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The case for a second look at Canadian bank insolvency legislation 1985

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THE CASE FOR A SECOND LOOK AT CANADIAN BANK INSOLVENCY LEGISLATION By MARY LOUISE RUHL B.A. The University of Toronto, 1981 L.L.B. The University of Toronto, 1984 A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF LAWS i n THE FACULTY OF GRADUATE STUDIES (Faculty of Law) We accept t h i s thesis as conforming to the required standard THE UNIVERSITY OF BRITISH COLUMBIA OCTOBER, 1987 © Mary Louise Ruhl, 1987 In presenting this thesis in partial fulfilment of the requirements for an advanced degree at the University of British Columbia, I agree that the Library shall make it freely available for reference and study. I further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the head of my department or by his or her representatives. It is understood that copying or publication of this thesis for financial gain shall not be allowed without my written permission. Department of The University of British Columbia 1956 Main Mall Vancouver, Canada V6T 1Y3 DE-6(3/81) i i ABSTRACT This thesis i s an analysis of the bank insolvency process i n Canada. The phenomenon of bank bailouts i s examined and three possible r a t i o n a l e for bailouts are put f o r t h . The conclusion i s reached that bank bailouts can be j u s t i f i e d on the basis of these ra t i o n a l e , and, therefore, that bank insolvency l e g i s l a t i o n should recognize the b a i l o u t process and provide an adequate and appropriate framework for t h i s process. Three recent bank f a i l u r e s , Canadian Commercial Bank, Northland Bank and the Bank of B r i t i s h Columbia, are discussed, with p a r t i c u l a r emphasis on the d i f f e r e n t b a i l o u t tools used by the government i n each case. These case studies are used as a framework within which to assess current Canadian bank insolvency l e g i s l a t i o n . The conclusion i s reached that the l e g i s l a t i v e framework i s inadequate to deal e f f e c t i v e l y with bank insolvency. By examining the American approach to bank insolvency and two recent Canadian studies on the subject, a model for reform i s proposed. The model contemplates a more highly- structured l e g i s l a t i v e framework, with broad powers granted to the deposit insurer to implement a ba i l o u t i n circumstances which j u s t i f y t h i s form of government intervention. F i n a l l y , t h i s model i s used as a basis on which to evaluate recent f i n a n c i a l sector reform i n i t i a t i v e s made by the federal government. i i i TABLE OF CONTENTS Heading Page Number A b s t r a c t i i I n t r o d u c t i o n 1 Chapter 1. Cause f o r Concern? 5 Chapter 2. R a t i o n a l e f o r Bank B a i l o u t s 14 1. Consumer P r o t e c t i o n 15 a) D e p o s i t o r s 16 b) Shareholders 23 c) Bank C r e d i t o r s 25 2. S t a b i l i t y o f the F i n a n c i a l System 2 6 3. P o l i t i c a l B e n e f i t 29 4. A d d i t i o n a l F a c t o r s i n the B a i l o u t 34 D e c i s i o n a) Market D i s c i p l i n e 34 b) C o s t - E f f i c i e n c y 37 Chapter 3. Canadian Bank In s o l v e n c y 39 L e g i s l a t i o n 1. R e g u l a t o r y Framework 39 a) The Bank of Canada 42 b) Department of Finance 42 c) O f f i c e o f the I n s p e c t o r General o f 4 3 Banks d) Canada Deposit Insurance C o r p o r a t i o n 44 2. L e g i s l a t i v e Framework 46 a) Bank A c t 4 6 b) Winding-up A c t 47 c) Canada Deposit Insurance C o r p o r a t i o n 48 A c t 3. Case S t u d i e s 51 a) Canadian Commercial Bank 51 b) N o r t h l a n d Bank 57 c) Bank of B r i t i s h Columbia 59 Chapter 4. E v a l u a t i o n of Bank In s o l v e n c y 63 L e g i s l a t i o n 1. P a y o f f o f Uninsured D e p o s i t o r s 64 2. Merger 65 3. Rescue Packages 69 Chapter 5. American Approach t o Bank 79 Ins o l v e n c y : The FDIC Model 1. L i q u i d a t i o n and Payoff 82 2. Purchase and Assumption T r a n s a c t i o n 84 3. D i r e c t F i n a n c i a l A s s i s t a n c e 93 i v Chapter 6. Canadian Proposals for Reform 101 1. Wyman Report 101 a) Proposals re: Structural Reform 101 b) Proposals re: Functional Reform 102 . 2. Estey Report 108 a) Structural Recommendations 108 b) Functional Recommendations 110 Conclusion: A Model for Reform 114 Chapter 7. Recent Federal Reform of Canadian 117 F i n a n c i a l Market Regulation 1. L e g i s l a t i v e Framework 117 a) O f f i c e of the Superintendent of 118 F i n a n c i a l I n s t i t u t i o n s b) Canada Deposit Insurance Corporation 119 Act c) Bank Act 122 2. Evaluation of Federal Reforms 123 a) Structural Aspects of Reform _ 124 b) Functional Aspects of Reform 12 6 Conclusion 129 Bibliography 131 1 THE CASE FOR A SECOND LOOK AT CANADIAN BANK INSOLVENCY LEGISLATION INTRODUCTION In the f a l l of 1985, the Canadian f i n a n c i a l system was rocked by i t s f i r s t bank f a i l u r e s since the co l l a p s e of the Home Bank of Canada i n 192 3. On September 1, 1985, the Department of Finance announced that curators would be appointed to supervise the business and a f f a i r s of the Canadian Commercial Bank and the Northland Bank. 1 Both banks were eventually l i q u i d a t e d . These f a i l u r e s were not i s o l a t e d events. In the l a s t two years, four other Canadian banks have been forced to merge with more v i a b l e i n s t i t u t i o n s i n order to survive: Continental Bank merged with a Canadian subsidiary of Lloyds Bank of London; Mercantile Bank of Canada merged with The National Bank of Canada; Morguard Bank was taken over by Security P a c i f i c Bank, a wholly-owned subsidiary of Security P a c i f i c Corp. of C a l i f o r n i a ; and the Bank of B r i t i s h Columbia sold s u b s t a n t i a l l y a l l of i t s assets t o the Hongkong Bank of 1 Canada, Estey Commission, Report of the I n q u i r y i n t o the Collapse of the CCB and Northland Bank (Ottawa: M i n i s t e r of Supply and Services, August, 1986) at 352 [hereinafter "Estey"]. 2 Canada. F o r t h e f i r s t time i n many decades, the Canadian government has had t o e x e r c i s e i t s l e g i s l a t i v e j u r i s d i c t i o n o v e r banks f a c e d w i t h a c t u a l o r t h r e a t e n e d i n s o l v e n c y . I t i s my t h e s i s t h a t t h i s e x p e r i e n c e has i l l u s t r a t e d t he inadequacy o f Canadian bank i n s o l v e n c y l e g i s l a t i o n . Assuming f e d e r a l r e g u l a t o r y i n s t i t u t i o n s w i l l f a c e more bank i n s o l v e n c i e s i n the f u t u r e , a s t r o n g argument can be made t h a t b r o a d e r and more f l e x i b l e powers a r e r e q u i r e d t o cope w i t h t h e s e i n s o l v e n c i e s . In p a r t i c u l a r , t h e power t o arr a n g e and s u b s i d i z e mergers o f t r o u b l e d banks w i t h v i a b l e i n s t i t u t i o n s o r t o e s t a b l i s h government a s s i s t a n c e programs which w i l l r e s t o r e i n s o l v e n t banks t o h e a l t h y o p e r a t i o n i s needed. In a r r i v i n g a t t h i s c o n c l u s i o n , t h i s paper w i l l p r o c e e d a l o n g t h e f o l l o w i n g c o u r s e : 2 1. I t w i l l be argued t h a t t h i s a r e a o f l e g i s l a t i o n i s i n immediate need o f re f o r m due t o t h e f a c t t h a t Canada, i n a l l l i k e l i h o o d , can expect more bank f a i l u r e s i n t h e f u t u r e ; 2. J u s t i f i c a t i o n s f o r government r e g u l a t i o n o f banks and, i n p a r t i c u l a r , f o r government i n t e r v e n t i o n i n ca s e s o f d i s t r e s s e d o r i n s o l v e n t banks w i l l be examined; 2 I t s h o u l d be noted t h a t a r e c e n t s p a t e o f i n s u r a n c e and t r u s t company f a i l u r e s has p a r a l l e l e d t h o s e o f the banks. See Economic C o u n c i l o f Canada, A Framework f o r F i n a n c i a l R e g u l a t i o n : A Research Report Prepared f o r the Economic C o u n c i l o f Canada:1987 (Ottawa: M i n i s t e r o f Supply and S e r v i c e s , 1987) a t 47 ( t a b l e 4-1) [ h e r e i n a f t e r "Economic C o u n c i l o f Canada, 1987"] f o r d e t a i l s o f t h e s e f a i l u r e s . A l t h o u g h t h e powers needed by r e g u l a t o r y a g e n c i e s t o d e a l w i t h the f a i l u r e s o f t h e s e o t h e r t y pes o f f i n a n c i a l i n s t i t u t i o n s a r e i n many ways comparable t o the powers needed i n t h e c o n t e x t o f bank f a i l u r e s , t h i s paper w i l l be r e s t r i c t e d t o an examination o f bank f a i l u r e s . 3 3. Canadian bank insolvency l e g i s l a t i o n as i t existed p r i o r to July, 1987, w i l l be ou t l i n e d and i t s operation examined i n the context of case studies of three banks: Canadian Commercial Bank ("CCB"), Northland Bank ("Northland") and the Bank of B r i t i s h Columbia (Bank of B.C); 4. The adequacy and appropriateness of Canadian bank insolvency l e g i s l a t i o n w i l l be evaluated and the conclusion reached that reform i s e s s e n t i a l ; 5. In attempting to develop a model f o r such reform, the American approach to bank insolvency w i l l be examined and compared to the Canadian approach; 6. The model w i l l be further developed by examining proposals on the Canadian banking sytem put f o r t h i n two studies commissioned by the fed e r a l government. Conclusions w i l l be reached on the d i r e c t i o n s which reform should take, and a model f o r such reform w i l l be proposed; 7. F i n a l l y , the conclusions reached i n chapter 6 w i l l be used to assess f i n a n c i a l sector reforms introduced i n two recent pieces of federal l e g i s l a t i o n : An Act to Amend Certain Acts Relating; to F i n a n c i a l I n s t i t u t i o n s (S.C. 1987, c.26) and the F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance System Amendment Act (S.C. 1987, c.23) . 4 CHAPTER 1. CAUSE FOR CONCERN? Unless the Canadian f i n a n c i a l system can be expected to s u f f e r more bank f a i l u r e s i n the future, an argument i n favour of expanded government powers to deal with such f a i l u r e s becomes a moot point. A v a r i e t y of reasons has been c i t e d f o r the bank f a i l u r e s which have occurred since 1985, i n c l u d i n g : inadequate management, lack of d i v e r s i f i c a t i o n i n loan p o r t f o l i o s , and the recession which h i t Western Canada i n 1981. 3 Undoubtedly, each f a i l u r e , when examined on i t s f a c t s , can be explained by the i n t e r a c t i o n of a number of c o n t r i b u t i n g f a c t o r s . I t i s submitted, however, that many of these f a c t o r s are merely symptoms of an underlying causal f a c t o r : the f e d e r a l government's recent p o l i c y of increasing competition among Canadian f i n a n c i a l i n s t i t u t i o n s . Between 1923 and the mid- 1960 's, the Canadian banking industry experienced r e l a t i v e s t a b i l i t y . The number of banks remained f a i r l y constant (11 at the end of 1925 to a low of 8 i n 1961; with the formation of only one new bank— the Mercantile Bank of Canada i n 1953). 4 In the mid-1960's, the fe d e r a l government embarked on a p o l i c y of increasing competition i n the f i n a n c i a l s e c t o r — a p o l i c y which remains a p r i o r i t y of the government's f i n a n c i a l sector p o l i c y today. The development of t h i s p o l i c y i s traced below. The approach has been to increase the number of banks i n the marketplace (and thereby 3 Economic Council of Canada, 1987, supra, note 2 at 46-49. 4 Estey, supra, note 1 at 359-363. 5 increase competition among banks) and to deregulate the f i n a n c i a l sector by breaking down the t r a d i t i o n a l four p i l l a r s , thereby increasing competition between banks and other f i n a n c i a l i n s t i t u t i o n s . The e f f e c t has been an increasi n g number of bank f a i l u r e s . I t i s the small banks which have tended to f a i l , due to the tendency of small banks to lack adequate loan d i v e r s i f i c a t i o n and a broad base of d e p o s i t s . 5 These c h a r a c t e r i s t i c s can be viewed as manifestations of competition rather than the actual cause of f a i l u r e . For example, reasons c i t e d by the Estey Commission i n i t s report of August, 1986 (the "Estey Report") f o r the f a i l u r e of the CCB included poor lending p r a c t i c e s , 6 and inadequate loan d i v e r s i f i c a t i o n . 7 I t can be argued that these c h a r a c t e r i s t i c s of the CCB were symptomatic of the competition faced by the bank when i t was formed. The bank attempted to occupy a niche which was considered unoccupied by the estab l i s h e d banks but, i n retrospect, was not. 8 In order to create business and thereby compete with the establi s h e d banks, the CCB was forced to lend where these banks refused to lend (thereby c r e a t i n g i t s own market). 9 I t i s submitted that i t was t h i s need to compete and f i n d an unoccupied niche that necessitated the cr e a t i o n of a high- 5 Coopers and Lybrand, A Study to Assess the Current Mandate and Operations of the Inspector General of Banks (Toronto, 1986) at 29 [hereinafter "Coopers and "Lybrand"]. 6 Estey, supra, note 1 at 11. 7 Ibid, at 417. 8 Ibid, at 2. 9 Ibid, at 71. 6 r i s k loan p o r t f o l i o which could not withstand the recession i n Western Canada and u l t i m a t e l y l e d to the CCB's co l l a p s e . . The regulatory approach of increasing competition i n the f i n a n c i a l sector emerged i n 1964 with the p u b l i c a t i o n of the Royal Commission on Banking and Finance (the "Porter Commission"). The Porter Commission proposed a comprehensive reform of Canadian f i n a n c i a l markets, s t r e s s i n g e f f i c i e n c y and innovation. I t recognized that i f competition among f i n a n c i a l i n s t i t u t i o n s was to be encouraged, the r e s t r i c t i o n s on the a b i l i t y of banks to compete would have to be removed. 1 0 Many of the Porter Commission's proposals were implemented i n the 1967 r e v i s i o n s to the Bank Act. The e f f e c t of t h i s Act was to grant banks greater freedom to compete. For example, i t permitted banks to make conventional mortgage loans, allowed f o r the removal of the c e i l i n g on bank loan rates i n three stages, l i m i t e d bank investments i n t r u s t companies i n order to prevent further concentration i n the f i n a n c i a l sector, and prevented i n t e r l o c k i n g d i r e c t o r s h i p s and c o l l u s i v e behaviour between banks and other f i n a n c i a l i n s t i t u t i o n s . 1 1 In 1976, the White Paper on the Revision o f Banking L e g i s l a t i o n reaffirmed the government's commitment t o increase competition i n the f i n a n c i a l sector: 10 H.H.Binhammer, Money, Banking & the Canadian F i n a n c i a l System (Toronto: Methuen Publications, 1968) at 137. 11 Canada, Department of Finance, The Regulation o f Canadian F i n a n c i a l I n s t i t u t i o n s : Proposals f o r Discussion (Ottawa: M i n i s t e r of Supply and Services, A p r i l , 1985) [hereinafter the "Green Paper"] at 22. 7 [Competition] remains the basic underlying objective of the government i n i t s approach to banking l e g i s l a t i o n . . . An adequate l e v e l of competition w i l l help to ensure that banking services are provided, throughout the nation, at the lowest cost to borrowers and the highest return to savers that are consistent with the s u r v i v a l and healthy growth of the country's f i n a n c i a l system. 2 . The r e v i s i o n s to the 1980 Bank Act further r e f l e c t e d t h i s p o l i c y of increased competition by easing the b a r r i e r s of entry i n t o the banking system. The new Act encouraged the formation of new banks i n several ways. For example, i t made i t e a s i e r f o r Canadians to s t a r t a bank by permitting incorporation by l e t t e r s patent (no longer r e q u i r i n g a p r i v a t e member's b i l l ) . I t also permitted wholly-owned fo r e i g n bank s u b s i d i a r i e s to operate i n Canada as chartered banks and allowed newly-formed domestic banks to be c l o s e l y - held f o r ten years i n order to give them a chance to grow and become new sources of competition. The e f f e c t of the 1980 Bank Act was summed up i n the Department of Finance's, The Regulation of Canadian F i n a n c i a l I n s t i t u t i o n s of A p r i l , 1985 (the "Green Paper") as follows: A l l of these measures had the e f f e c t of making entry in t o banking easier and of promoting competition i n the f i n a n c i a l system. 12 Canada, Department of Finance, White Paper on the Revision of Canadian Banking L e g i s l a t i o n (Ottawa: M i n i s t e r of Supply and Services, August, 1976) at 16. 13 Green Paper, supra, note 11 at 22. 