areas of greatest risk and concern. These areas receive the most intense supervision.
12. Supervisory rating system: is a rating system used by supervisors to reflect in a comprehensive fashion a bank’s financial condition, compliance with laws and regulations, and overall operating soundness. As such, the system helps to identify those banks whose financial, operating or compliance weaknesses require special supervisory attention and/or warrant a higher than normal degree of supervisory concern.
13. Systemic situation: is a situation with serious adverse effects on the general health or structure of the financial system and on financial stability. For example, the failure of a major bank might cause a substantial number of other banks to fail, leading to a loss of confidence in the safety and soundness of a significant sector of the banking system and the disruption of payment services. Systemic problems do not arise only with large banks. They may arise when a number of small banks fail simultaneously or where a small bank has a critical position in a particular market segment.
14. Weak bank: is a bank whose liquidity or solvency is impaired or will soon be impaired unless there is a major improvement in its financial resources, risk profile, business model, risk management systems and controls, and/or quality of governance and management in a timely manner.

This chapter is not intended to serve as a comprehensive supervisory handbook covering all types of preventive action, since many actions should take place in the course of supervision. Rather, the goal of this chapter is to provide guidance on identifying weak banks and addressing their challenges effectively.

This chapter is designed for the supervisory community, including international financial institutions (IFIs) that advise supervisors. It is relevant across a wide range of contexts, whether the institution is a small local bank or a large international banking group, a public or privately owned bank, or a universal bank, financial group, or financial conglomerate. It should be recognised that certain aspects of this chapter may be more suitable to specific types of banks. For example, stress testing requirements are typically more relevant for larger and systemically important banks.

The structure of this chapter reflects the different stages of addressing weak banks. It begins by outlining the guiding principles for supervisors in dealing with weak banks. It then highlights techniques for identifying weak banks, followed by an overview of corrective measures that can help turn around a weak bank.

When dealing with weak banks, supervisory actions aim at preserving the value of the bank's assets with minimal disruption to its operations (ie maintaining the economic entity). These actions are guided by the objective of minimising resolution costs and mitigating systemic impact. However, in certain cases, it may be necessary for the bank, as a legal entity, to cease to exist.

Consistent with the Basel Core Principles, the guiding principles for a supervisor when dealing with weak banks include:

