An insolvent bank cannot meet its obligations to creditors and depositors. When shareholder equity is insufficient to cover the regulatory capital requirements, a central bank can intervene to avoid a run on the bank. A bank run accelerates the process to wind down the bank while limiting options for recovery and compensation of creditors.
Relatively new to the arena of bank failures is the closure of the financial institution as a result of sanctions violations or weak anti money laundering (AML) controls. The sale of the deposit accounts to another financial institution becomes problematic in such events to safeguard the creditors. This is because there is uncertainty over the legitimacy of specific deposits since the court can only decide on criminal activities.
When a bank is failing or likely to fail, it can be in the best interest of creditors to let a regulator intervene. This intervention results in the activation of the Deposit Guarantee Scheme (DGS) to provide creditors with liquidity and ultimate keep customer confidence intact and prevent panic on the financial markets. After the DGS paid the insured deposits to the qualifying creditors, the regulator need to present the rules of the NCWOL test to the court to request a bail-in or liquidation of the bank. During this process, shareholders of the bank can object against the actions of the regulator and stall the further proceedings to dismantle the bank. The outcome of the NCWOL test can be that healthy business units of the bank, or the full operation is sold to another financial institution. If the NCWOL test concludes that a winding down of the bank is required to achieve maximum creditor compensation, the court can approve the regulatory request.
The winding down of a financial institution can have four directions which are decided on in the best interest of the stakeholders. Special administration, receivership, liquidation and resolution all have specific elements to come to an efficient and orderly closure while assets of the bank are distributed to the creditors. A creditor hierarchy is followed to disperse the available liquidity on a pro rata basis per creditor group. Creditor groups follow a ranking of prioritization where unsecured liabilities, subordinated debt and Tier 1 equity and Tier 2 debt have a lower position than the secured creditors. It must be clarified that bank deposits are guaranteed up to the maximum DGS coverage, whilst the surplus of the balance is unsecured and subordinated in a creditor hierarchy.
Bank failure can be contagious and have systemic effects. To avoid contamination to other financial institutions, the shadow banking market and the economy, regulators bailed-out several financial institutions at the expense of the taxpayer. These rescue missions became untenable over time and the traditional bail-out is adjusted to a bail-in, where creditors participate in the banks losses.