8 The number o f a c t i v e banks i n Canada i n c r e a s e d from n i n e i n 1967 t o s i x t y n i n e by t h e end o f 1985, l a r g e l y as a r e s u l t o f t h e 1980 r e v i s i o n s t o the A c t . 1 4 The f e d e r a l government's i n t e n t i o n t o pursue t h i s f i n a n c i a l s e c t o r p o l i c y of i n c r e a s i n g c o m p e t i t i o n has c o n t i n u e d s i n c e 1980. F o r example, i n t h e Green Paper, the Department o f F i n a n c e l i s t e d as one i mportant g o a l t h e promotion o f c o m p e t i t i o n , i n n o v a t i o n and e f f i c i e n c y i n the f i n a n c i a l s e c t o r . I t recommended some degree o f d e r e g u l a t i o n , whereby f i n a n c i a l i n s t i t u t i o n s would be g i v e n g r e a t e r scope t o o f f e r a wider v a r i e t y o f f i n a n c i a l s e r v i c e s t h a n i n t h e p a s t . 1 5 The Green Paper d i d r e f l e c t a r e c o g n i t i o n t h a t t h e long-term r i s k o f t h e p o l i c y of i n c r e a s e d c o m p e t i t i o n would be t h a t some f i n a n c i a l i n s t i t u t i o n s would d i s a p p e a r , through f a i l u r e o r merger. The f e d e r a l government's commitment t o i n c r e a s i n g c o m p e t i t i o n among banks was f u r t h e r e v i d e n c e d by new c o m p e t i t i o n l e g i s l a t i o n i n t r o d u c e d i n 1986: t h e C o m p e t i t i o n A c t (S.C. 1986, c.26). The s t a t e d purpose o f t h i s new l e g i s l a t i o n was t o " m a i n t a i n and encourage c o m p e t i t i o n i n Canada" ( s e c t i o n 1 9 ( 1 ) ) . Of s i g n i f i c a n c e i s the f a c t t h a t t h i s A c t expanded the scope o f p r e - e x i s t i n g c o m p e t i t i o n law t o i n c l u d e b a n k s — f o r example, i n t e r b a n k agreements are now under th e a u t h o r i t y o f the D i r e c t o r of I n v e s t i g a t i o n and 14 Coopers and Lybrand, supra, note 5 a t 22. 15 Green Paper, supra. note 11 a t 2. 9 Research rather than the O f f i c e of the Inspector General of Banks. 1 6 A recent statement of the government's p o l i c y of incre a s i n g competition i n the f i n a n c i a l sector i s contained i n New D i r e c t i o n s f o r the F i n a n c i a l Sector tabled i n the House of Commons on December 18, 198 6, i n which the M i n i s t e r of State f o r Finance stressed the promotion of competition as a major p o l i c y goal. One way i t proposed to achieve t h i s goal was to increase the powers of t r u s t , loan and insurance companies to compete with banks i n commercial lending, a t r a d i t i o n a l stronghold of the banks. 1 7 S i m i l a r l y , p o r t f o l i o r e s t r i c t i o n s on t r u s t , loan and insurance companies i n the f i e l d of consumer loans would be e l i m i n a t e d . 1 3 The p o l i c y paper also recommended that banks, t r u s t , loan and insurance companies be allowed to o f f e r investment advice and p o r t f o l i o management services and a f u l l range of s e c u r i t i e s a c t i v i t i e s through s u b s i d i a r i e s . 1 9 F u l l networking powers would be made a v a i l a b l e to f i n a n c i a l i n s t i t u t i o n s as well as an expanded range of f i d u c i a r y powers. 2 0 These proposals were, f o r the most part, implemented i n the F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance System Amendment Act and An Act to Amend Certain Acts Relating to F i n a n c i a l 16 Barry R. Campbell, "The Competition A c t — The Special Case of Banks" (1987) 1 Banking and Finance Law Review 225 at 22 6. 17 Canada, M i n i s t e r of State f o r Finance, New Directions for the F i n a n c i a l Sector (tabled i n the House of Commons on December 18, 1986) at 12 [hereinafter New D i r e c t i o n s ] . 18 Ibid, at 12. 19 Ibid, at 13. 20 Ibid, at 13. 10 I n s t i t u t i o n s , proclaimed on J u l y 2 and J u l y 3, 1987, r e s p e c t i v e l y . This l e g i s l a t i o n i s discussed i n f r a i n chapter 7. At the same time that the government has been implementing a p o l i c y of increased competition i n the f i n a n c i a l sector, i t has made some attempts to counter-act the e f f e c t s of competition by increasing supervision and reg u l a t i o n of f i n a n c i a l i n s t i t u t i o n s i n order to protect t h e i r solvency. The Green Paper recognized solvency, improved consumer pro t e c t i o n and c o n t r o l of s e l f - d e a l i n g and c o n f l i c t s of i n t e r e s t as important goals and advocated s t r i c t e r r e g u l a t i o n and supervision of f i n a n c i a l i n s t i t u t i o n s to achieve these goals. S i m i l a r l y , i n New Directions f o r the F i n a n c i a l Sector, the government recommended a strengthening of the d i r e c t o r s ' r o l e i n the reg u l a t i o n of f i n a n c i a l i n s t i t u t i o n s , an enhanced r o l e f o r auditors, and s t r i c t e r r u l e s with respect to s e l f - d e a l i n g and c o n f l i c t s of i n t e r e s t . I t also proposed the cr e a t i o n of a supra-regulatory body, the O f f i c e of the Superintendent of F i n a n c i a l I n s t i t u t i o n s , which would possess more e f f e c t i v e supervisory and enforcement powers. M The object of s t r i c t e r supervision such as that proposed i n the Green Paper and i n New Directions f o r the F i n a n c i a l Sector (and implemented i n the recent l e g i s l a t i v e 21 The O f f i c e of the Superintendent of F i n a n c i a l I n s t i t u t i o n s was created by the F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance System Amendment Act. This new regulatory body i s discussed i n chapter 7. 1 1 reforms), i s to give greater capacity to regulators to spot impending c r i s e s through greater inspection and supervisory powers and to prevent p o t e n t i a l insolvencies through more powerful enforcement techniques. I t i s submitted, however, that the e f f e c t s of competition are e s s e n t i a l l y independent of the regulatory regime. Regulation can c o n t r o l c e r t a i n excesses which could lead to insolvency, but cannot be r e l i e d upon to prevent f a i l u r e s . This i s the approach taken by the Canadian Bankers 1 A s s o c i a t i o n i n i t s Comments on The System of Bank Regulation and Supervision i n Canada of January, 1986: ...regulatory supervision cannot prevent e i t h e r human or i n s t i t u t i o n a l f a i l u r e . The market system must be allowed to work through the forces of competition. F a i l u r e i s an occasional consequence of the competitive adjustment process of the market. 2 2 That increased supervision cannot be considered a cure f o r the e f f e c t s of competition i s i l l u s t r a t e d by the American experience. The U.S. system employs an intensive system of bank supervision and inspection but has not had a successful record i n preventing bank i n s o l v e n c i e s . The three f e d e r a l regulatory agencies i n the United States r e l y on four supervisory techniques: a wide v a r i e t y of d e t a i l e d p r u d e n t i a l reports provided by the banks on a regular basis; on-site safety and soundness examinations conducted by agency inspectors r e s u l t i n g i n a comprehensive bank report 22 Canadian Bankers' Association, Comments on the System of Bank Regulation and Supervision i n Canada (January, 1 9 8 6 ) . 12 and a r a t i n g being assiged to the bank; computer-assisted s u r v e i l l a n c e programs used to discover signs of developing problems; and a v a r i e t y of enforcement powers to remedy unsafe p r a c t i c e s or close problem banks. 2 3 Despite t h i s comprehensive and onerous supervision, the U.S. f i n a n c i a l system suffered 118 bank f a i l u r e s i n 1985 and 138 i n 1986. 2 4 Therefore, i t i s not c e r t a i n that more int e n s i v e supervision w i l l prevent bank f a i l u r e s i n the future or counter-act the e f f e c t s of the government's p o l i c y of i n c r e a s i n g competition i n the f i n a n c i a l sector. Conclusion Therefore, there has been a d i s t i n c t trend i n f i n a n c i a l sector p o l i c y toward the promotion of competition among f i n a n c i a l i n s t i t u t i o n s . This has been f a c i l i t a t e d by easing the r e s t r i c t i o n s f o r entry f o r new banks and breaking down the f u n c t i o n a l d i s t i n c t i o n s between various types of f i n a n c i a l i n s t i t u t i o n s . As non-bank i n s t i t u t i o n s continue to gain more power to perform t r a d i t i o n a l banking functions, Canadian banks w i l l experience more competition than they have ever faced. Even i f the supervisory process i s strengthened, as long as there are increasing numbers of banks which are facing increased competition from each other and from other f i n a n c i a l i n s t i t u t i o n s , there w i l l , i n a l l l i k e l i h o o d , be some f a l l o u t — p a r t i c u l a r l y of small, new 23 Estey, supra, note 1 at 391-392. For more d e t a i l s on the American system of regulation, see chapter 5 herein. 24 Gordon F.Boreham, "Banking i n Canada and the USA: Some Comparisons" (1987) 94 Canadian Banker 6 at 11. 13 banks. In f a c t , the M i n i s t e r of State f o r Finance, Thomas Hockin r e c e n t l y indicated that t h i s was the expected r e s u l t when he stated, i n the context of h i s government's proposed f i n a n c i a l sector l e g i s l a t i o n , that: "No l e g i s l a t i o n can or should prevent some r o t t i n g apples from f a l l i n g o f f the This very r e a l p o s s i b l i t y of future bank f a i l u r e s has made i t important f o r the government to have c l e a r , adequate and appropriate powers to deal e f f e c t i v e l y with a s i t u a t i o n of actual or imminent bank insolvency. 25 Bruce Constantineau, "Let 'Rotting Apples' F a l l , Hockin Says", The Vancouver Sun (March 5, 1987) at B - l . 14 CHAPTER 2. RATIONALE FOR BANK BAILOUTS Before examining the r a t i o n a l e f o r government in t e r v e n t i o n i n cases of bank insolvency ( i . e . a bank " b a i l o u t " ) , i t i s important to define the types of int e r v e n t i o n that w i l l be described i n t h i s paper as a "b a i l o u t " . E s s e n t i a l l y , the concept of a b a i l o u t w i l l be used to include any s i t u a t i o n where: a) government f i n a n c i a l resources are used to keep a f a i l i n g i n s t i t u t i o n a f l o a t or to f a c i l i t a t e i t s merger with a v i a b l e i n s t i t u t i o n or b) c l i e n t s of i n s t i t u t i o n s that have f a i l e d are compensated out of p u b l i c funds. 1 T r a d i t i o n a l l y , the banking industry has been subject to government in t e r v e n t i o n i n the form of reg u l a t i o n and supervision. This has developed out of a perception that banks (and other f i n a n c i a l i n s t i t u t i o n s ) are somehow d i f f e r e n t from other businesses and should be treated d i f f e r e n t l y . 2 I t i s b a s i c a l l y t h i s reason that j u s t i f i e s b a i l i n g out banks while l e t t i n g ordinary i n d u s t r i a l and 1 The l a t t e r aspect of t h i s d e f i n i t i o n would include payouts of insured claims under p u b l i c deposit insurance schemes. Although the deposit insurance fund i s funded by premiums assessed against insured i n s t i t u t i o n s , the premium, i s i n d i r e c t l y paid by the users of f i n a n c i a l services (in the form of increased cost f o r those s e r v i c e s ) . This c l a s s i s as wide as the taxpayer c l a s s and, therefore, the deposit insurance scheme i s ult i m a t e l y funded by p u b l i c funds. 2 George B. Balamut, "A Morality Tale: Everything's Got a Moral I f Only You Can Find I t " (1975) 27 Ad L Rev 343 at 3 45, note 5. 15 commercial corporations succeed or f a i l as the market d i c t a t e s . Two c h a r a c t e r i s t i c s of banks d i s t i n g u i s h them from non- f i n a n c i a l corporations and j u s t i f y t h e i r d i f f e r e n t i a l treatment: a) the f a c t that much of t h e i r c a p i t a l i s supplied by depositors and b) t h e i r important r o l e i n the f i n a n c i a l system. Out of these c h a r a c t e r i s t i c s , i t i s submitted, flow two fundamental r a t i o n a l e f o r b a i l i n g out banks: 1) consumer p r o t e c t i o n and 2) maintenance of the s t a b i l i t y of the f i n a n c i a l system. These two r a t i o n a l e also j u s t i f y the ongoing re g u l a t i o n and supervision of banks. I t i s submitted that there i s an a d d i t i o n a l r a t i o n a l e f o r b a i l i n g out b a n k s — one that includes the type of p o l i t i c a l , s o c i a l and economic considerations operating i n the government b a i l o u t s of any b u s i n e s s — which w i l l be described as "public b e n e f i t " . Each of these r a t i o n a l e i s examined below. 1. Consumer Protection The ground of consumer p r o t e c t i o n — the p r o t e c t i o n of su p p l i e r s of c a p i t a l to banks— i s often c i t e d as a fundamental j u s t i f i c a t i o n f o r bank reg u l a t i o n . A bank's c a p i t a l s u p p l i e r s are comprised of three groups: depositors, c r e d i t o r s (secured and unsecured) and equity- holders ( i . e . shareholders). Government in t e r v e n t i o n i s aimed at b e n e f i t t i n g a bank's depositors as opposed to i t s shareholders or c r e d i t o r s . Depositors possess s p e c i a l 16 c h a r a c t e r i s t i c s which j u s t i f y t h e i r p r o t e c t i o n by the government while i n d u s t r i a l and commercial enterprises are allowed to f a i l . The consumer pr o t e c t i o n concerns which j u s t i f y p r e f e r e n t i a l treatment of depositors as compared to sup p l i e r s of c a p i t a l to ordinary commercial and i n d u s t r i a l corporations w i l l be examined f i r s t . Then, the consumer pr o t e c t i o n r a t i o n a l e w i l l be applied to the other suppliers of bank c a p i t a l ( i . e . shareholders and cre d i t o r s ) i n order to determine whether these same concerns are a p p l i c a b l e . a) Depositors Depositors, as a c l a s s , d i f f e r fundamentally from su p p l i e r s of debt and share c a p i t a l to no n - f i n a n c i a l corporations. As R.C. Clark pointed out i n h i s a r t i c l e , "The Soundness of F i n a n c i a l I n s t i t u t i o n s " , investors i n ordinary i n d u s t r i a l corporations come "predominantly from an e l i t e group of persons who inhabit the higher brackets of income or wealth". 3 ' The supp l i e r s of c a p i t a l to f i n a n c i a l intermediaries, on the other hand, come from a broad c l a s s which c o n s i s t s of v i r t u a l l y every a d u l t — r i c h and poor. 4 Clark contrasts c a p i t a l s u p p l i e r s to f i n a n c i a l i n t e r m e d i a r i e s — a t r u l y p u b l i c c l a s s of c a p i t a l s u p p l i e r s — with the e l i t e c l a s s which supplies c a p i t a l to ordinary i n d u s t r i a l corporations. 3 R.C.Clark, "The Soundness of F i n a n c i a l I n s t i t u t i o n s " (1976) 86 Yale Law Journal 1 at 11 [hereinafter " C l a r k " ] . 4 Ibid, at 11. 17 In Canada, Clark's d i s t i n c t i o n can be u s e f u l l y applied to bank depositors and investors i n ordinary commercial and i n d u s t r i a l corporations. In 1984, 85 percent of Canadians had a personal savings account i n a chartered bank— t r u l y a p u b l i c c l a s s . 5 In addition, the vast majority of these accounts were r e l a t i v e l y small. For example, i n 1984, the composition of personal savings accounts of chartered banks was as follows: 18.1 m i l l i o n accounts of l e s s than $1,000; 9.8 m i l l i o n with amounts between $1,000 and $9,999; 2.7 m i l l i o n t o t a l l i n g between $10,000 and $99,999; and 58,000 with amounts exceeding $100,000.6 With the average savings account containing $3,429, i t can be sa i d that Canadian depositors are, on average, small savers. In contrast, only 10 percent of Canadians own share equity i n c o r p o r a t i o n s . 7 The Economic Council of Canada described t h i s l a t t e r c l a s s as follows: The owners of shares i n p u b l i c l y traded companies...tend to be i n higher-income and higher- education groups and reside mostly i n l a r g e r urban centres.8 C l e a r l y , t h i s can be considered an " e l i t e c l a s s " i n comparison to the average bank depositor. 5 Economic Council of Canada, 1987, supra, chapter 1, note 2 at 64. 6 Canadian Bankers' Association, Bank Facts/85: The Chartered Banks of Canada (1985). 7 Economic Council of Canada, supra, chapter 1, note 2 at 64. 8 I b i d , at 64. 