1. Early identification of risk. Supervisors should incorporate forward-looking tools (eg EWS, reviews of governance and management, macroeconomic surveillance and stress testing) to identify weak banks at an early stage.
2. Early intervention. Supervisors should act promptly and intervene at an early stage. Experience from many countries shows that regulatory and supervisory forbearance exacerbates the problems of a weak bank, allowing them to grow rapidly and become more widespread and systemic. It thus makes eventual resolution efforts more difficult and costly (but there may in some circumstances still be a limited role for discretion in the decision to trigger early intervention.
3. Effectiveness. the supervisor must make its best effort, given the available information at its disposal, to consider all costs (including, in the case of a G-SIB, exogenous costs such as instability of the financial system) in deciding on a course of action.
4. Flexibility. Supervisors may flexibly apply recovery measures for a weak bank. Such measures, however, should be strengthened accordingly if earlier recovery measures do not produce the necessary progress on a specified schedule. Moreover, the supervisor should act decisively in concert with the resolution authority when the weak bank reaches the point of non-viability.
5. Clear internal governance processes. Supervisors should design their own governance processes to ensure that their discretionary decisions are taken at a level within the organisational hierarchy that is appropriate to the significance of the issue at hand and with a clear indication of the underlying reasons for the decision. Governance processes may include early warning thresholds. Where these are breached, the supervisory process should also track the reasons behind a decision to defer an action or to lessen the intensity of ordinary supervisory measures.
6. Consistency. Supervisory actions should be consistent and well understood, so as not to distort the competitive environment and to minimise confusion and uncertainty in times of crisis. Actions must be supported by a well functioning supervisory rating system: the ratings should be the basis for subsequent supervisory actions so that similar problems in different banks, large or small, private or state-owned, will receive similar treatment.
7. Transparency and cooperation. Inadequate or incorrect information from the bank increases uncertainty for everyone involved. It can lead to misplaced supervisory action and add to the costs of solving the problems. The bank and the relevant authorities should aim for a high degree of information-sharing and transparency about their intended actions. Decisions on the extent of disclosures, if any, to the wider financial community and the general public are more difficult. These decisions depend on the specific situation and will need to be carefully assessed in each case. A major consideration must be whether the disclosure contributes to the supervisor’s objective in dealing with the weak bank and maintaining broader systemic stability.
8. Avoiding potential systemic problems. To avoid distorting competition in the financial sector, all banks should, in general, be subject to the same supervisory and regulatory framework. This applies in normal times as well as in times of distress. However, a more intensive framework may be applied to systemic banks, for good reasons. Systemic banks have bigger interbank linkages and carry out a wider range of activities, often including cross-border operations. They also tend to be large, so a failure will create greater spillover effects. But systemic problems do not arise only with large banks. They may arise when a number of small banks fail simultaneously or where a small bank has a critical position in a particular market segment.
9. Early preparation. Deterioration in the perceived position of a bank can occur rapidly. For this reason, it is important that supervisors take early preparatory steps to ensure they are well equipped to respond to a crisis situation in a supervised bank. For banks that are systemic, additional preparation for crisis situations, both by supervisors and by banks themselves, is particularly important. Systemic banks should be obliged to draw up recovery plans demonstrating how they would tackle financial crisis situations and which measures they would take to avoid failure. Resolution plans should not assume that taxpayers’ money or a lender of last resort facility from the central bank can be relied on to resolve the bank. Supervisors should be required to identify systemic banks2 and review and challenge banks’ recovery plans, and resolution authorities and supervisors should prepare for the failure of a systemic bank by having resolution plans ready.

It is important to distinguish between the symptoms and causes of bank problems. The symptoms of weak banks are usually poor asset quality, lack of profitability, loss of capital, excessive leverage (eg in excess of the leverage ratio), excessive risk exposure (eg in terms of concentration of risk), reputation problems and liquidity concerns. The different symptoms often emerge together. The causes of weak banks can usually be traced to one or more of the following conditions: an inappropriate business model given the business environment, poor or inappropriate governance, poor decision-making by senior management and/or a misalignment of internal incentive structures with external shareholder/stakeholder interests.

Banking difficulties often arise from a combination of factors, with credit problems being the most common due to lending being central to banking. While strong capital requirements are essential for banking sector stability, they must be complemented by robust liquidity management, as liquidity can deteriorate rapidly and disrupt operations. In addition to credit and liquidity risk, banks’ weaknesses may stem from market, operational, interest rate or strategic risks.

Excessive risk exposures, credit losses, liquidity problems, and capital shortfalls stem from weaknesses in corporate governance3 (eg weak oversight by the board of directors, absence of an effective risk appetite framework), compensation policies (eg those focused on short- term earnings, without risk adjustments) and internal control systems. These shortcomings frequently fail to prevent the following issues:

