A Special Insolvency Regime for Banks

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This is the second of five articles in the Bank Resolution series:

1. Financial Crises and Regulatory Responses
2. A Special Insolvency Regime for Banks
3. Bank Capitalization and Early Warnings
4. Systemic Importance of Banks; Resolution Alternatives
5. Bank Resolution Techniques

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Intro

The Mexican bank resolution framework recognizes the unique role that banks play in the economy and the special nature of bank insolvency. It also understands that subjecting bank bankruptcies to common commercial laws would be inappropriate given the unique effects that a bank failure can have on a country's economy. This special regime is designed to address the particular characteristics of banks and their importance to the overall economic system.

Why Bank Require a Special Regime

The justification for a special insolvency regime for banks rests on three key characteristics that distinguish banks from other businesses:

• Liquidity Mismatch: Banks hold highly liquid liabilities in the form of deposits that are repayable on demand, while their assets are typically long-term loans that are difficult to liquidate quickly. This mismatch creates a vulnerability to bank runs, where a loss of confidence can lead to mass withdrawals that the bank cannot meet.

• Financial Intermediation: Banks perform a crucial financial intermediation service, acting as the conduit between savers and borrowers. This function is fundamental to the efficient allocation of financial resources in the economy.

• Systemic Risk: The failure of a bank can potentially trigger a chain reaction of defaults throughout the economy, as depositors and other banks connected to the failed institution become unable to meet their own obligations.

The Three Pillars

Given these characteristics of banks, their insolvency regime in Mexico is built upon three pillars:

• Protection of Depositors' Interests: This pillar aims to maintain public confidence in the banking system by ensuring that depositors' funds are safeguarded to the greatest extent possible.

• Soundness of the Payment System: This pillar focuses on maintaining the integrity and functionality of the payment system, which is crucial for the day-to-day operations of the economy.

• Prevention of Systemic Risk: This pillar aims to prevent the failure of one bank from cascading through the financial system and broader economy.

These pillars often come into conflict with each other and with other principles of insolvency law, such as equal treatment of creditors or asset maximization. As a result, lawmakers and regulators must often make difficult compromises in designing and implementing the insolvency regime.

Preventive and Remedial Tools

The special insolvency regime for banks in Mexico encompasses both preventive and remedial tools.?

• Preventive Tools: Preventive tools are designed to keep banks from becoming insolvent in the first place. These include capitalization requirements, liquidity requirements, loan loss reserves, asset allocation and risk management rules, deposit insurance, executive compensation rules, central bank last resort loans, and payment systems rules.

• Remedial Tools: Remedial tools, on the other hand, come into play when a bank is already in financial distress. These tools are designed to resolve the situation in a way that minimizes disruption to the financial system and protects depositors. The specific remedial tools used depend on factors such as the size of the bank, its importance to the financial system, and the extent of its financial difficulties.

Conclusions

This special insolvency regime represents a delicate balance between various competing interests. On one hand, it seeks to maintain financial stability and protect depositors. On the other hand, it must also respect principles of fairness and avoid creating moral hazard by being too protective of banks or their managers.

The existence of a special regime for bank resolution underscores the critical role that banks play in the modern economy. By providing a framework for dealing with bank failures that prioritizes systemic stability and depositor protection, it helps to maintain confidence in the banking system and support overall economic stability.?

The regime, however, faces ongoing challenges., These challenges include the need to adapt to new financial products and evolving systemic risks, highlighting the need for continued vigilance and adaptation in financial regulation.

The complete version of the article from which this series was taken can be found here