18 A r i s i n g out of the d i f f e r e n t composition of the two cl a s s e s , are several reasons explaining why depositors require s p e c i a l p r o t e c t i o n . F i r s t , the funds contained i n the savings account of the average depositor represent l i f e savings, i . e . non-disposable income. Owners of share and debt c a p i t a l i n n o n - f i n a n c i a l corporations, on the other hand, tend to be i n v e s t i n g d i s c r e t i o n a r y income— income they can more r e a d i l y a f f o r d to Ipse. 9 As a r e s u l t , losses caused by bank insolvency w i l l have a greater d i s u t i l i t y f o r depositors than s i m i l a r losses suffered by ordinary c a p i t a l i n v e s t o r s . 1 0 To prevent the devastating e f f e c t s that l o s t deposits can i n f l i c t , depositors are protected through government in t e r v e n t i o n . A second j u s t i f i c a t i o n f o r p r o t e c t i n g depositors a r i s e s from t h i s p u b l i c c l a s s ' s lack of access to f i n a n c i a l information about depository i n s t i t u t i o n s . Without exposure to adequate f i n a n c i a l information, i t i s impossible f o r depositors to assess the r i s k i n e s s of investment a l t e r n a t i v e s . This concern was r e f l e c t e d by the Department of Finance i n the Green Paper: M i l l i o n s of Canadians have entrusted t h e i r savings to f i n a n c i a l i n s t i t u t i o n s and a large proportion of them know l i t t l e , i f anything, about the r i s k s those i n s t i t u t i o n s are i n c u r r i n g i n the course of t h e i r business d e a l i n g s . 1 1 9 Clark, supra, note 3 at 21. 10 Ibid, at 21. 11. Green Paper, supra, chapter 1, note 11 at 12. 19 Several f a c t o r s contribute to the informational b a r r i e r faced by depositors: i) the cost of obtaining and assessing f i n a n c i a l information; i i ) depositors' lack of the necessary motivation to make use of f i n a n c i a l information; and i i i ) reluctance on the part of regulatory bodies to compel f i n a n c i a l i n s t i t u t i o n s to d i s c l o s e pertinent information, i) Cost: For small depositors, the s i z e of t h e i r investment does not warrant the costs associated with obtaining and assesssing investment information. As Clark put i t : ... the costs of obtaining accurate, relevant, i n t e l l i g i b l e , and personally usable information about the r i s k s of a l t e r n a t i v e investments i n f i n a n c i a l intermediaries i s excessively high f o r many p u b l i c s u p p l i e r s of c a p i t a l , i n r e l a t i o n to the amounts to be invested. 1 2 I t i s not c o s t - e f f i c i e n t f o r the depositor to seek investment advice due to the small s i z e of the average deposit and the tendency of f i n a n c i a l advisers to t i e the sale of f i n a n c i a l products to f i n a n c i a l advice. Not only i s investment advice expensive, i t i s probably more d i f f i c u l t f o r a small saver to obtain than f o r an investor: F i n a n c i a l planners have shown l i t t l e i n t e r e s t i n taking business from persons with an annual gross income of l e s s than $30,000 because of t h e i r l i m i t e d capacity to purchase more so p h i s t i c a t e d f i n a n c i a l products. Thus persons of more modest means may have more d i f f i c u l t y i n obtaining adequate 12. Clark, supra, note 3 at 15. 20 information or i n gaining access to c e r t a i n types of f i n a n c i a l products. 13 C e r t a i n l y the average depositor would lack the f i n a n c i a l s o p h i s t i c a t i o n and/or the time to make an assessment themselves. In contrast to t h i s are the investors i n n o n - f i n a n c i a l c o r p o r a t i o n s — the e l i t e s u p p l i e r s of c a p i t a l — f o r whom i t i s c o s t - e f f i c i e n t to assess (or to have assessed) the f i n a n c i a l information d i s c l o s e d by corporations before making investment decisions due to the large amounts at r i s k . These investors e i t h e r possess the f i n a n c i a l s o p h i s t i c a t i o n necessary to assess f i n a n c i a l information or can j u s t i f y the cost of f i n a n c i a l advice. i i ) Motivation: An a d d i t i o n a l informational b a r r i e r facing depositors i s the motivation to make use of f i n a n c i a l information. In the case ot depositors, tn.e. T^c^ss^cpj motivation may be l a c k i n g because they generally do not perceive themselves as r i s k - t a k e r s — they consider banks as safe places to keep those funds which they can l e a s t a f f o r d to l o s e . 1 4 Investors i n non-financial corporations, on the other hand, are more l i k e l y to perceive themselves as r i s k - t a k e r s — they are i n v e s t i n g l a r g e r sums at higher r i s k i n order to earn a higher return. These fact o r s i n s t i l the 13 Economic Council of Canada,1987 supra, chapter 1, note 2 at 64. 14 This motivational problem may be on the decline as more depositors have been made aware of r i s k as a r e s u l t of recent bank (and other f i n a n c i a l i n s t i t u t i o n ) f a i l u r e . 21 motivation to assess whatever information i s a v a i l a b l e and make investment decisions on the basis of that assessment, i i i ) A v a i l a b i l i t y : The t h i r d f a c t o r c o n t r i b u t i n g to the informational problem faced by depositors i s government and i n s t i t u t i o n a l reluctance to d i s c l o s e i n f o r m a t i o n — p a r t i c u l a r l y information r e l a t i n g to d i s t r e s s e d i n s t i t u t i o n s . 1 5 This reluctance i s based on fear that the d i s c l o s u r e of damaging information w i l l cause depositors to withdraw t h e i r funds, turning a threat of insolvency into a r e a l i t y . Disclosure of banking problems has t r a d i t i o n a l l y been considered by regulators to be inc o n s i s t e n t with the promotion of a sound and stable banking system. 1 6 Edward B r a i n s i l v e r , general counsel to the American Federal Deposit Insurance Corporation i n 1975 summed up that regulatory body's p o l i c y with respect to d i s c l o s u r e as follows: To have continuous d i s c l o s u r e of the bank's d e t e r i o r a t i n g condition can, i n our opinion, r e s u l t i n l a r g e r losses to everyone— the holders of uninsured deposits, FDIC's insurance fund, and ul t i m a t e l y the remaining s e c u r i t y holders who must bear the brunt of the lo s s and obtain t h e i r recovery out of the assets l e f t a f t e r complete l i q u i d a t i o n , and without the be n e f i t of the s u b s t a n t i a l premium that may be paid f o r the bank's going concern value. In the long run, we f e e l that meaningful d i s c l o s u r e s of a bank's d e t e r i o r a t i n g condition would be counter productive to the best i n t e r e s t s of most of the concerned persons. 1 7 15 The issue of di s c l o s u r e i s debateable and there are those who argue i n favour of increased d i s c l o s u r e : see, f o r example, John Evans, "Disclosure Through a Glass Darkly" (1975) 27 Ad.L.Rev.357 at 364. 16 John Evans, supra, note 15 at 3 62. 17 Edward B r a i n s i l v e r , " F a i l i n g Banks: FDIC's Options and Constraints" (1975) 27 Ad.L.Rev. at 340 [hereinafter " B r a i n s i l v e r " ] . 22 Therefore, i f relevant information i s unavailable, depositors cannot be expected to evaluate the r i s k s of f i n a n c i a l i n s t i t u t i o n s accurately and base t h e i r investment decisions accordingly. This leaves bank management free to carry on business i n a h i g h - r i s k manner, without the d i s c i p l i n e imposed by depositor investment d e c i s i o n s . I t i s the need to protect depositors from such r i s k that j u s t i f i e s b a i l i n g out depositors who lose t h e i r investments due to a r i s k they could not have a n t i c i p a t e d . The Canadian government has responded to t h i s need f o r depositor p r o t e c t i o n by implementing a system of deposit insurance which insures a maximum of $60,000 f o r each depositor i n each insured i n s t i t u t i o n . The $60,000 l i m i t , an a r b i t r a r y l i m i t , represents an attempt to protect the small depositor. The d i s c u s s i o n thus f a r of the consumer p r o t e c t i o n r a t i o n a l e f o r government b a i l o u t s of banks has concentrated on the needs of average depositors ( i . e . small depositors) and the comprehensive p r o t e c t i o n afforded them by deposit insurance. However, there i s a subclass within the depositor c l a s s which should be examined separately: the large depositor with funds i n excess of $60,000. I t i s more d i f f i c u l t to j u s t i f y p r o t e c t i n g these depositors on consumer pr o t e c t i o n grounds. This c l a s s consists l a r g e l y of commercial depositors with d i v e r s i f i e d investments, and i t 23 i s submitted, therefore, that i t i s more comparable to Clark's c l a s s of e l i t e s u p p l i e r s of c a p i t a l than the p u b l i c c l a s s he d e s c r i b e s . 1 8 They are better able to withstand the f i n a n c i a l shock of a bank f a i l u r e (and the r e s u l t i n g l o s s of t h e i r deposits) than small depositors. Furthermore, they are more l i k e l y to possess the f i n a n c i a l s o p h i s t i c a t i o n necessary to evaluate the r e l a t i v e r i s k s of f i n a n c i a l i n s t i t u t i o n s accurately and are i n v e s t i n g large enough sums that such evaluation can be performed economically. Due to these d i f f e r e n c e s between insured and uninsured depositors, the consumer pr o t e c t i o n concerns which j u s t i f y deposit insurance as a method of b a i l i n g out small depositors, do not j u s t i f y s i m i l a r p r o t e c t i o n f o r large depositors. b) Shareholders Does the consumer p r o t e c t i o n r a t i o n a l e which j u s t i f i e s p r o t e c t i o n of small depositors apply to a bank's shareholders? The holders of share c a p i t a l i n a bank d i f f e r i n fundamental respects from i t s depositors. 18 When Clark describes h i s p u b l i c c l a s s of c a p i t a l s u p p l i e r s to f i n a n c i a l intermediaries, he does not d i s t i n g u i s h between insured and uninsured members of t h i s c l a s s . He recognizes that the p u b l i c c l a s s does contain some extremely wealthy members (see Clark, supra, note 3 at 11). However, fo r the purpose of t h i s paper, these large depositors are examined separately. They are i d e n t i f i e d on the same basis as the government has i d e n t i f i e d them fo r deposit insurance purposes. I t should be noted that t h i s b asis of i d e n t i f i c a t i o n i s problematic due to the brokering of deposits, i . e . the breaking of large deposits into parcels of $60,000 and the d i s t r i b u t i o n of them among a number of f i n a n c i a l i n s t i t u t i o n s i n order to obtain the p r o t e c t i o n of deposit insurance. 24 Depositors hold an unsecured claim to t h e i r funds and do not share i n p r o f i t s earned by the bank. Their primary motivation f o r supplying c a p i t a l to banks i s to save t h e i r money— they are not intending to r i s k i t i n order to make a p r o f i t . 1 9 Shareholders, on the other hand, do p r o f i t from the bank's successes. In the event of extraordinary gain, i t i s the shareholders who reap extraordinary p r o f i t rather than the depositors (who hold f i x e d claims). On the other hand, any l o s s incurred by shareholders i s l i m i t e d to t h e i r i n i t i a l investment due to the p r i n c i p l e of l i m i t e d l i a b i l i t y . Limited l i a b i l i t y plus the high debt to equity r a t i o which i s c h a r a c t e r i s t i c of the c a p i t a l strucuture of banks means that more of the depositors' wealth than that of the shareholders i s on the l i n e when banks make r i s k y investments.2 0 Shareholders, unlike depositors, tend to b e n e f i t from excessive r i s k - t a k i n g . 2 1 Thus, consumer p r o t e c t i o n concerns do not j u s t i f y government compensation of shareholders i n the event of bank f a i l u r e . Like the shareholders of non-financial corporations, they are r i s k - t a k e r s : i f the business t h r i v e s , t h e i r r i s k pays o f f ; i f i t f a i l s , t h e i r investment i s l o s t . 19 From an economic point of view, depositors, l i k e shareholders, are r i s k i n g t h e i r funds. Whenever there i s a return, there i s an associated r i s k . However, from a psychological point of view, depositors do not perceive themselves as r i s k - t a k e r s . 20 Economic Council of Canada, 1987, supra. chapter 1, note 2 at 57. 21 Charles Freedman, "Comments" i n Jacob Zieg e l , Leonard Waverman, David Conklin, Canadian F i n a n c i a l I n s i t u t i o n s : Changing the Regulatory Environment (Toronto: Ontario Economic Council, 1985) at 88 [hereinafter " Z i e g e l " ] . 25 c) Bank C r e d i t o r s The consumer p r o t e c t i o n r a t i o n a l e which j u s t i f i e s p r o t e c t i o n o f a bank's s m a l l d e p o s i t o r s does not a p p l y t o i t s c r e d i t o r s . C l e a r l y , s e c u r e d c r e d i t o r s a r e a l r e a d y p r o t e c t e d by t h e i r s e c u r i t y upon which t h e y can r e a l i z e i n t h e event o f d e f a u l t . Unsecured c r e d i t o r s a r e u n p r o t e c t e d but, i t i s s u b m i t t e d , t h e y t e n d t o resemble C l a r k ' s f i n a n c i a l l y - s o p h i s t i c a t e d and e l i t e c l a s s o f c a p i t a l s u p p l i e r s r a t h e r than a p u b l i c c l a s s . 2 2 As such, t h e y do not need t h e p r o t e c t i o n which, i t has been argued, i s r e q u i r e d by s m a l l d e p o s i t o r s . I t i s more l i k e l y t h a t the funds l o a n e d t o a bank by an unsecured c r e d i t o r r e p r e s e n t d i s c r e t i o n a r y income r a t h e r than l i f e s a v i n g s . Furthermore, u n s e c u r e d c r e d i t o r s t e n d t o d i v e r s i f y t h e i r investments and, t h e r e f o r e , t h e f a i l u r e o f one bank would have l e s s d i s u t i l i t y f o r them than f o r a s m a l l d e p o s i t o r . T h e r e f o r e , l i k e an u n i n s u r e d d e p o s i t o r , t h e consumer p r o t e c t i o n r a t i o n a l e does not j u s t i f y t h e government b a i l i n g them out i n t h e event o f bank f a i l u r e . C o n c l u s i o n T h e r e f o r e , t h e r e are consumer p r o t e c t i o n r a t i o n a l e f o r compensating some s u p p l i e r s o f c a p i t a l i n the event of a bank f a i l u r e o r f o r p r e v e n t i n g t h e f a i l u r e from o c c u r r i n g i n 22 I t s h o u l d be noted t h a t the statements made v i s a v i s unsecured c r e d i t o r s are not e v i d e n c e d by e m p i r i c a l d a t a — more e m p i r i c a l study i s r e q u i r e d on t h i s c l a s s of c a p i t a l s u p p l i e r s . 26 the f i r s t place. On. the basis of consumer prote c t i o n , reformed bank insolvency l e g i s l a t i o n should aim at p r o t e c t i o n of insured depositors i n a l l s i t u a t i o n s of bank f a i l u r e . This i s e f f e c t i v e l y achieved through deposit insurance. The consumer p r o t e c t i o n r a t i o n a l e , however, cannot j u s t i f y the b a i l i n g out of an insolvent bank's uninsured depositors, shareholders or c r e d i t o r s . 2. S t a b i l i t y of the F i n a n c i a l System The second basic j u s t i f i c a t i o n f o r b a i l i n g out d i s t r e s s e d banks l i e s i n the importance of maintaining the s t a b i l i t y of the f i n a n c i a l system. This s t a b i l i t y i s e s s e n t i a l i n order f o r f i n a n c i a l i n s t i t u t i o n s to e f f e c t i v e l y carry out t h e i r functions as i n t e g r a l parts of the payments system, (thereby f a c i l i t a t i n g expeditious transactions between p a r t i e s ) , as f i n a n c i a l intermediaries ( i . e . t r a n s f e r r i n g funds from savers to borrowers) and as safekeepers of funds and s u p p l i e r s of f i n a n c i a l information and a d v i c e . 2 3 The fear i s that the f a i l u r e of one bank w i l l create a domino e f f e c t : depositors w i l l lose confidence i n banks leading to the f a i l u r e s of other banks and thereby d e s t a b i l i z i n g the f i n a n c i a l system. 2 4 Banks are more susceptible to f a i l u r e than non-financial operations because of t h e i r h i ghly leveraged c a p i t a l s t r u c t u r e . 2 5 The 23 Economic Council of Canada, 1987, supra, chapter 1, note 2 at 1. 24 Green Paper, supra, chapter 1, note 11 at 11. 25 Economic Council of Canada, 1987, supra, chapter 1, note 2 at 50. 27 c o m p a r a t i v e l y s m a l l e q u i t y p o r t i o n o f t h i s c a p i t a l i z a t i o n i s t h r e a t e n e d by any s i g n i f i c a n t l o s s . 2 6 Furthermore, a l a r g e p e r c e n t a g e o f a bank's a s s e t s a r e i l l i q u i d w h i l e most o f i t s l i a b i l i t i e s a r e p a y a b l e on demand o r w i t h i n a s h o r t t i m e . 