1. Poor lending practices
   1. Poor underwriting skills or overly aggressive loan expansion programmes.
   2. Absence of incentives to identify problem loans at an early stage and take corrective action.
2. Excessive concentrations
   1. Concentrations in funding, lending, sources of income, and risk across products, business lines, countries, or legal entities, which can destabilise banks.
   2. Lending focused on a single geographical area or industrial sector can lead to simultaneous impairments if those areas or sectors face economic challenges. While diversification reduces this risk, it may pose challenges for specialised or small banks.
   3. Products containing the same types of risk under different labels and in different booking units, such as structured products and off-balance sheet funding structures, can mask exposures and risks.
   4. Overreliance on credit rating agencies and concentrated investments can heighten risks.
   5. Reliance on a narrow range of funding sources, particularly when coupled with concentrations in lending, can be destabilising.
3. Structural liquidity imbalances
   1. Structural weaknesses, such as unsustainable maturity structure, high loan-to-deposit ratios, or low levels of stable funding, can undermine a bank’s liquidity position.
   2. Business models overly reliant on market liquidity often fail to account for liquidity risks.
4. Excessive risk-taking
   1. Speculative trading or other risky behaviours driven by compensation schemes tied to short-term performance (eg short-term increases in the bank's profits, earnings or share price).
   2. Incentives that fail to account for related risks encourage higher risk profiles and underinvestment in critical risk management areas, such as information technology (IT) tools needed to accurately aggregate and monitor risk positions.
   3. A bank's culture oriented towards year-on-year profit increases, governance weaknesses, lack of risk experience and skills among senior executive and non-executive management and insufficient influence of the risk function exacerbate excessive risk-taking.
   4. Risk management frameworks may not evolve at the same pace as financial innovation.
5. Overrides
   1. Limits on concentration, connected lending, value-at-risk exposure of the trading book, and liquidity risk tolerance may be bypassed by dominant individuals or through political interference in public sector banks.
6. Excessive balance sheet growth
   1. Limited oversight of balance sheet growth, and cross-border funding needs.
   2. Banks may fail to price the risk of off-balance sheet vehicles that may need to be funded on the balance sheet, precisely when external funding becomes difficult or expensive.
   3. Boards may lack mechanisms to monitor the implementation of strategic decisions, such as balance sheet growth.
7. Fraud and criminal activities
   1. Fraud or criminal activities and self-dealing by one or more individuals.

External factors such as negative macroeconomic shocks (including a currency crisis, a weak real economy, inadequate preparation for financial sector liberalisation, a massive market liquidity squeeze etc) may also lead to problems for banks. While a well-managed and financially sound bank may withstand these pressures, such external shocks are likely to expose weaknesses in management and control in weaker banks.

When a bank approaches failure, supervisors, in coordination with the resolution authority, should prepare detailed and comprehensive contingency plans to respond promptly to the bank's distress. These plans can draw on a wide range of early intervention instruments that supervisors can use in identifying and dealing with weak banks, including statutory powers and the ability to exercise moral suasion. In drawing up their plans, supervisors must thoroughly understand the limits of these powers and their capacity.

A supervisory contingency plan should encompass a range of scenarios, from distress at a large, systemically important bank to the decline of a smaller bank that can be managed with little disruption. Systemic problems may arise with respect to smaller banks when a number of them become distressed simultaneously or where a small bank has a critical position in a particular market segment.

For non-systemic banks, the supervisor and resolution authority should consider at an early stage whether a detailed, individual resolution plan for the bank, including a resolvability assessment, is needed, or if a range of general scenarios is sufficient.

The supervisory contingency plan should be set according to a risk-based approach and tested regularly. Generally, it should meet the objectives implied by the following actions:

1. mechanisms by which the supervisor will become aware of a weak bank and/or systemic problems;
2. the authority to make decisions relating to the identification and assessment of a weak bank (ie at what point must the supervisor's involvement move from normal oversight to more intensive day-to-day supervision?);
3. arrangements to discuss the problems at the bank with its board and management without delay;
4. arrangements to conduct an in-depth assessment, including the use of independent experts if necessary;
5. arrangements for reporting the assessment findings and who will be informed, inside and outside the supervisory agency;
6. responsibilities for determining the supervisor's detailed course of action;
7. the means of communicating and coordinating supervisory action with other relevant parties (in particular, resolution authorities, finance ministries and central banks);
8. internal coordination between relevant departments;
9. mechanisms for monitoring the success (or otherwise) of supervisory actions and adjusting them as necessary; and
10. adequate financial and staff resources for intense supervision, including arrangements for coordinating with and contributing to an ongoing resolution planning and resolvability assessment process.

In addition to financial information, the supervisor must have rapid access to a wide range of relevant non-financial information about the bank, including its organisational and legal structure, participation in payment systems etc. Some of this information should be kept by the supervisor; the rest (primarily operating data that are frequently changed) should be kept at the bank.