2 7 Thus, i n t h e event o f a run on d e p o s i t s , a bank may be u n a b l e t o meet d e p o s i t o r demands q u i c k l y enough, r e s u l t i n g i n t h e f o r c e d s a l e o f a s s e t s a t " f i r e s a l e " p r i c e s . T h i s can r e s u l t i n i n s o l v e n c y . 2 8 D e p o s i t i n s u r a n c e i s o f g r e a t a s s i s t a n c e i n m a i n t a i n i n g s t a b i l i t y o f t h e f i n a n c i a l system by p r e v e n t i n g bank r u n s . 2 9 Because i n s u r e d d e p o s i t o r s know t h a t t h e i r c l a i m s w i l l be s e t t l e d promptly i n t h e event o f f a i l u r e , t h e y have l i t t l e i n c e n t i v e t o withdraw t h e i r funds on t h e s t r e n g t h o f rumour o r t h e c o l l a p s e o f o t h e r i n s t i t u t i o n s . However, bank runs s t i l l o c c u r — due i n l a r g e p a r t t o t h e a c t i o n s o f u n i n s u r e d d e p o s i t o r s . Two r e c e n t examples a r e p r o v i d e d by t h e Bank o f B.C. and C o n t i n e n t a l Bank ( " C o n t i n e n t a l " ) . Both banks s u f f e r e d from c o n t a g i o n a r i s i n g out o f the f a i l u r e s o f the CCB and N o r t h l a n d i n September, 1985. F o r example, i n t h e f o u r months f o l l o w i n g t h e d e c l a r a t i o n o f t h e i r i n s o l v e n c y , C o n t i n e n t a l l o s t $2.6 b i l l i o n ( r e p r e s e n t i n g almost one h a l f 26 O n t a r i o Task F o r c e on F i n a n c i a l I n s t i t u t i o n s , F i n a l Report (Toronto: November, 1985) [ h e r e i n a f t e r "Dupre"] at 30. 27 I b i d , a t 30. 2 8 Economic C o u n c i l o f Canada, supra. c h a p t e r 1, note 2 a t 46. 29 Laurence S.Goodman, S h e r r i l l S h a f f e r , "The Economics of D e p o s i t I n surance: A C r i t i c a l E v a l u a t i o n o f Proposed Reforms" (1984) 2 Y.J.Reg.145 a t 148 [ h e r e i n a f t e r "Goodman"]. of i t s deposits) i n a bank run. A large majority of these withdrawals were made by the bank's uninsured depositors: Unlike some runs, where depositors l i n e up at the door, t h i s one was i n v i s i b l e . Money managers were leaving i n what's known as a ' f l i g h t to q u a l i t y ' . They wanted t h e i r money i n l a r g e r , safer i n s t i t u t i o n s and they moved i t i n large chunks. In the end, the $2.6 b i l l i o n i n losses came from only 3000 of the bank's 150,000 a c c o u n t s — an average p u l l o u t i n excess of $85,000. 3 1 S i m i l a r i l y , the Bank of B.C.'s deposits plunged $355.6 m i l l i o n i n f i s c a l year 1984-85, ending October 3 1 . 3 2 Once again the withdrawals were made almost e n t i r e l y by commercial depositors; i n f a c t deposits held by small depositors increased throughout the Bank of B.C. c r i s i s . 3 3 Therefore, the p o t e n t i a l f o r banks runs caused by l o s s of depositor confidence i s very r e a l . , On the basis of the Continental and Bank of B.C. experience, i t would appear that deposit insurance i s not s u f f i c i e n t to prevent bank runs. This observation i s made by the Economic Council of Canada i n i t s 1987 Report: In the recent insolvencies i n Canada, deposit insurance has l i m i t e d the l o s s of confidence. But i t has been unable to prevent i t completely, as witnessed by the s h i f t i n deposits from smaller, regional i n s t i t u t i o n s to l a r g e r , national firms. 4 30 Rod McQueen, "Showing the Colours" Canadian Business ( A p r i l , 1986) 16 at 16. 31 Ibid, at 81. 32 John Schreiner, "Is Edgar on a Kaiser R o l l ? " F i n a n c i a l Post Magazine (March 1, 1986) 22 at 26. 33 Ibid, at 26. 34 Economic Council of Canada,1987, supra, chapter 1, note 2 at 51. 29 I t i s s u b m i t t e d t h a t i n c i r c u m s t a n c e s where a d e s t a b i l i z i n g bank run i s a r e a l r i s k , t h e government i s j u s t i f i e d i n b a i l i n g out a bank i n o r d e r t o m a i n t a i n s t a b i l i t y . The b a n k i n g community i s c l o s e l y l i n k e d and f a i l u r e o f one bank may w e l l a f f e c t a l l . Banks, as c e n t r a l p l a y e r s i n t h e f i n a n c i a l system, p e r f o r m important f u n c t i o n s and, t h e r e f o r e , t h e r e i s v a l u e i n m a i n t a i n i n g c o n f i d e n c e i n them. M a i n t a i n i n g t h e s t a b i l i t y o f t h e f i n a n c i a l system s h o u l d be a p r i m a r y g o a l o f t h e government when r e s o l v i n g bank f a i l u r e s — c o n f l i c t i n g i n t e r e s t s have t o be s u b o r d i n a t e d when th e r i s k o f s y s t e m i c f a i l u r e i s h i g h . T h i s i s not t o say t h a t banks s h o u l d never be a l l o w e d t o f a i l o r t h a t u n i n s u r e d d e p o s i t o r s s h o u l d always be b a i l e d out, but t h e r e i s good r e a s o n f o r a v o i d i n g the k i n d o f i n s t a b i l i t y which would weaken d e p o s i t o r c o n f i d e n c e i n t h e system. 3. P o l i t i c a l B e n e f i t In a stu d y e n t i t l e d , The P o l i t i c a l Economy of B u s i n e s s B a i l o u t s . M i c h a e l T r e b i l c o c k e t a l . examine a number of b u s i n e s s b a i l o u t s by the Canadian government i n an e f f o r t t o e x p l a i n government d e c i s i o n s t o b a i l out some f a i l i n g f i r m s and not o t h e r s . The study examines economic and p o l i t i c a l r a t i o n a l e f o r b a i l o u t s , on a t h e o r e t i c a l l e v e l . I t i s argued t h a t t h e economic r a t i o n a l e f o r b a i l o u t s j u s t i f i e s government i n t e r v e n t i o n i n s i t u a t i o n s where the o p e r a t i o n of the market w i t h o u t such i n t e r v e n t i o n would l e a d t o a s o c i a l l y undesirable outcome. D The object of a b a i l o u t i s to improve economic e f f i c i e n c y by c o r r e c t i n g market i m p e r f e c t i o n s . 3 6 The p o l i t i c a l r a t i o n a l e i s based on the p u r s u i t of s e l f - i n t e r e s t by p o l i t i c i a n s — decisions to intervene are motivated by the desire to increase e l e c t o r a l support through granting b e n e f i t s to groups of marginal v o t e r s . 3 7 When these t h e o r e t i c a l propositions are applied to case studies of business b a i l o u t s , the conclusion i s reached that b a i l o u t s i n recent Canadian h i s t o r y are more consistent with the p o l i t i c a l r a t i o n a l e than the e c o n o m i c 3 8 — i . e . that b a i l o u t s are the r e s u l t of a strategy on the part of p o l i t i c a l actors to seek net p o l i t i c a l b e n e f i t rather than to maximize s o c i a l b e n e f i t s . 3 9 This conclusion was summarized as follows: In summary, arguments supporting government in t e r v e n t i o n that were based on p o l i t i c a l expedience applied i n v i r t u a l l y a l l of the b a i l o u t cases. S e l f - i n t e r e s t e d u t i l i t y maximization was more evident on the part of p o l i t i c a l actors than was any d e s i r e to increase economic e f f i c i e n c y . Thus, b a i l o u t s can best be understood as part of p o l i t i c i a n s ' basic s t r a t e g i e s to enhance t h e i r prospects f o r staying i n power by 'magnifying the gain and depreciating the pain' of income r e d i s t r i b u t i o n . 4 0 35 Michael Trebilcock, et a l . , The P o l i t i c a l Economy of Business B a i l o u t s : Volume 1 (Toronto: Ontario Economic Council, 1985) at 270 [hereinafter "Trebilcock et a l . " ] . 36 Ibid, at 276 37 I b i d , at 348. 38 Ibid, at 354. 39 I b i d , at 353. 4 0 I b i d , at 21. 31 P o l i t i c a l gain i s achieved by recognizing s p e c i f i c i n t e r e s t s (for example, the i n t e r e s t of organized labour i n r e t a i n i n g jobs) and providing b e n e f i t s to s p e c i f i c groups. Evidence of the strong incentives created by the p o l i t i c a l system to intervene i n banks fac i n g p o t e n t i a l or actual insolvency i s provided by case studies of recent bank b a i l o u t s . For example, p o l i t i c a l b e n e f i t can be used to explain, at l e a s t i n part, the government's d e c i s i o n to b a i l out uninsured depositors of CCB and Northland. In testimony given before the Standing Senate Committee, the M i n i s t e r of State (Finance), j u s t i f i e d her government's departure from the general r u l e of market d i s c i p l i n e as follows: We cannot ignore the r e a l i t y of circumstances that, i n t h i s case, were not without s i g n i f i c a n c e . The government recognized that there were v a l i d reasons f o r departing from the general r u l e . These depositors joined with the government i n demonstrating support and confidence i n our banking system i n general and i n regional banks i n p a r t i c u l a r . We were concerned, as well, about the impact i n western Canada i f holders of deposits over the $60,000 insured l i m i t had to absorb those los s e s . Those depositors included many i n d i v i d u a l s and small businesses, c h a r i t a b l e organizations, r e l i g i o u s organizations, c r e d i t unions, m u n i c i p a l i t i e s and school boards, as well as other groups. 1 Thus, there were a number of i n t e r e s t s which influenced the government's d e c i s i o n to b a i l out CCB and Northland, i n a d d i t i o n to the i n t e r e s t s of consumer pr o t e c t i o n and f i n a n c i a l s t a b i l i t y . F i r s t , was the i n t e r e s t of regional 41 Proceedings of the Standing Senate Committee on Banking, Trade and Commerce (Ottawa: November 19, 1985) at 31:7 [hereinafter "Proceedings"]. 32 economic development— i n p a r t i c u l a r , the i n t e r e s t i n developing regional banks i n western Canada. This i n t e r e s t i n p rovince-building and regional development explains a large percentage of the Canadian government's decisions to b a i l out businesses between the l a t e 1950's and the l a t e 1970's. 4 2 Secondly, the government reacted to a moral and, e s s e n t i a l l y p o l i t i c a l , commitment to uninsured depositors who demonstrated t h e i r support i n the banks by maintaining t h e i r deposits. C l e a r l y , i t would have been p o l i t i c a l l y detrimental f o r the government to l e t these depositors lose, i n the face of government assurances as to the v i a b i l i t y of the banks. A t h i r d incentive f o r b a i l i n g out the banks arose from the composition of the uninsured depositor c l a s s , which included a large number of voters and p o l i t i c a l l y - i n f l u e n t i a l i n s t i t u t i o n s , concentrated i n one region. In The P o l i t i c a l Economy of Business Bailouts, the co-authors determined that government assistance i n the form of b a i l o u t s i s generally granted to marginal d i s t r i c t s ( i . e . any r i d i n g i n which a s i g n i f i c a n t number of voters w i l l be adversely a f f e c t e d by the business f a i l u r e ) which have e f f e c t i v e p o l i t i c a l representation (for ex., the support of a Cabinet m i n i s t e r ) . 4 3 A strong argument can be made that the region which bene f i t t e d from the CCB and Northland b a i l o u t s was a marginal d i s t r i c t and, therefore, a candidate f o r a b a i l o u t . 42 Trebilcock, et a l . , supra. note 34 at 72. 43 I b i d , at 349. 33 Therefore, the r a t i o n a l e of p o l i t i c a l b e n e f i t can be used to explain government decisions to b a i l out banks (as well as n o n - f i n a n c i a l corporations). Whether i t i s a j u s t i f i c a t i o n f o r such int e r v e n t i o n i s a r g u a b l e — because i t i s based on a s e l f - s e r v i n g and short-sighted premise, i t i s harder to j u s t i f y than the motivations of consumer pr o t e c t i o n and f i n a n c i a l s t a b i l i t y . For the purposes of t h i s paper, i t i s assumed that government decisions to b a i l out some banks and not others w i l l continue to be influenced by considerations of p o l i t i c a l b e n e f i t . Furthermore, i t i s submitted that t h i s influence of the p o l i t i c a l b e n e f i t r a t i o n a l e i s a valuable aspect of the b a i l o u t d e c i s i o n — to the extent that i t acts as a v e h i c l e f o r the recognition, promotion and p r o t e c t i o n of important l o c a l , r e g ional and n a t i o n a l i n t e r e s t s (other than the i n t e r e s t s of consumer pr o t e c t i o n and f i n a n c i a l s t a b i l i t y ) . In order to c o n t r o l the p u b l i c b e n e f i t r a t i o n a l e and j u s t i f y i t s r o l e i n the b a i l o u t process, i t i s submitted that i t s influence on the d e c i s i o n to b a i l out a bank should be recognized i n bank insolvency l e g i s l a t i o n — but confined to circumstances i n which the nat i o n a l i n t e r e s t c a l l s f o r the p r o t e c t i o n of a r i g h t or i n t e r e s t which would be jeopardized by allowing a bank to f a i l . Conclusion Therefore, three r a t i o n a l e explain government decisions to b a i l out banks: consumer protection, f i n a n c i a l s t a b i l i t y 34 and p o l i t i c a l b e n e f i t . Each o f t h e s e r a t i o n a l e j u s t i f y b a i l i n g out banks o r t h e i r c l i e n t s i n some c i r c u m s t a n c e s . I t i s s u b m i t t e d t h a t bank i n s o l v e n c y l e g i s l a t i o n s h o u l d r e f l e c t t h e s e r a t i o n a l e and p r o v i d e t e c h n i q u e s f o r r e s o l v i n g bank f a i l u r e s which a r e c o n s i s t e n t w i t h t h e s e r a t i o n a l e . 4. A d d i t i o n a l F a c t o r s i n t h e B a i l o u t D e c i s i o n I t has been argued t h a t government d e c i s i o n s t o b a i l out banks can be e x p l a i n e d by t h e p r e s e n c e o f one o r more o f t h e f o l l o w i n g r a t i o n a l e : consumer p r o t e c t i o n , maintenance o f t h e s t a b i l i t y o f t h e f i n a n c i a l system and p o l i t i c a l b e n e f i t . However, i t i s s u b m i t t e d t h a t t h e r e a r e o t h e r i n t e r e s t s / c o n c e r n s which s h o u l d be a d d r e s s e d i n t h e b a i l o u t d e c i s i o n . These concerns, i f r e c o g n i z e d by government, would t e n d t o a f f e c t i t s c h o i c e of b a i l o u t i n s t r u m e n t r a t h e r t h an t h e u n d e r l y i n g d e c i s i o n o f whether o r not t o b a i l out a bank. The two concerns which are d i s c u s s e d below a r e : market d i s c i p l i n e and c o s t - e f f i c i e n c y . 4 4 a) Market D i s c i p l i n e Under th e d i s c u s s i o n on consumer p r o t e c t i o n , i t was argued t h a t t h e government i s j u s t i f i e d i n compensating s m a l l d e p o s i t o r s on consumer p r o t e c t i o n grounds, but not 44 There a r e o t h e r concerns and i s s u e s which, i t may be argued, s h o u l d i n f l u e n c e the b a i l o u t d e c i s i o n . For example, i t i s argued i n T r e b i l c o c k , e t . a l . a t 354, t h a t d e c i s i o n makers s h o u l d be made more s e n s i t i v e t o the economic, l o n g - term consequences of b a i l o u t p o l i c i e s . T h i s economic r a t i o n a l e f o r b a i l o u t s i s not developed i n t h i s paper but i s d i s c u s s e d , on a t h e o r e t i c a l l e v e l by T r e b i l c o c k e t a l . i n c h a p t e r s 3, 4, 5 and 6. l a r g e d e p o s i t o r s . The government has attempted t o d i s t i n g u i s h t h e two c l a s s e s and a f f o r d p r o t e c t i o n t o s m a l l d e p o s i t o r s by t h e implementation o f a d e p o s i t i n s u r a n c e scheme w i t h an i n s u r a n c e c e i l i n g o f $60,000. T h i s l e g i s l a t i v e r e s ponse t o t h e consumer p r o t e c t i o n c o n c e r n 4 5 a l s o r e f l e c t s t h e government's i n t e r e s t i n market d i s c i p l i n e — l a r g e d e p o s i t o r s a r e e x c l u d e d from i n s u r a n c e p r o t e c t i o n i n t h e e x p e c t a t i o n t h a t t h e y w i l l m a i n t a i n some degree o f d i s c i p l i n e i n t h e market. A good d e f i n i t i o n o f market d i s c i p l i n e i s found i n Robert 0. Edm i n s t e r ' s a r t i c l e "Bank R e g u l a t i o n and D e p o s i t Reform: Some Hard Q u e s t i o n s f o r Congress": [Market d i s c i p l i n e ] means t h a t i n v e s t o r s e v a l u a t e f i n a n c i a l i n s t i t u t i o n s on t h e b a s i s o f a v a i l a b l e i n f o r m a t i o n , d e c i d e which ones a r e o p e r a t i n g i n t h e i r (the i n v e s t o r s ' ) i n t e r e s t , t h e n move funds i n a p p r o p r i a t e d i r e c t i o n s depending on r i s k and r e t u r n e x p e c t a t i o n s . I f an i n s t i t u t i o n f a i l s t o meet e x t e r n a l e x p e c t a t i o n s , i t i s ' d i s c i p l i n e d ' b; i n v e s t o r s who withdraw t h e i r f u n d s . 