Supervisors should ensure that banks themselves, especially systemic banks, have a credible plan for handling periods of unexpected stress, including episodes that will pose a serious risk to their viability. The recovery plan is drawn up by the bank to identify options to restore financial strength or viability in case of severe stress. Supervisors should review the recovery plan as part of the overall supervisory process, assessing its credibility and ability to be effectively implemented. This should be done in close cooperation with the resolution authorities.

The recovery plan should describe the bank's strategy and organisational setup and the measures available for restoring the bank's financial strength and viability under stress, especially with regard to a capital shortfall and liquidity pressures. It should furthermore comprise credible governance processes and early warning indicators with trigger levels that ensure the timely implementation of recovery measures and the continuous operation of critical services.

Recovery plans should be updated annually, or more frequently if there has been a material change to a firm's business model or structure. The firms should test their menu of recovery options by selecting the appropriate one(s) against a variety of stress scenarios set by the authorities and implied by their business model and risk profile.

Importantly, any sort of financial difficulties (particularly if these are known or suspected in the market) will require the bank to have adequate liquidity to enable it to meet its obligations while the weaknesses are being corrected or other action is taken. Hence, effective and detailed contingency liquidity planning is necessary. Such a plan should, at a minimum, address how to resolve a liquidity crisis triggered by a loss of confidence in the bank itself. The plan should anticipate that the bank may experience difficulties in rolling over its liabilities and demonstrate how it would continue to meet its obligations for a reasonable period of time in such a case. Supervisors should request and regularly examine bank contingency funding plans (or liquidity recovery plans) that provide or activate new funding sources, allow for capital to be raised in a short period of time, or provide for assets to be sold or securitised.

In practice, individual weaknesses rarely occur in isolation. Bank and their supervisors must often address a range of interconnected problems simultaneously. The keys to turning around a weak bank are timely assessment and a comprehensive, credible and proportionate corrective action plan. A deep understanding of the bank’s risk culture and appetite of the bank is essential during this process, as is the ability to effectively challenge management's assumptions. Depending on the circumstances, disclosing that the bank has initiated a corrective action plan may help in maintaining or restoring confidence in the bank.

Distinguishing a common weakness from one that might lead to solvency problems is a complex task. Potential problems are usually connected to the rationale behind the strategy. For large banks, early identification is particularly challenging because the combination of multiple business lines might hide the actual contribution of each facility to overall performance and compromise the early detection of weaknesses. For simpler banks, aggressive plans incompatible with the bank's structure and scale, and rapid growth when associated with historically poor earnings, should be of particular concern.

While improving the capital position addresses the immediate symptom, supervisors should also investigate the root causes of the decline to determine whether additional measures are needed. For instance:

1. In cases of rapidly increasing risk weighted assets, supervisors should assess whether the bank has the financial strength as well as managerial and organisational capacity to handle the new risks.
2. If the reduction in capital is caused by the redemption of low quality capital instruments (eg redemption of subordinated debt), supervisors should determine whether the reduction of capital was voluntary, and evaluate the need to increase the amount of high-quality capital.
3. For operational losses, supervisors should identify the underlying causes of the losses, distinguishing between temporary losses (eg emanating from unexpected market developments) and chronic losses.
4. In cases of exchange rate mismatches, supervisors should assess the bank's foreign exchange risk management practices.

A drop in the bank's capital adequacy ratios below, or close to, the supervisory and/or statutory minimum should trigger formal action by the supervisor against the bank to restore the ratio.

The supervisor's main consideration is whether, and how soon, the bank can restore the level and quality of its capital to an acceptable level. The bank should therefore be required to provide the supervisor with a clear account of how it will restore the capital ratios (eg common equity Tier 1 ratio, total capital ratio) and the time frame, with relevant milestones, for doing so.

It would be prudent for the supervisor to ask for assurances from the bank's major shareholders that they continue to support the bank and are prepared to contribute to restoring the capital position by means of capital injection if the bank's position deteriorates further.