4 The problem w i t h d e p o s i t i n s u r a n c e and government b a i l o u t s aimed a t p r o t e c t i n g u n i n s u r e d as w e l l as s m a l l d e p o s i t o r s i t h a t a l l d e p o s i t o r s would l o s e t h e i r i n c e n t i v e t o a s s e s s r i s k and move t h e i r funds a c c o r d i n g t o t h a t assessment. When market d i s c i p l i n e i s e l i m i n a t e d , the r i s k s o f i n s t i t u t i o n a l f a i l u r e a re s h i f t e d t o the d e p o s i t i n s u r a n c e 45 D e p o s i t i n s u r a n c e i s a l s o a response t o t h e need t o m a i n t a i n f i n a n c i a l s t a b i l i t y by p r e v e n t i n g bank runs. 4 6 Robert 0. Edminster, "Bank R e g u l a t i o n and D e p o s i t Reform - Some Hard Q u e s t i o n s f o r Congress" (1987) 104 The Banking L . J . 42 a t 43 [ h e r e i n a f t e r " E d m i n s t e r " ] . fund and the taxpayer. This argument was made i n the F i n a l Report of the Ontario Task Force on F i n a n c i a l I n s t i t u t i o n s which stated that acts of b a i l i n g out uninsured depositors: . . . e f f e c t i v e l y remove the influence of the market to enforce the prudent management of deposit- taking i n s t i t u t i o n s . They encourage persons making deposits which may be worth m i l l i o n s of d o l l a r s to do so with l i t t l e care, p e r c e i v i n g that governments w i l l save them from the consequences of t h e i r own imprudence. Market d i s c i p l i n e becomes a compelling reason f o r denying uninsured depositors the p r o t e c t i o n of a b a i l o u t afforded to smaller depositors. The expectation i s that the investment decisions of uninsured depositors w i l l maintain an e f f e c t i v e degree of market d i s c i p l i n e . 4 8 Unsecured c r e d i t o r s are another source of market d i s c i p l i n e . Like uninsured depositors, c r e d i t o r s do not b e n e f i t from bank management assuming increased r i s k due to the f i x e d rate of return earned on debt s e c u r i t i e s . 4 9 Furthermore, c r e d i t o r s 1 funds are locked i n and cannot be withdrawn upon demand (unless the debt s e c u r i t y can be 47 Dupre, supra, note 26 at 48. 48 The use of brokered deposits decreases the p o t e n t i a l influence of uninsured depositors on market d i s c i p l i n e . In 1984, Canada's 6 l a r g e s t chartered banks had 74% of t h e i r Canadian d o l l a r deposits insured. However, i n smaller banks, e s p e c i a l l y banks r e l y i n g on wholesale deposits, the proportion of uninsured deposits i s higher: i n 1984, other Canadian banks averaged only 31.1% insured deposits (see: Economic Council of Canada, 1987 at 50). Proposals have been made to c o n t r o l brokered deposits and the adverse e f f e c t they have on market d i s c i p l i n e (see: F i n a l Report of the Working Committee on the Canada Deposit Insurance Corporation (Ottawa: M i n i s t e r of Supply and Services, A p r i l , 1985) at 30-32 [hereinafter "Wyman"]. 49 Goodman, supra, note 29 at 161. 37 s o l d ) . Therefore, unsecured c r e d i t o r s have a strong i n c e n t i v e to assess the r i s k i n e s s of a l t e r n a t i v e i n s t i t u t i o n s before i n v e s t i n g 5 0 — an i n c e n t i v e that would disappear i f they expected to be b a i l e d out. I t i s submitted, therefore, that market d i s c i p l i n e i s an important consideration which should be r e f l e c t e d i n the b a i l o u t d e c i s i o n . I t i s not an i n t e r e s t which should override more fundamental i n t e r e s t s of consumer p r o t e c t i o n and f i n a n c i a l s t a b i l i t y . However, once the d e c i s i o n i s made to provide government assistance to a d i s t r e s s e d bank, market d i s c i p l i n e should a f f e c t the way the d e c i s i o n i s implemented ( i . e . which of the bank's c a p i t a l s u p p l i e r s should be b a i l e d out). b) C o s t - E f f i c i e n c y A second f a c t o r which should influence the implementation of the b a i l o u t d e c i s i o n i s c o s t - e f f i c i e n c y . B a i l o u t s are funded by the deposit insurance scheme and/or government revenues. The i n t e r e s t of c o s t - e f f i c i e n c y d i c t a t e s that governments resolve bank f a i l u r e s i n a way that involves the l e a s t d r a i n on p u b l i c funds. This i s an e s p e c i a l l y important consideration i n the case- of a large bank, the b a i l o u t of whose insured depositors could completely exhaust the deposit insurance fund. At present, the Canadian deposit insurance fund i s a subject of concern fo r government o f f i c i a l s and i s i n need of replenishment. 50 Ibid, at 161. 38 For example, at the end of 1985, the fund had a d e f i c i t of $1.2 b i l l i o n . 5 1 Therefore, c o s t - e f f i c i e n c y should be a concern of decision-makers when implementing a d e c i s i o n to b a i l out a bank. Conclusion Therefore, i n a d d i t i o n to the three r a t i o n a l e f o r government b a i l o u t s of banks, i t i s submitted that there are two a d d i t i o n a l i n t e r e s t s which should be r e f l e c t e d i n the b a i l o u t d e c i s i o n and, therefore, i n bank insolvency l e g i s l a t i o n : market d i s c i p l i n e and c o s t - e f f i c i e n c y . The following two chapters of t h i s paper c o n s i s t of an evaluation of Canadian bank insolvency l e g i s l a t i o n i n l i g h t of the r a t i o n a l e f o r bank b a i l o u t s and the i n t e r e s t s of market d i s c i p l i n e and c o s t - e f f i c i e n c y . 51 The Canadian Bankers' Association, Response to B i l l C-42: An Act Respecting F i n a n c i a l I n s t i t u t i o n s and the Deposit Insurance System (Toronto: A p r i l , 1987) at Appendix C. 39 CHAPTER 3. CANADIAN BANK INSOLVENCY LEGISLATION On J u l y 2 and 3, 1987, l e g i s l a t i o n reforming the reg u l a t i o n of f i n a n c i a l i n s t i t u t i o n s and the deposit insurance system was proclaimed by the fed e r a l government. The changes which t h i s new l e g i s l a t i o n have made to the l e g i s l a t i v e framework preceding i t w i l l be examined i n chapter 7. However, i t i s the p r e - e x i s t i n g l e g i s l a t i o n which c o n t r o l l e d the government * s responses to the bank f a i l u r e s experienced i n Canada to date. Therefore, i t i s the pre-July, 1987 l e g i s l a t i v e framework which i s the subject of the following a n a l y s i s . Before examining the sources of the fed e r a l government's l e g i s l a t i v e authority over bank insolvency, a b r i e f o u t l i n e of the regulatory framework and the i n s t i t u t i o n s responsible f o r bank re g u l a t i o n i n Canada w i l l be provided. Although the focus of t h i s paper i s government power to respond to actual or threatened bank insolvency, some understanding of i t s underlying powers to prevent insolvency through regu l a t i o n and supervision i s important. 1. Regulatory Framework The Canadian banking system i s governed by the terms and p r o v i s i o n s of the Bank Act (S.C. 1980, c.40). The Act esta b l i s h e s two classes of banks: Schedule A and Schedule B. Schedule A banks are widely-held by the p u b l i c with no i n d i v i d u a l or corporation holding i n excess of 10% of the 40 shares of any c l a s s and not more than 25% of the shares of any c l a s s being held by a Canadian or for e i g n i n d i v i d u a l or corporation. Part V of the Bank Act sets out the authorized business and powers of banks, which include accepting deposits, borrowing money, acting as f i n a n c i a l agents, guaranteeing payment or repayment of funds, lending money (which includes making mortgages), and i n v e s t i n g i n s e c u r i t i e s . Section 174 sets out the l i m i t a t i o n s on the powers of banks. Generally, banks are p r o h i b i t e d from dealing i n goods, wares or merchandise or engaging i n any trade or business except as authorized by the Act. Under Part V, each bank i s required to maintain adequate c a p i t a l and adequate and appropriate forms of l i q u i d i t y i n r e l a t i o n to i t s operations. Banks are required by s e c t i o n 2 08 to maintain primary reserves and, i f required by the Bank of Canada, secondary reserves. The r e g u l a t i o n of banks i s based on a t r i p a r t i t e system c o n s i s t i n g of i n t e r n a l regulation, external a u d i t i n g and inspection by federal a u t h o r i t i e s . Internal r e g u l a t i o n i s conducted i n several ways. The bank's d i r e c t o r s are given the r e s p o n s i b i l i t y of managing the business and a f f a i r s of the bank, subject to the provisions of the Act (section 34). Section 54 imposes a statutory duty of care, owed by d i r e c t o r s and o f f i c e r s to the bank. Section 243 imposes an o b l i g a t i o n on the d i r e c t o r s to appoint an audit committee, comprised of at l e a s t three independent d i r e c t o r s . The purpose of the audit committee i s to examine the work of the 41 bank's i n t e r n a l and external auditors, before the f i n a n c i a l statements are approved by the d i r e c t o r s (section 243(3)). When informed by the external auditors of an e r r o r or misstatement i n a f i n a n c i a l statement, the d i r e c t o r s are obligated to prepare revised f i n a n c i a l statements or otherwise inform the shareholders and the Inspector General of the e r r o r (section 243(8)). Banks also use i n t e r n a l inspection departments which t e s t the bank's i n t e r n a l c o n t r o l systems and the q u a l i t y of i t s l o a n s . 1 The second aspect of bank re g u l a t i o n i s performed by the shareholders' auditors. At l e a s t two external auditors must be appointed annually by the shareholders of the bank (section 2 37) . These auditors report to the shareholders on the f i n a n c i a l statements at each year end and to the c h i e f executive o f f i c e r and c h i e f general manager on matters which may a f f e c t the well-being of the bank. The t h i r d branch of the t r i p a r t i t e regulatory structure, inspection by f e d e r a l a u t h o r i t i e s , w i l l be discussed below, under the heading, " O f f i c e of the Inspector General of Banks". The four governmental i n s t i t u t i o n s relevant to bank supervision and regulation: the Bank of Canada, the Department of Finance, the O f f i c e of the Inspector General of Banks and the Canada Deposit Insurance Corporation, are discussed b r i e f l y below. 1 Estey, supra, chapter 1, note 1 at 38. 42 a) The Bank of Canada The Bank of Canada i s governed by.the Bank of Canada Act. Canada's c e n t r a l bank, t h i s i n s t i t u t i o n i s responsible f o r monetary p o l i c y and acts as the Canadian government's f i s c a l agent ( i . e . i t manages the p u b l i c debt) and as a lender of l a s t r e s o r t to banks. In i t s r o l e as the regulator of l i q u i d i t y , the Bank of Canada provides ordinary advances (usually one day) to banks experiencing s h o r t f a l l s i n t h e i r reserve balances or i n the reserves required by s e c t i o n 208 of the Bank A c t . 2 Under s e c t i o n 18(1)(h), the Bank of Canada i s empowered to make extraordinary (maximum of s i x months) l i q u i d i t y payments to banks unable to meet depositor withdrawals due to a run on deposits. I t i s obligated to report a l l l i q u i d i t y advances made to banks to the M i n i s t e r of Finance, which information i s published i n the Canada Gazette (section 25(1)). The Bank of Canada does not possess supervisory powers over the banks. b) Department of Finance The M i n i s t e r of Finance i s granted supervisory powers under the Bank Act. For example, under sec t i o n 246(4), the M i n i s t e r can authorize an examination of a bank when i t i s believed that an offence has been committed under the Bank Act. Under sec t i o n 239(1), the M i n i s t e r has the power to revoke the appointment of auditors and under sec t i o n 2 29 can require a bank to f u r n i s h such other information as he may 2 Estey, supra, chapter 1, note 1 at 57. 43 require i n ad d i t i o n to the returns required by Part VII. Under sect i o n 175(1), a bank s h a l l comply with any r u l e s i n the form of written d i r e c t i v e s from the M i n i s t e r with respect to c a p i t a l adequacy and l i q u i d i t y . I t i s the Mi n i s t e r who appoints a curator to supervise the business and a f f a i r s of an insolvent bank. In p r a c t i c e , the M i n i s t e r of Finance r e l i e s h e a v i l y on the O f f i c e of the Inspector General of Banks f o r d a i l y administration of the Act, while r e s t r i c t i n g i t s a t t e n t i o n to p o l i c y matters. 3 c) O f f i c e of the Inspector General of Banks Created i n the aftermath of the 1923 f a i l u r e of the Home Bank of Canada, the O f f i c e of the Inspector General of Banks (the "OIGB") i s a branch of the Department of Finance and possesses the primary supervisory r e s p o n s i b i l i t y over banks. 4 Under sect i o n 245 of the Bank Act, an Inspector General of Banks i s appointed by the Governor General i n Council on the recommendation of the M i n i s t e r of Finance. The Inspector i s responsible f o r the administration of the Act (section 246(1)). In f u l f i l l i n g h i s supervisory functions, the Inspector i s required by sect i o n 246(2) to make or cause to be made, at l e a s t once a year, such examination or inquiry into the business and a f f a i r s of each 3 Estey, supra, chapter 1, note 1 at 56. 4 I t should be noted that the F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance System Amendment Act replaced the OIGB with a new body: the O f f i c e of the Superintendent of F i n a n c i a l I n s t i t u t i o n s . I t ret a i n s much of the powers and duties with respect to banks as held by the OIGB but i s given several new powers which are discussed i n chapter 7. 44 bank as the Inspector deems necessary. He i s to s a t i s f y himself that the provisions of the Bank Act are being observed (for example, c a p i t a l adequacy and l i q u i d i t y ) and that the bank i s i n sound f i n a n c i a l condition. The r e s u l t s of such examination are to be reported to the M i n i s t e r . According to section 246(4), the Min i s t e r , when he has reason to bel i e v e that an offence under the Act has been or i s about to be committed, s h a l l d i r e c t the Inspector to make such i n q u i r y as i s necessary to determine the fa c t s and report the r e s u l t s to the Mi n i s t e r . The Inspector i s given the r i g h t to access the bank's books, documents, cash etc. and the r i g h t to require the d i r e c t o r s , o f f i c e r s and auditors of the bank to provide such information as he may require (section 246(5)). In r e a l i t y , although the Inspector has f u l l powers to inspect the banks, he r e l i e s h e a v i l y on the shareholders' auditors and the i n t e r n a l bank inspection system. 5 d) Canada Deposit Insurance Corporation The Canada Deposit Insurance Corporation (the "CDIC") i s a Crown corporation and i s governed by the Canada Deposit Insurance Corporation Act (R.S.C. 1970, c.C-3). I t i s responsible f o r insu r i n g deposits at banks and other deposit-taking i n s t i t u t i o n s to a maximum of $60,000. The CDIC's insurance fund i s provided f o r by the assessment o f premiums on member i n s t i t u t i o n s at the rate of one-tenth o f 5 Coopers and Lybrand, supra, chapter 1, note 5 at 21. one percent of insured deposits. The Board of Directors of the CDIC i s comprised of a Chairman selected by the Governor General i n Council, the Governor of the Bank of Canada, the Deputy M i n i s t e r of Finance, the Superintendent of Insurance and the Inspector General of Banks. Despite i t s obvious i n t e r e s t as insurer i n avoiding bank f a i l u r e s , the CDIC has very l i m i t e d supervisory powers. I t i s e n t i t l e d to have the a f f a i r s of chartered banks examined on i t s behalf by the OIGB but i s not e n t i t l e d to conduct i t s own inspection. A f t e r an examination i s made on i t s behalf, the examiner i s to report to the Corporation as to whether or not any changes have occurred i n the circumstances of the bank that might m a t e r i a l l y a f f e c t the Corporation's p o s i t i o n as insurer (section 23). I t has the authority to prescribe standards of sound business and f i n a n c i a l p r a c t i c e s when concerned about a bank's p r a c t i c e s but has no corresponding enforcement powers. When the Corporation i s of the view that a member i n s t i t u t i o n i s following unsound business or f i n a n c i a l p r a c t i c e s , i t i s required by s e c t i o n 24 to report the f a c t s to the president or chairman of such i n s t i t u t i o n , who s h a l l cause the report to be presented to a d i r e c t o r s ' meeting. Although the CDIC's powers to regulate and supervise banks before they reach insolvency are l i m i t e d , once insolvency i s threatened, i t s powers to act are s l i g h t l y broader. The s p e c i f i c 6 The F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance Amendment Act allows the premium l e v e l s to be set by regulation, subject to a statutory c e i l i n g of one-sixth of one percent of insured deposits. 