If the existing shareholders are unable to provide the necessary capital injection, other options can be considered, such as:

1. selling or securitising assets, thereby reducing the capital needed to support the business;
2. replacing assets to lower the portfolio's risk weight;
3. cutting operating costs and capital expenditure, including bonuses to managers and directors;
4. limiting or restricting the payment of dividends and variable compensation;
5. restricting the redemption of subordinated debt or other instruments; and
6. bringing in a new shareholder who can contribute new capital.

A less obvious problem involves a capital adequacy ratio that drops (eg because of a loss) to a level below what the market expects, but remains above the supervisory and/or statutory minimum. This may affect confidence in the bank, particularly if there is an expectation that the ratio may fall further in the future.

Some banks have demonstrated limited understanding of, or control over, their potential balance sheet growth and liquidity needs. This has led to failures in pricing the risk of off-balance sheet vehicles that may need to be funded on-balance sheet during times of market stress. In such circumstances, a capital injection to restore the capital adequacy ratio to pre-loss levels may be necessary to reassure depositors and the broader market of the bank’s stability. Supervisors must closely coordinate with the bank’s management to address these issues effectively.

Asset quality problems can become serious in different ways. Provisions and write-offs can result in the bank incurring losses, leading to a reduction in its capital adequacy ratio. This is one of the most common reasons for a decline in a bank's capital strength. But even if the bank continues to make a profit, poor asset quality can still pose problems for four main reasons:

1. If the problem is not dealt with by proper problem loan management, the loan write-offs are likely to remain large or even escalate.
2. Problem loans in excess of the industry norm may indicate not only poor credit underwriting standards, but in all likelihood poor management, which may be a warning of incipient problems elsewhere.
3. Public and market knowledge of the bank's relatively poor performance on asset quality may affect confidence in the bank, leading to deposit withdrawal or increased cost of funding.
4. Asset encumbrance may limit the options in recovery and resolution, as there are fewer unsecured creditors and less collateral available to deal with liquidity risks. Supervisors may wish to consider how encumbered the assets of the bank are when considering what action to take when the bank becomes weak.

For asset quality problems, on-site examinations are usually the most useful way of evaluating the extent of the problem. The examination should focus on whether problem loans are being identified promptly, whether the bank has a dedicated problem loan management/recovery unit that is operating effectively, whether problem loans are being classified correctly and whether adequate provisions are being set aside.

On asset quality reviews, the supervisor needs to ensure that these are forward-looking, considering macroprudential analyses. The supervisor is likely to be able to make use of: (i) peer group comparisons (eg experience from other on-site examinations); and (ii) stress testing to gauge the scale of the problem and the particular areas of concern. Supervisors are increasingly requiring some larger banks and banks with significant concentrations to do stress testing as a routine management practice.

A bank with asset quality problems should devise an appropriate remedial action plan. This may include:

1. negotiating new agreements with its viable but weak debtors (eg through loan maturity extensions, interest rate reductions, partial debt forgiveness and debt-to-equity swaps);
2. taking possession of loan collateral or other debtor assets;
3. writing off long-term problem loans; and
4. selling assets or transferring them to a special purpose debt management vehicle – although the supervisor should determine that such transactions are not designed only to remove low-quality assets as a form of regulatory arbitrage.

In practice, however, certain principles apply no matter what approaches the bank takes. First, the bank needs a realistic assessment of its current asset quality and should not be tempted to hide the problem by entering into cosmetic restructurings with insolvent debtors. Second, it needs to put resources into strengthening its problem loan management unit so that it can boost recoveries. Third, it needs to be prepared to "bite the bullet" on provisioning. Prolonged problems with asset quality cast a shadow over the bank. To be effective, provisions must be determined on the basis of the short-term realisable value for collateral, or a conservative present value estimate of the borrower's likely repayments, not on longer-term, potentially optimistic projections of future value. If the bank has the resources or can secure additional resources (for example, by capital injection), it is preferable to try to clean up the balance sheet as expeditiously as possible. This may, however, result in the bank suffering a large reduction in profitability and capital.