46 provisions of the Canada Deposit Insurance Corporation Act which grant authority to the Corporation to deal with insolvency or threatened insolvency are discussed below under the heading " L e g i s l a t i v e Framework". 2. L e g i s l a t i v e Framework The power of federal i n s t i t u t i o n s to act i n a bank insolvency s i t u a t i o n i s derived from three sources: the Bank Act, the Canada Deposit Insurance Corporation Act, and the Winding-up Act. a) Bank Act Under s e c t i o n 276 of the Bank Act, a bank i s consituted insolvent i f i t suspends payment f o r ninety consecutive days of any l i a b i l i t y as i t accrues. Once insolvent, the bank may exercise the powers conferred upon i t by the Act only f o r the purpose of winding up the business of the bank under the Winding-up Act (section 276(2)). When a bank suspends payment of i t s l i a b i l i t i e s , the M i n i s t e r s h a l l , under section 278, appoint a curator to supervise the business and a f f a i r s of the bank. S i m i l a r l y , i f the Inspector reports that i n h i s opinion a bank w i l l be unable to pay i t s l i a b i l i t i e s as they accrue, the M i n i s t e r may appoint a curator (section 278(2)). Once appointed, the curator i s responsible f o r supervising the business and a f f a i r s of the bank and has a l l powers and s h a l l take a l l steps necessary to protect the i n t e r e s t s of c r e d i t o r s and 47 shareholders of the bank and to conserve i t s assets and ensure t h e i r proper d i s p o s i t i o n (section 279) . For such purposes, the curator i s e n t i t l e d to free access to the bank's accounts, records, cash, s e c u r i t i e s , etc. The curator r e t a i n s i t s powers of supervision over the busines and a f f a i r s of the bank u n t i l he i s removed from o f f i c e by the M i n i s t e r or u n t i l a l i q u i d a t o r i s appointed to wind up the business of the bank (section 279(2)). • Upon insolvency, the p r i o r i t i e s of c r e d i t o r s ' claims are determined according to section 277. Claims of the governments of Canada and of any province (except debts evidenced by bank debentures) are the f i r s t and second charges, r e s p e c t i v e l y , on the bank's assets. Next, deposit l i a b i l i t i e s are to be paid i n f u l l , then a l l other l i a b i l i t i e s of the bank, followed by debentures and those l i a b i l i t i e s ranking equally with debentures. F i n a l l y , f i n e s or p e n a l t i e s c o n s t i t u t e the l a s t charge on the bank's assets. b) Winding-up Act (R.S.C.1970, c.W-10) An a p p l i c a t i o n f o r a winding-up order of an insolvent bank i s to be made by the bank (section 11) or by a c r e d i t o r of the bank having a claim i n excess of $1000 (section 153). Upon a p p l i c a t i o n f o r a winding-up order, the court may make the order requested, dismiss i t , adjourn i t , or make any interim or other order i t deems j u s t (section 13). I f the bank opposes the a p p l i c a t i o n on the ground that i t has not 48 become insolvent, the court may i n i t s d i s c r e t i o n adjourn the a p p l i c a t i o n f o r a maximum of s i x months and order a person to inquire into the a f f a i r s of the bank and report to the court (section 14). Before making a winding-up order, the court must d i r e c t that both the shareholders and the c r e d i t o r s of the bank hold meetings i n order to as c e r t a i n t h e i r wishes as to the appointment of a l i q u i d a t o r (section 153(2)). The chairman of each meeting i s to report the r e s u l t s of the proceeding to the court and i f a winding-up order i s made, the court w i l l appoint a maximum of three l i q u i d a t o r s from among those nominated by the shareholders and c r e d i t o r s . The l i q u i d a t o r ( s ) , once appointed, i s to take i n t o h i s co n t r o l a l l property of the bank, prepare a statement of the bank's assets, debts and l i a b i l i t i e s and generally do a l l things necessary f o r winding up the a f f a i r s of the bank and d i s t r i b u t i n g i t s assets (sections 33-35). The court may appoint inspectors to a s s i s t and advise the l i q u i d a t o r i n the l i q u i d a t i o n of the bank. Once a winding-up order i s made, the bank s h a l l cease to carry on business except as required f o r i t s b e n e f i c i a l winding-up (section 19). c) Canada Deposit Insurance Corporation Act The fundamental r e s p o n s i b i l i t i e s of the CDIC under the Canada Deposit Insurance Corporation Act are to insure deposits and to compensate depositors when t h e i r insured deposits are l o s t as a r e s u l t of the f a i l u r e of a member i n s t i t u t i o n . Section 11 of the Act sets out the powers of the CDIC. Generally, the Corporation i s authorized to do a l l things necessary or i n c i d e n t a l to the p u r s u i t of i t s objects. The Corporation's objects are set out i n se c t i o n 8 and are as follows: to provide, f o r the b e n e f i t of persons having deposits with member i n s t i t u t i o n s , against the loss of deposits; to provide the deposit insurance required by the Act f o r fed e r a l i n s t i t u t i o n s ; to examine in t o the a f f a i r s of member i n s t i t u t i o n s f o r the purpose of obtaining information r e l a t i v e to deposit insurance; and to accumulate, manage and invest a deposit insurance fund. Section 11 goes on to provide a non-exhaustive l i s t of the Corporation's powers, which includes the following powers: i) to acquire assets from a member i n s t i t u t i o n and make, or guaranteee loans, advances or deposits with a member i n s t i t u t i o n f o r the purpose of reducing a r i s k or threatened l o s s to the Corporation; i i ) to borrow money from the Government of Canada and issue bonds and debentures th e r e f o r ; i i i ) to act as a curator of a bank or l i q u i d a t o r or r e c e i v e r of a member i n s t i t u t i o n when duly appointed as such; iv) to assume the costs of winding up a member i n s t i t u t i o n ; v) to guarantee the payment of the fees of and the costs incurred by a l i q u i d a t o r or r e c e i v e r of a member i n s t i t u t i o n ; v i) to acquire assets of a member i n s t i t u t i o n from a l i q u i d a t o r or rec e i v e r thereof; v i i ) to make an advance fo r the purpose of paying a claim against a member i n s t i t u t i o n f o r which the Corporation i s acting as rec e i v e r or l i q u i d a t o r i n respect of any insured deposit and becoming 50 subrogated as an unsecured c r e d i t o r f o r the amount of such advance; and v i i i ) to make or cause to be made such inspection of member i n s t i t u t i o n s as i s authorized under the Act or the p o l i c y of insurance. Under sec t i o n 13(4), the Corporation i s required to pay any claim i n respect of an insured deposit as soon as poss i b l e a f t e r the o b l i g a t i o n a r i s e s . The Corporation i s e n t i t l e d to make such payment where a winding-up order has been made or the member i n s t i t u t i o n i s unable to make any payment i n respect of the deposit by reason of an order of a court or where the Corporation i s s a t i s f i e d that the member i n s t i t u t i o n i s unable to pay immediately and i n f u l l any insured deposits (section 13(4.1)). The CDIC has the authority to i n i t i a t e the winding-up of a bank i f the Corporation i s of the view that the bank i s or i s about to become insolvent (section 29). When a bank ceases to take deposits, or i s , i n the opinion of the CDIC, insolvent, the CDIC may cancel i t s insurance under sec t i o n 27 of the Act. When i t s deposit insurance i s cancelled, the member i n s t i t u i o n i s obligated to n o t i f y i t s depositors of that f a c t . Furthermore, the Corporation may give p u b l i c notice of such c a n c e l l a t i o n i f i t i s of the opinion that such notice would serve the p u b l i c i n t e r e s t . Therefore, the CDIC has some powers to act i n the event of the threatened or actual insolvency of a chartered bank. However, i t w i l l be argued that these powers are inadequate 51 i f the CDIC i s to be able to f u l l y protect i t s i n t e r e s t as insurer. 3. Case Studies As a framework i n which to analyze the f e d e r a l government's l e g i s l a t i v e authority to deal with bank insolvency, case studies of CCB, Northland and the Bank of B.C. w i l l be employed, with p a r t i c u l a r emphasis on the government's response to the actual or threatened insolv e n c i e s of these three banks. The case studies w i l l be used to examine and assess the adequacy of the l e g i s l a t i o n under which government agencies have been empowered to deal with bank f a i l u r e . a) Canadian Commercial Bank O r i g i n a l l y incorporated i n 1975 as the Canadian Commercial and I n d u s t r i a l Bank, the CCB operated predominantly i n Alberta and B r i t i s h Columbia, concentrating on r e a l estate and energy l o a n s . 7 From i t s inception, i n order to compete with the b i g s i x banks, the CCB attempted to f i l l what i t perceived to be an unoccupied niche, by making higher r i s k loans to the commercial middle market. 8 The bank was designed as a business bank rather than as a consumer bank and u n t i l 198 3 r e l i e d on funding from the wholesale money market rather than r e t a i l deposits, thereby avoiding the expense of e s t a b l i s h i n g a chain of r e t a i l 7 Estey, supra, chapter 1, note 1 at 72. 8 I b i d , at 405. branches. In the Estey Report, the Commission observed that: "The bank was seen i n the West as well as by the f e d e r a l government as being one which would 'lend money where the established banks refused to l e n d ' " . 1 0 In i t s e a r l y years, the bank grew quickly, as d i d the Western economy. In order to finance t h i s growth, ra p i d expansion of i t s loan p o r t f o l i o was necessary, which increased the r i s k of making u n s a t i s f a c t o r y l o a n s . 1 1 The bank's troubles, which became evident i n 1982, were tr i g g e r e d by the recession which h i t Western Canada i n 1981. The e f f e c t of t h i s economic downturn was that a high percentage of the loans i n the CCB's excessively concentrated p o r t f o l i o became non-performing. 1 2 By 1983, i t was c l e a r that the CCB's deposit base, dependent as i t was on the unstable, v o l a t i l e and c y c l i c a l wholesale market was dangerous and management attempted to s h i f t to the more stable r e t a i l market. 1 3 By the f i s c a l year end of 1984, r e t a i l deposits had r i s e n from a n e g l i g i b l e percentage to 2 0% of t o t a l d e p o s i t s . 1 4 However, the number of bad loans i n CCB's p o r t f o l i o continued to r i s e between 1984 and 1985. 1 5 Adding to i t s d i f f i c u l t i e s , was the c o s t l y attempt to d i v e r s i f y i t s investments by the a c q u i s i t i o n of an 9 Ibid, at 426. 10 Estey, supra, chapter 1, note 1 at 71. 11 Ibid, at 74. 12 Ibid, at 11. 13 Ibid, at 71-72. 14 I b i d , at 81. 15 I b i d , at 83. 53 i n t e r e s t i n Westlands Bank—a problem-ridden C a l i f o r n i a bank. 1 6 Management, recognizing that the bank was i n serious trouble, resorted to several s u r v i v a l t a c t i c s , i n an attempt to t i d e the bank over u n t i l the economy improved. Management placed u n s a t i s f a c t o r y loans i n t o a workout arrangement which e n t a i l e d the adoption of a v a l u a t i o n standard r e f e r r e d to by management as "baseline v a l u e " . 1 7 Baseline value was the a n t i c i p a t e d value of the loan, based on an assumption that the economy would r e c o v e r . 1 8 Based on t h i s v a l u a t i o n , management recognized questionable accrued i n t e r e s t as income although i t had not i n f a c t been received, f a i l e d to make s p e c i f i c provisions i n i t s f i n a n c i a l statements f o r bad loans and e s t a b l i s h e d s e c u r i t y values on the basis of future ( i . e . higher) values rather than present ( i . e . depressed) v a l u e s . 1 9 These accounting techniques had the e f f e c t of shoring up the bank's f i n a n c i a l statements. 2 0 By the end of f i s c a l year 1984, the f i n a n c i a l statements no longer revealed the bank's true status, which delayed the ultimate i n s o l v e n c y . 2 1 Meanwhile, neither the bank's external auditors nor the OIGB put a stop to management's questionable p r a c t i c e s . The Estey Report concluded that the CCB's external auditors were aware of these management p r a c t i c e s and accepted them 16 Ibid, at 81. 17 I b i d , at 86. 18 I b i d , at 91. 19 Ibid, at 91. 20 Ibid, at 83-93. 21 Ibid, at 100. 5 4 although by 1983 they were expressing concern that the accounting p r a c t i c e s were not as conservative as they might w i s h . " Despite t h e i r concern, they continued to c e r t i f y the bank's f i n a n c i a l statements, f e e l i n g t h e i r p r o f e s s i o n a l duty had been discharged by communicating t h e i r concerns to the bank's Audit Committee. 2 3 The Estey Report concluded that the auditors d i d not apply standard p r i n c i p l e s of bank aud i t i n g to the f i n a n c i a l statements. 2 4 Furthermore, they f a i l e d to report u n s a t i s f a c t o r y conditions a f f e c t i n g the well-being of the bank to the c h i e f executive o f f i c e r and c h i e f general manager as required by s e c t i o n 242 of the Bank A c t . 2 5 The Estey Report also concluded that the OIGB knew of the bank's d e t e r i o r a t i n g condition between 1982 and 1983 and of the unconservative p r a c t i c e s adopted by management, but ignored a l l warning s i g n a l s . 2 6 I t r e l i e d on the f a c t that the external auditors continued to c e r t i f y the bank's f i n a n c i a l statements as well as statements of management fo r i t s lack of a c t i o n . 2 7 On March 14, 1985, representatives of the CCB informed the OIGB and the Bank of Canada that the CCB could no longer operate without f i n a n c i a l a s s i s t a n c e . 2 8 In response, the Bank of Canada made su b s t a n t i a l l i q u i d i t y advances to the 22 Ibid, at 137-149. 23 Ibid, at 151. 24 Ibid, at 153. 25 Ibid, at 151. 26 Ibid, at 164. 27 Ibid, at 158. 28 Ibid, at 105. 55 CCB i n March and e a r l y A p r i l . At the same time, negotiations began, the object of which was to i n s t a t e a support program to restore the CCB to solvency and, u l t i m a t e l y , healthy operation. In the course of these negotiations, the president of the CCB i n d i c a t e d that loan l o s s p r o v i s i o n s t o t a l l i n g $244 m i l l i o n were n e c e s s a r y . 2 9 This assessment was confirmed by the OIGB, on the basis of an incomplete inspection of the bank's loan p o r t f o l i o . 3 0 A support package i n the amount of $255 m i l l i o n was u l t i m a t e l y agreed upon, with the p a r t i c i p a n t s c o n s i s t i n g of the CDIC (contributing $75 m i l l i o n ) , the f e d e r a l government ($60 m i l l i o n ) , the Province of A l b e r t a ($60 m i l l i o n ) and a banking group comprised of the b i g s i x banks (contributing a t o t a l of $60 m i l l i o n ) . 3 1 The government of Canada was authorized to p a r t i c i p a t e i n the rescue plan by the passage of the Canadian Commercial Bank Assistance Act (R.S.1984- 1985, c.9). The banking group had i n s i s t e d during negotiations of the rescue plan that CCB debenture holders waive t h e i r r i g h t to p r i n c i p a l or i n t e r e s t u n t i l the support plan p a r t i c i p a n t s recovered t h e i r c o n t r i b u t i o n s . 3 2 When the debenture holders refused to so agree, the Governments of Canada, Albe r t a and B r i t i s h Columbia purchased $39 m i l l i o n i n debentures. Thus, CCB debenture holders were paid o f f before the rescue program was implemented. The members of the banking group received warrants to acquire shares of the 29 Ibid, at 110-111. 30 Ibid, at 110. 31 Ibid, at 499. 32 Ibid, at 111. 56 CCB i n the future, i n exchange f o r t h e i r f i n a n c i a l c o n t r i b u t i o n . The e f f e c t of these warrants when exercised would have been to v i r t u a l l y eliminate the i n t e r e s t s of the e x i s t i n g s h a r e h o l d e r s . 3 3 In addition, the CCB was obliged to pay one h a l f of the bank's pre-tax income to the p a r t i c i p a n t s i n the rescue plan and suspend a l l dividends on CCB shares u n t i l the $255 m i l l i o n c o n t r i b u t i o n was r e p a i d . 3 4 A f t e r the rescue plan was i n s t i t u t e d , f u r t h e r and more comprehensive p o r t f o l i o examinations were conducted by the OIGB. As a r e s u l t , i t became c l e a r that many of the CCB's loans were overvalued on the balance sheet and that the support group had devised t h e i r rescue plan with inadequate and inaccurate i n f o r m a t i o n . 3 5 I t quickly became obvious that the $255 m i l l i o n infused into the CCB was g r o s s l y inadequate and the CCB's f i n a n c i a l outlook appeared d i m . 3 6 In J u l y and August of 1985, the p o s s i b i l i t y of a merger was considered but no party could be found who was w i l l i n g to merge with the CCB without a s u b s t a n t i a l government s u b s i d y . 3 7 On September 1, 1985, the OIGB informed the M i n i s t e r of Finance that a curator should be.appointed as the CCB was no longer able to pay i t s l i a b i l i t i e s as they came due. The bank was u l t i m a t e l y l i q u i d a t e d , with insured and uninsured depositors r e c e i v i n g f u l l compensation and the 33 Ibid, at 116-118. 34 Ibid, at 499. 35 Ibid, at 121. 36 Ibid, at 126. 37 Proceedings of the Standing Senate Committee on Banking, Trade and Commerce (Ottawa: November 19, 1985) at 31:7 [hereinafter "Proceedings"]. 57 members of the support group (who were not c l a s s i f i e d as depositors) l o s i n g t h e i r c o n t r i b u t i o n s . 3 8 b) Northland Bank Incorporated i n 1975, Northland was, l i k e the CCB, a Western-based bank designed to lend to h i g h e r - r i s k mid- market commercial borrowers and to r e l y e s s e n t i a l l y on funding from wholesale money markets. 3 9 Although the bank grew s t e a d i l y from 1975 u n t i l 1982, i t suffered from geographic concentration, a lack of experienced management, and a n o n - d i v e r s i f i e d loan p o r t f o l i o which concentrated on the c y c l i c a l energy and r e a l estate i n d u s t r i e s . 4 0 Due to i t s lending p r a c t i c e s and r e l i a n c e on the wholesale money markets, Northland was vulnerable to the recession which h i t Albe r t a i n 1981. 4 1 By 1983, i t was c l e a r to management that i t was fa c i n g a large number of nonperforming l o a n s . 4 2 In response, management adopted s u r v i v a l t a c t i c s (much l i k e those used by CCB's management) i n an attempt to maintain a healthy appearance u n t i l the Western economy recovered. One t a c t i c adopted by management was to turn to the r e t a i l market f o r a more stable core of d e p o s i t s . 4 3 Another stategy was to place u n s a t i s f a c t o r y loans into a workout which management f e l t j u s t i f i e d i n f l a t i n g the value of the loan or i t s c o l l a t e r a l , c a p i t a l i z i n g i n t e r e s t and 38 Estey, supra, chapter 1, note 1 at 530. 3 9 Ibid, at 2. 40 Ibid, at 181. 41 Ibid, at 186. 42 Ibid, at 187. 43 Ib i d , at 189. taking accrued but unreceived i n t e r e s t into income. The e f f e c t of these t a c t i c s was summarized i n the Estey Report: The F i n a n c i a l Statements became gold f i l l i n g s covering c a v i t i e s i n the assets and i n the earnings of the bank. By conventional standards of banking and bank accounting the bank would have been shown as short on assets and earnings. The confidence of the money market would have been l o s t and deposits withdrawn. The bank, without outside assistance, would have had to close i t s doors as e a r l y as 1983. 5 As i n the case of the CCB, Northland's external auditors accepted managements's p r a c t i c e of taking i n t o account t h e i r expectations of future improved economic conditions when valuing a s s e t s . 4 6 They were not conservative when reviewing management workouts of u n s a t i s f a c t o r y l o a n s . 4 7 The Estey Report concluded that the auditors expressed concern to the Audit Committee only o c c a s i o n a l l y and i n e f f e c t u a l l y . 4 8 In 1982-1983, the OIGB became aware of the discrepancy between present day values of Northland's loans and those future values ascertained by management. 4 9 However, i t r e l i e d on the external auditors and management and d i d not d i r e c t i t s powers to deal with the bank's problems u n t i l 1985. 5 0 Northland's problems were compounded by the highly p u b l i c i z e d b a i l o u t of the CCB i n March, 1985. The two banks 44 Ibid, at 4. 45 Ibid, at 5-6. 46 Ibid, at 242. 47 Ibid, at 248. 48 Ibid, at 244. 49 Ibid, at 253. 50 Ibid, at 262. 5 9 were seen by depositors as belonging to the same category and as a r e s u l t , Northland suffered a loss of deposits and a f a l l i n share p r i c e s . 5 1 L i q u i d i t y advances which u l t i m a t e l y t o t a l l e d $500 m i l l i o n were made by the Bank of Canada to replace these l o s t d e p o s i t s . 5 2 On September 1, 1985, the OIGB informed the Bank of Canada that Northland was unable to meet i t s l i a b i l i t i e s as they came due and recommended to the M i n i s t e r of Finance that a curator be appointed. The l i q u i d a t i o n process was delayed due to management's b e l i e f that Northland could be r e h a b i l i t a t e d or merged with a v i a b l e i n s t i t u t i o n . Four proposals were put f o r t h but each involved s u b s t a n t i a l open-ended indemnities from government and were, therefore, r e j e c t e d by government o f f i c i a l s . 5 3 The bank was l i q u i d a t e d i n e a r l y 1986 with insured and uninsured depositors having received f u l l compensation. c) Bank of B r i t i s h Columbia Formed i n 1967 and promoting i t s e l f as "Canada's Western Bank", the Bank of B.C. was successful i n the r e t a i l market, b u i l d i n g f o r t y one r e t a i l branches i n B r i t i s h Columbia and Alberta. However, l i k e the CCB and Northland, i t s u ffered from the economic downturn which h i t the Western economy i n 1982. In 1983, i t posted loan losses of $51 m i l l i o n and i n 1984 had $122 m i l l i o n worth of outstanding 51 Ibid, at 6. 52 Ibid, at 6. 53 Proceedings, supra, note 37 at 31:9. loans on which i n t e r e s t payments had ceased to be made. Despite an i n f u s i o n of new c a p i t a l i n 1985, i t s deposits dropped dramatically i n that year due to confidence l o s t as a r e s u l t of the collapses of CCB and N o r t h l a n d . 5 5 By A p r i l , 1986, l i q u i d i t y advances from the Bank of Canada had reached a maximum height of $975 m i l l i o n . 5 6 Following the f a i l u r e s of the CCB and Northland, Bank of B.C. management conducted an unsuccessful search f o r a p o t e n t i a l purchaser or merger partner. In the second quarter of the f i n a n c i a l year ending October 31, 198 6, management decided to consolidate i t s operations by c l o s i n g some Western branches and reducing foreign o p e r a t i o n s . 5 7 In November, 1986, the Bank of B.C.'s external auditors informed management that they would be unable to provide an u n q u a l i f i e d audit opinion on the f i n a n c i a l statements due to concern over the bank's future v i a b i l i t y . 5 8 The OIGB conducted four reviews of the bank's loan p o r t f o l i o between September, 1985 and September, 198 6, concluding that the bank was i n a precarious p o s i t i o n . 5 9 Management conducted a renewed search f o r prospective purchasers i n the fourth quarter of 198 6. The CDIC offered to contribute f i n a n c i a l support to a proposed t r a n s a c t i o n 54 John Shreiner, "Is Edgar on a Kaiser R o l l ? " , F i n a n c i a l Post Magazine (March 1, 1986) at 22. 55 Ibid, at 22. 56 Bank of B r i t i s h Columbia, Management Information C i r c u l a r (December 12, 1986) at 8 [hereinafter "Information C i r c u l a r " ] . 57 Ibid, at 8. 58 I b i d , at 10. 59 Ibid, at 10. 61 a f t e r c a l c u l a t i n g that l i q u i d a t i o n of the Bank of B.C. would r e s u l t i n an immediate payment of $1.3 b i l l i o n to insured d e p o s i t o r s . 6 0 The Hongkong Bank of Canada (a subsidiary of the Hongkong and Shanghai Banking Corporation) was the only party w i l l i n g to conclude a tr a n s a c t i o n with the amount of subsidy being o f f e r e d by the CDIC. 6 1 I t agreed to purchase 98.6% of the Bank of B.C.'s t o t a l assets ( i n c l u d i n g the majority of i t s domestic and i n t e r n a t i o n a l loan p o r t f o l i o ) f o r $63.5 m i l l i o n and assumed s u b s t a n t i a l l y a l l of i t s l i a b i l i t i e s ( i n c l u d i n g a $400 m i l l i o n debt to the Bank of Canada and a l l of i t s deposit l i a b i l i t i e s ) . 6 2 The CDIC contributed $200 m i l l i o n to cover any po s s i b l e future losses associated with the Bank of B.C.'s loan p o r t f o l i o . 6 3 As a r e s u l t of t h i s purchase assumption arrangement, a l l of the bank's depositors were protected from p o t e n t i a l losses. In the course of winding up i t s business, the Bank of B.C. w i l l r e a l i z e upon the remaining assets and s a t i s f y the retained l i a b i l i t i e s . The amount which shareholders w i l l receive upon l i q u i d a t i o n w i l l depend upon the r e a l i z a t i o n of the remaining assets, the progress of l i t i g a t i o n i n v o l v i n g the Bank of B.C., the settlement of the retained l i a b i l i t i e s and whether or not the Bank of B.C. i s e n t i t l e d to an e x i s t i n g pension fund s u r p l u s . 6 4 I t i s l i k e l y that shareholders w i l l s u f f e r a s u b s t a n t i a l but not complete l o s s — Bank of B.C.'s 60 Ibid, at 11. 61 Ibid, at 15. 62 Ib i d , at 5. 63 Ibid, at 5. 64 Ibid, at 7. management expects preference shareholders to be paid out f u l l y and common shareholders to receive between $0.55 and $1.20 per share (which would increase to between $1.20 and $1.85 per share i f the bank i s e n t i t l e d to withdraw the pension s u r p l u s ) . 6 5 The preceeding three examples of bank failures/mergers are u s e f u l because although the f a c t u a l s i t u a t i o n s of the banks involved are roughly comparable, i n each case the government responded d i f f e r e n t l y to the threatened or actual insolvency. The government's responses i n these cases provide i n s i g h t into the operation of Canadian bank insolvency l e g i s l a t i o n and a s s i s t i n the following evaluation of that l e g i s l a t i o n . 65 Ibid, at 7. 63 CHAPTER 4. EVALUATION OF BANK INSOLVENCY LEGISLATION The l e g i s l a t i v e approach t o bank i n s o l v e n c y embodied i n t h e t h r e e A c t s o u t l i n e d i n c h a p t e r 3 c o n c e n t r a t e s on one c o u r s e o f a c t i o n i n t h e f a c e o f an i n s o l v e n c y : l i q u i d a t i o n and p a y o f f o f i n s u r e d d e p o s i t o r s . The e f f e c t o f t h i s r esponse i s t o b a i l out i n s u r e d d e p o s i t o r s , a form o f government i n t e r v e n t i o n which i s j u s t i f i e d on t h e grounds o f consumer p r o t e c t i o n . However, t h i s may not always be t h e most a p p r o p r i a t e s o l u t i o n depending on what o t h e r i n t e r e s t s a r e i n need o f p r o t e c t i o n . 1 The case s t u d i e s show t h a t o t h e r o p t i o n s have been c o n s i d e r e d and i n some c i r c u m s t a n c e s , i m p l e m e n t e d — r e g a r d l e s s o f t h e l i m i t e d o p t i o n s open t o t h e government under th e Bank A c t , the Canada D e p o s i t Insurance C o r p o r a t i o n A c t , and t h e Winding-up A c t . S p e c i a l l e g i s l a t i o n was passed when n e c e s s a r y t o empower the government t o t a k e t h e a c t i o n i t deemed a p p r o p r i a t e . The case s t u d i e s p o i n t t o the need f o r r e f o r m o f t h e o v e r l y r e s t r i c t i v e bank i n s o l v e n c y l e g i s l a t i o n i n f o r c e a t t h e time o f t h e f a i l u r e s . By examining th e a l t e r n a t i v e r esponses t o bank i n s o l v e n c i e s which th e government and t h e CDIC have made i n the c o n t e x t of the C C B , ~ 1 C l e a r l y , a p r i v a t e s e c t o r s o l u t i o n would be more d e s i r a b l e than any form o f government i n t e r v e n t i o n . However, t h i s paper assumes t h a t such a s o l u t i o n would be u n o b t a i n a b l e — which i s g e n e r a l l y the case due t o d e t e r i o r a t i o n o f the bank's l o a n p o r t f o l i o . See R i c h a r d M. Rosenberg, Donald B. Given, " F i n a n c i a l l y T r o u b l e d Banks: P r i v a t e S o l u t i o n s and R e g u l a t o r y A l t e r n a t i v e s " (1987) The Banking Law J o u r n a l 234 a t 285 { h e r e i n a f t e r "Rosenberg"]. 64 Northland and Bank of B.C., the s p e c i f i c d i s a b i l i t i e s and l i m i t a t i o n s of the l e g i s l a t i v e framework become evident. These a l t e r n a t e courses of a c t i o n included: a) paying o f f uninsured depositors; b) s u b s i d i z i n g mergers with v i a b l e i n s t i t u t i o n s ; and c) arranging and c o n t r i b u t i n g to rescue packages designed to restore insolvent banks to healthy operation. a) Payoff of Uninsured Depositors Although the CDIC i s obligated to pay claims of only insured depositors i n the event of l i q u i d a t i o n , i n some circumstances the government has decided that the claims of uninsured depositors should be paid as w e l l . The j u s t i f i c a t i o n s f o r the government's d e c i s i o n to b a i l out uninsured depositors of CCB and Northland were discussed supra (chapter2). Because no l e g i s l a t i v e a u thority existed f o r t h i s type of complete payout, the F i n a n c i a l I n s t i t u t i o n s Depositors Compensation Act (R.S.C. 1985 c. 51) was passed, aut h o r i z i n g the government to pay the claims, i n c l u d i n g i n t e r e s t , of the uninsured depositors of the two banks. This h i g h l i g h t s a d e f i c i e n c y i n the l e g i s l a t i v e structure i n place at the time of the f a i l u r e of these banks: i t d i d not contemplate t h i s form of government response to bank f a i l u r e yet the government was compelled by the i n t e r e s t s of f i n a n c i a l s t a b i l i t y and regional economic development to make such a response. Although there are circumstances i n which the b a i l out of uninsured depositors and c r e d i t o r s i s 65 j u s t i f i e d , i t w i l l be argued t h a t t h e r e a r e more c o s t - e f f i c i e n t and b e n e f i c i a l t e c h n i q u e s f o r a c h i e v i n g t h i s r e s u l t t han t h e l i q u i d a t i o n and p a y o f f approach t a k e n by the government i n t h e CCB and N o r t h l a n d c a s e s . These a l t e r n a t e t e c h n i q u e s and t h e c r i t e r i a f o r t h e i r i mplementation s h o u l d be c l e a r l y s e t f o r t h i n r e v i s e d bank i n s o l v e n c y l e g i s l a t i o n . 2. Merger Merger i s a second response t o bank f a i l u r e which i s not contemplated by Canadian bank i n s o l v e n c y l e g i s l a t i o n . I f a t r o u b l e d bank can arrange a merger p r i v a t e l y , t h e r e i s no need f o r government i n t e r v e n t i o n and t h e r e f o r e , no need f o r a u t h o r i z i n g l e g i s l a t i o n . However, i t i s o f t e n t h e case t h a t a d i s t r e s s e d bank cannot f i n d a w i l l i n g merger p a r t n e r w i t h o u t t h e c o n t r i b u t i o n o f a government s u b s i d y o r indemnity. The merger approach was used i n t h e Bank of B.C. case and was contemplated i n b o t h t h e CCB and N o r t h l a n d s i t u a t i o n s . The purchase o f s u b s t a n t i a l l y a l l o f t h e a s s e t s and the assumption o f s u b s t a n t i a l l y a l l o f t h e l i a b i l i t i e s o f the Bank o f B.C. by the Hongkong Bank of Canada was f a c i l i t a t e d by a s u b s i d y from t h e CDIC. When the I n s p e c t o r G e n e r a l ' s team reviewed the Bank o f B.C.'s l o a n p o r t f o l i o i n September, 1986, i t c o n c l u d e d t h a t the bank's p o s i t i o n was p r e c a r i o u s and encouraged the bank t o arrange a s a l e t o a v i a b l e f i n a n c i a l i n s t i t u t i o n . 2 I t was c l e a r t h a t the CDIC 2 I n f o r m a t i o n C i r c u l a r , supra, c h a p t e r 3, note 56 a t 10. 66 would incur a s u b s t a n t i a l l o s s i f the Bank of B.C. were forced to l i q u i d a t e . Therefore, i n order to avoid the looming prospect of l i q u i d a t i o n and payoff (and an immediate estimated payout of $1.3 b i l l i o n ) , 3 the CDIC agreed to provide s i g n i f i c a n t f i n a n c i a l support i f a t r a n s a c t i o n could be arranged which would avoid involuntary l i q u i d a t i o n of the Bank of B.C. The purchase assumption t r a n s a c t i o n which was entered i n t o by the Hongkong Bank of Canada was subsidzed by the CDIC i n the amount of $2 00 m i l l i o n . There does not appear to e x i s t any l e g i s l a t i v e authority f o r the CDIC to have made such f i n a n c i a l assistance. Under s e c t i o n 11 of the Canada Deposit Insurance Corporation Act, the Corporation i s authorized to do a l l things necessary or i n c i d e n t a l to i t s objects. I t s objects are to provide deposit insurance and make payments .to insured depositors i n accordance with the Act; examine into the a f f a i r s of member i n s i t u t i o n s f o r the purpose of obtaining information r e l a t i v e to despoit insurance; and to accumulate, manage and invest a deposit insurance fund (section 8). I t would be st r e t c h i n g the language of section 8 to f i t the CDIC's actions i n the Bank of B.C. case within one of these subsections. The Act goes on i n section 11 to provide a non-exhaustive l i s t of the Corporation's powers (see chapter 3 supra) but none appear to encompass the payment of a subsidy to an acquiring i n s t i t u t i o n . 