The supervisor will almost certainly expect the bank to set targets in terms of a reduction of problem loans to a certain level by a particular time and will want to monitor the progress the bank is making by means of on-site visits or reports by the bank's external or internal auditors.

Beyond dealing with the immediate problem, the supervisor should also ensure that the bank fully reviews its processes for credit assessment, credit approval and credit monitoring. Weaknesses in these will almost certainly have played a large part in the general asset quality problem.

Supervisors do not select senior management for banks, but they should be responsible for evaluating the expertise and integrity (the “fit and proper" test) of proposed directors and senior management, and they should prevent or discourage appointments they deem detrimental to the interests of depositors. They may require one or more members of the management body or senior management to be removed or replaced if they are found unfit to perform their duties or deemed detrimental to the interests of depositors. Supervisors should also evaluate directors and senior managers as part of the regular supervision of the bank. Moreover, supervisors should ensure that a bank’s corporate governance structure provides appropriate incentives that support the bank’s business plan; the governance structure should clearly communicate risk limits and expectations for integrity throughout the organisation. Supervisors should also understand the bank’s management succession plans and opportunities.

If the supervisor is of the view that an employee is not up to the job, as indicated by the bank's performance, it may be difficult in many jurisdictions for the supervisor to formally request the removal of the employee in the absence of fraud or massive incompetence. In such situations it may be more effective for the supervisor to discuss the quality of management with the board of directors or the major shareholders of the bank and to seek their voluntary commitment to strengthening management. The emphasis should be on bringing in strong individuals with the skills the bank needs in key positions – eg CEO, financial controller or head of credit – or consultants to boost the performance of the existing team.

As a last resort, if the law permits, a supervisor may appoint an individual to run the affairs of the bank temporarily for the purpose of seeking solutions to the difficulties encountered. The appointment should be made in a manner that does not give the impression that the responsibility of bank management has shifted to the supervisor.

Deteriorating earnings must be addressed, as they will lead directly to reduced liquidity and weaker solvency. Banks must be required to reduce or restructure unprofitable activities (eg close branches) and to reduce costs (eg cut bonuses and salaries and/or the number of employees). If the problems are severe, a significant reorganisation of the bank may be necessary. In parallel, other actions must be taken to turn around its earnings, such as changes to the business model and operating plans.

Supervisors and banks alike should consider operational limitations to the transferability of liquidity. They should ensure that during economically stressed periods, liquidity is maintained in a quantity sufficient to comply with legal and regulatory restrictions on the transfer of liquidity among regulated entities.

Supervisors' liquidity requirements may differ in terms of how required minimum levels of liquidity are expressed. A decline in liquidity below the required minimum will normally trigger a series of actions by the supervisor, such as requiring the bank to indicate how, and when, it plans to restore its liquidity to an acceptable level. Corrective measures must first strengthen the short-term resilience of the bank's liquidity risk profile by ensuring that it has sufficient high-quality liquid assets to survive a stress scenario. Further, the bank should implement structural measures to promote resilience over a longer time horizon (eg increasing the most stable components of funding, reducing the loan-to-deposit ratio).

If a bank is unable to restore its liquidity position, or the position shows signs of weakening further, prompt action is critical. To facilitate such action, the supervisor should require the bank to prepare detailed cash flow projections that would allow it to continue at least to the end of the business week, at which time the supervisor would decide whether the bank should reopen in the following week. Stress tests should be carried out based on these projections to give a better idea of how long the bank's liquidity can last if the liquidity losses continue or accelerate.

Stress tests and scenario analyses aim to identify potential weaknesses or vulnerabilities in a bank's liquidity position, enabling changes to be put in place to counter those weaknesses (eg a diversification of funding sources or an increase in contingent liquidity sources). The testing helps identify and quantify the depth, source and degree of potential liquidity and funding strain, and to analyse possible effects on the bank's cash flow, liquidity position, costs and other aspects of its financial condition over various time horizons.

The bank can take several actions to improve its liquidity position. First, as regards withdrawals and assuming the bank's underlying position is healthy, it can issue statements to reassure the public, and it may wish to address large depositors directly. Second, as regards its liquidity stock, it can try to secure lines from counterparts or sell or repurchase assets so as to boost liquidity. It can also seek liquidity support from its major shareholders.

Private sector mechanisms should usually be exhausted before any emergency liquidity assistance from the central bank is considered, partly to reduce moral hazard and partly to minimise the risk of losing public funds. To reduce the risk of losing public funds, collateral should be required, if possible, for emergency liquidity assistance. Depending on the circumstances, the central bank may wish to help restore confidence by issuing a statement confirming that it stands ready to provide liquidity support in the current case and in other cases should it be necessary to maintain financial stability.

The bank's risk management processes must be adequate to address all risks that the bank is facing.

Bank management has a duty to establish prudent risk limits in relation to its financial strength and risk management capabilities and routinely monitor these limits and take prompt corrective action if the risk threatens the financial condition of the bank.

Similarly, in cases where systematic/operational deficiencies in operational areas lead to large losses, erosion of public confidence and possibly insolvency. Supervisors must require the bank to address the deficiencies promptly.

More generally, banks should also have business resilience and continuity plans in place to limit losses in the event of business disruption. Banks are exposed to disruptive events. Some of these events may prevent the bank from fulfilling some or all of its business obligations. To provide resilience against these risks, a bank's business continuity plans should be commensurate with the nature, size and complexity of its operations. Such plans should consider different types of likely or plausible scenarios to which the bank may be vulnerable.4

When a bank cannot resolve its weaknesses on its own, it should consider a private sector solution. This may consist of a merger or acquisition. Banks, even those that fail, are attractive targets to investors, especially financial institutions, because of their intrinsic franchise value.5

Arrangements for a merger or acquisition should take place early, ie before the bank fails and enters resolution, and may be facilitated by the supervisor. In some cases, owners and certain creditors may have to make concessions to attract acquirers. Acquirers should have capital sufficient to acquire and run the new bank and a management team capable of implementing a reorganisation programme. If the acquirer is a foreign bank, the supervisor faces additional concerns, such as the laws and regulations of the relevant foreign jurisdictions. The supervisor will also need to coordinate closely with foreign authorities to learn about the acquirer and its related activities.

Authorities should keep in mind that, even in good times, mergers and acquisitions (M&As) are not easy for the institutions involved. This stems from different corporate cultures and jurisdictional legal requirements, the incompatibility of IT systems, the need for personnel layoffs etc. The integration of staff and information systems must be very carefully thought through in any merger plan.

The interested acquiring institution should have a clear understanding of the underlying causes and problems of the weak bank. Full and accurate information should be provided by the weak bank to all potential acquirers, although this may have to be provided sequentially and under strict confidentiality agreements.

Owners of a weak bank who are trying to sell their stake to minimise their own personal losses will generally not attach great importance to the identity of the prospective buyers. These circumstances may open the way for some potential buyers who may be less interested in the banking operations of the bank than in its legal title and registration. Such buyers may wish to misuse the bank (eg for money laundering) or use it for other business interests that may jeopardise the bank’s continuing existence. In accordance with the Basel Core Principles, supervisors are obliged to check the reliability of any new shareholder and have the power to reject applicants. Supervisors should use these powers uncompromisingly.

The advantages of an M&A solution are that it:

1. maintains the weak bank as a going concern and helps preserve the value of the assets (thereby reducing the cost to the government or deposit insurer); and
2. minimises the impact on markets, as there are fewer disruptions in banking services to customers of the weak bank.

In an M&A transaction, the supervisor should actively monitor the problems in the acquired bank and take steps to require that they be adequately addressed by the management of the resultant bank.

The exercise of resolution actions and powers is the responsibility of the resolution authority; however, supervisors should be aware of bank-specific resolution issues and cooperate closely with the resolution authority during their day-to-day supervision.

The Financial Stability Board’s Key Attributes of effective resolution regimes for financial institutions (Key Attributes), is the international standard for resolution regimes and sets out the core features of effective resolution regimes for financial institutions that are, or could be, systemically significant if they fail.