3 Ibid, at 10. 67 T h e r e f o r e , t h e CDIC's s o l u t i o n t o the t h r e a t e n e d i n s o l v e n c y o f the Bank o f B.C. was beyond th e scope o f i t s a u t h o r i z i n g l e g i s l a t i o n . However, i t was a r g u a b l y a more a p p r o p r i a t e s o l u t i o n t han t h e l i q u i d a t i o n approach contemplated by t h a t l e g i s l a t i o n . F o r example, by s u b s i d i z i n g t h e purchase o f t h e Bank o f B.C. i n t h e amount o f $2 00 m i l l i o n , t h e CDIC a v o i d e d the almost i n e v i t a b l e payment o f a p p r o x i m a t e l y $1.3 b i l l i o n t o the bank's i n s u r e d d e p o s i t o r s . The bank was a b l e t o remain i n o p e r a t i o n , t h e r e b y m a i n t a i n i n g i t s g o i n g c o n c e r n v a l u e . Furthermore, t h e bank's u n i n s u r e d d e p o s i t o r s and c r e d i t o r s d i d not l o s e any p o r t i o n o f t h e i r investment and were saved the h a r d s h i p o f w a i t i n g u n t i l t h e bank was l i q u d a t e d f o r t h e s a t i s f a c t i o n (and p o s s i b l y o n l y p a r t i a l s a t i s f a c t i o n ) o f t h e i r c l a i m s . 4 The bank's s h a r e h o l d e r s s u f f e r e d a s i g n i f i c a n t l o s s , but a v o i d e d l o s s o f t h e i r e n t i r e investment which would have been t h e l i k e l y outcome o f i n v o l u n t a r y l i q u i d a t i o n . 5 T h e r e f o r e , t h e Bank o f B.C. i s a c l e a r example o f t h e inadequacy o f t h e p r e s e n t l e g i s l a t i v e s t r u c t u r e and the i n a p p r o p r i a t e n e s s o f the l i q u i d a t i o n and p a y o f f approach i n some s i t u a t i o n s . 4 I t w i l l be argued t h a t t h i s e f f e c t o f a purchase and assumption ( i . e . o f b a i l i n g out u n i n s u r e d d e p o s i t o r s and c r e d i t o r s ) i s not d e s i r a b l e i n a l l c i r c u m s t a n c e s due t o i t s adverse e f f e c t on market d i s c i p l i n e (see c h a p t e r 5, s e c t i o n 2 ) . However, i f the c i r c u m s t a n c e s a r e such t h a t the government i s j u s t i f i e d i n p a y i n g out the c l a i m s of u n i n s u r e d d e p o s i t o r s i n any event, a purchase and assumption has many advantages over a l i q u i d a t i o n and p a y o f f . 5 I n f o r m a t i o n C i r c u l a r , supra, c h a p t e r 3, note 56 a t 22. 68 The merger option was contemplated by the government i n the CCB case as a method of dealing with the bank's looming insolvency. The OIGB investigated the p o t e n t i a l of a merger i n August of 1985 and reported to the M i n i s t e r of State as follows: No bank would be w i l l i n g to amalgamate with them unless some t h i r d party ( i . e . , the CDIC or the government i n some form or other) pays the l a r g e r bank. Payment could be by purchasing bad and nonearning loans at face value or by funding the nonearning loans and providing an indemnity against lo s s e s . . . Obviously, there i s l i t t l e to d i s t i n g u i s h t h i s from a l i q u i d a t i o n approach...6 The merger option was u l t i m a t e l y abandoned. The p o s s i b i l i t y of a merger was also considered i n the Northland case. However, l i k e the CCB, the bank's assets had d e t e r i o r a t e d to such an extent that government subsidies required to amke the bank acceptable to proposed partners were unacceptably large. For example, the OIGB asked the National Bank to consider a merger with Northland. National refused a f t e r examining the bank's loan p o r t f o l i o . 7 When the government f a i l e d to f i n d a w i l l i n g merger partner, i t had no a l t e r n a t i v e but to use i t s power under sect i o n 278 of the Bank Act to appoint a curator to oversee the bank's operations. Further merger e f f o r t s were made a f t e r the appointment of the curator: the l i q u i d a t i o n process was delayed and the government retained a consultant who worked with Northland management to come up with a v i a b l e 6 Estey, supra. chapter 1, note 1 at 521. 7 Proceedings, supra, chapter 3, note 37 at 31:9. reorganization or merger.* Merger partners were sought among major i n t e r n a t i o n a l banks but a l l required federal commitment to cover losses on the bank's loan p o r t f o l i o . 9 The government refused to make such a commitment and on September 30, announced i t s d e c i s i o n to seek approval to have Northland wound up. Therefore, the merger option was contemplated i n the CCB and Northland cases but r e j e c t e d because the banks' assets had de t e r i o r a t e d to an extent that made the necessary government subsidy p r o h i b i t i v e l y large. However, i f such a s o l u t i o n had been attempted e a r l i e r , i t may have met with the success achieved i n the Bank of B.C. case and avoided the c o s t l y payoff of the insured and uninsured depositors of both banks. 3. Rescue Packages A t h i r d course of action which the government has taken i n the face of bank f a i l u r e i s the arrangement of a rescue program ( i . e . the i n f u s i o n of government funds into a f a i l i n g bank with the aim of r e s t o r i n g i t to healthy operation). There i s no l e g i s l a t i v e framework i n existence which provides c r i t e r i a f o r deciding when a Canadian bank should be rescued by the government. Nor i s there l e g i s l a t i o n g i v i n g government agencies the authority to i n s t i t u t e a rescue program or the f l e x i b l e powers needed to implement i t . However, i n the spring and summer of 1985, 8 Ibid, at 31:9. 9 Estey, supra. chapter 1, note 1 at 598-599. 70 when faced with the f i n a n c i a l d i f f i c u l t i e s of the CCB and Northland, the government contemplated and, i n the case of CCB, attempted a rescue through d i r e c t f i n a n c i a l assistance. In the Northland case, the government considered a rescue package as an a l t e r n a t i v e to the l i q u i d a t i o n and payoff approach. 1 0 In July, 1985, the bank's management proposed a major r e s t r u c t u r i n g arrangement to government o f f i c i a l s i n the hopes of r e s t o r i n g depositor confidence i n the bank. 1 1 The proposal involved the purchase by the Government of Canada of $250 m i l l i o n worth of the bank's loans. However, o f f i c i a l s from the Bank of Canada, the Department of Finance and the OIGB rej e c t e d the proposal on the basis that i t was premature: ...the proposal, which would be viewed as a government b a i l - o u t operation, would heighten the perception that the true s i t u a t i o n of the Northland, and of other small banks, was much worse than the p u b l i c has been l e d to b e l i e v e and could f u r t h e r undermine confidence i n the Northland and po s s i b l y , i n other small banks.12 In August of 1985, a further proposal i n v o l v i n g i n t e r e s t - free loans from the CDIC or the federal government to Northland was rejected by government o f f i c i a l s f o r much the same reasons. In September, a f t e r a curator was appointed, a government-appointed consultant received four further proposals to rescue the bank through r e s t r u c t u r i n g . However, these were rejected by the government on two 10 Proceedings, supra. chapter 3, note 37 at 31:9. 11 Estey, supra. chapter 1, note 1 at 578. 12 Ibid, at 579. 71 grounds: 1) each involved "large and open-ended subsidies" from the government and 2 ) none would guarantee a "vi a b l e ongoing banking operation that would not be dependent on continuing government s u p p o r t " . 1 3 Although the p o s s i b i l i t y of a rescue program was u l t i m a t e l y r e j e c t e d by the government i n the context of the Northland insolvency, the s i g n i f i c a n t point i s that the government d i d i n f a c t consider t h i s approach before r e s o r t i n g to the statutory procedure of l i q u i d a t i o n and payoff and the compensation of uninsured depositors. In the CCB case, the government a c t u a l l y made a rescue attempt (for d e t a i l s of the program see chapter 3 supra). In making the d e c i s i o n to implement and contribute p u b l i c funds to the rescue operation, government o f f i c i a l s had to balance the de s i r e to avoid government investment i n a pr i v a t e business against the p o t e n t i a l negative e f f e c t s of f a i l u r e . These included: p o s s i b l e repercussions f o r small, Western-based f i n a n c i a l i n s t i t u t i o n s and the Western Canadian economy; possib l e i n t e r n a t i o n a l i m p l i c a t i o n s ; d i s r u p t i o n to the busineses of CCB borrowers; and adverse e f f e c t s on the v i a b i l i t y of the regional bank c o n c e p t . 1 4 Lacking the l e g i s l a t i v e authority to make d i r e c t f i n a n c i a l contributions to a d i s t r e s s e d bank, the federal government passed s p e c i a l enabling l e g i s l a t i o n : the Canadian Commercial Bank Assistance Act. Under the terms of that Act, $75 m i l l i o n was authorized to be paid from the 13 Proceedings, supra, chapter 3, note 37 at 31:9. 14 Estey, supra, chapter 1, note 1 at 478-479. 72 Consolidated Revenue Fund f o r the purposes of the federal government's p a r t i c i p a t i o n i n the CCB rescue. In addition, the Act gave the Mi n i s t e r of State (Finance) the power to enter i n t o any agreements necessary to provide f i n a n c i a l support to the CCB under the terms of the proposed support package. The CDIC also p a r t i c i p a t e d i n the rescue program i n the amount of $75 m i l l i o n . Presumably, the Corporation's power to make t h i s c o n t r i b u t i o n derived from se c t i o n 11(a) of the Canada Deposit Insurance Corporation Act. Under the terms of that section, the Corporation i s e n t i t l e d to acquire assets from or make loans to a bank f o r the purpose of reducing a r i s k or reducing or averting a threatened loss to the Corporation. The c a p i t a l infused into the CCB by the support group was described i n the j o i n t agreement as a purchase of a package of nonperforming loans and could, therefore, be considered a purchase of assets within the meaning of sect i o n 11. A l t e r n a t i v e l y , the tr a n s a c t i o n could be described as a loan by v i r t u e of i t s repayment p r o v i s i o n (which i s more c h a r a c t e r i s t i c of a loan than of a purchase and s a l e ) . C l e a r l y , the CDIC's p a r t i c i p a t i o n — whether an asset purchase or a l o a n — was made i n an attempt to avert a threatened l o s s to the Corporation, as required by sect i o n 11. From i t s inception, the support package was almost c e r t a i n to f a i l and within several months had done so. The 73 Estey Report c i t e d several reasons f o r the f a i l u r e of the rescue plan, i n c l u d i n g the following: i) m i s c a l c u l a t i o n of the amount of assistance and the type of assistance r e q u i r e d — the funds were inadequate and d i d not provide the CCB with an immediate flow of income. The rescue funds were paid d i r e c t l y to the Bank of Canada to reduce l i q u i d i t y advances—they became a further debt o b l i g a t i o n of the CCB and d i d not a l l e v i a t e the insolvency of the CCB; i i ) lack of d i r e c t involvement by the one f e d e r a l agency experienced i n l i q u i d a t i o n — t h e CDIC; i i i ) inadequate inspection of the loan p o r t f o l i o by the OIGB and inadequate communication of the r e s u l t s of examinations to the p a r t i c i p a n t s i n the support program. Due to the lack of accurate and adequate information regarding the bank's f i n a n c i a l status, an i n s u f f i c i e n t and inappropriate plan was put into place to save a bank which may well have been beyond the point of rescue; iv) lack of a method fo r dealing with the i n t e r e s t s of CCB shareholders. The only method used to deal with t h e i r i n t e r e s t s was the granting of warrants to 74 the banking group i n exchange f o r i t s advancement of funds under r i s k y circumstances. The warrants would have v i r t u a l l y eliminated the sharholders 1 i n t e r e s t s at some future time. Estey argued that i t was inappropriate to grant equity i n the CCB to competitor banks—recovery of t h e i r advances and maintenance of the s t a b i l i t y of the f i n a n c i a l system would have been s u f f i c i e n t consideration f o r t h e i r f i n a n c i a l assistance; v) f a i l u r e to replace the bank's management (and thereby help to restore confidence i n the bank); vi ) lack of an authorized leader to d i r e c t the design and execution of the plan; and v i i ) lack of a mechanism to monitor the operation of the program. 1 5 The f a c t that the CCB rescue program f a i l e d does not demand the conclusion that such an approach to threatened insolvency i s always inappropriate. Estey's r e t r o s p e c t i v e a n a l y s i s of t h i s attempt indicates that there were s p e c i f i c and i d e n t i f i a b l e reasons for i t s f a i l u r e and a future attempt may be more successful i f these p i t f a l l s can be 15 For a complete discussion of these reasons f o r the f a i l u r e of the CCB rescue plan, see Estey, supra, chapter 1, note 1 at 114-121. 75 avoided. On the basis of Estey's evaluation of the rescue attempt, i t i s concluded that a more structured l e g i s l a t i v e framework i s needed to guide regulatory agencies i n the i n i t i a l d e c i s i o n to implement a rescue program and i n the s t r u c t u r i n g and monitoring of i t t h e r e a f t e r . Statutory authority should be vested i n one agency to assume leadership over and c o n t r o l of the process. In addition, a statutory mechanism i s required to deal with the i n t e r e s t s of the shareholders of an insolvent bank i n order to avoid t h e i r unjust enrichment when d i r e c t government assistance i s provided to an insolvent bank. The CCB experience i s h e l p f u l i n that i t provides t h i s type of i n s i g h t into the search f o r reformed l e g i s l a t i o n i n the area of bank insolvency. Conclusion The case studies show, therefore, that the basic response to bank insolvency contemplated by the present l e g i s l a t i o n — l i q u i d a t i o n and p a y o f f — h a s been considered by government to be inapproporiate or undesirable i n dealing with recent bank f a i l u r e s . I t i s submitted that, i n these cases, the government's d e c i s i o n to resolve the insolvencies through methods other than l i q u i d a t i o n and payoff, can be explained by the operation of the r a t i o n a l e of f i n a n c i a l s t a b i l i t y and/or the p o l i t i c a l b e n e f i t r a t i o n a l e . I f consumer p r o t e c t i o n had been the government's sole objective i n these cases, l i q u i d a t i o n and payoff would have been an 76 appropriate and adequate response— due to the p r o t e c t i o n afforded by deposit insurance. Deposit insurance i s an e f f e c t i v e method of p r o t e c t i n g small depositors. In a d d i t i o n to providing t h i s p rotection, l i q u i d a t i o n and payoff has the added advantage of maintaining some measure of market d i s c i p l i n e through the insurance c e i l i n g of $60,000 (which encourages uninsured depositors to i n v e s t i g a t e the r i s k i n e s s of a l t e r n a t i v e investments). I t also maintains f i n a n c i a l s t a b i l i t y to the extent of preventing bank runs on insured deposits (although, as discussed i n chapter 2, i t does not prevent runs on uninsured d e p o s i t s ) . In circumstances of r e l a t i v e f i n a n c i a l s t a b i l i t y where consumer p r o t e c t i o n i s the government's major concern, therefore, deposit insurance i s an appropriate response to bank f a i l u r e . 1 6 I t i s i n circumstances where there e x i s t s , or the government perceives there to e x i s t , one of the other r a t i o n a l e f o r b a i l o u t s , that the l i q u i d a t i o n and payoff approach proves inadequate. In the case studies, the government perceived a r i s k of a d e s t a b i l i z i n g bank run or was motivated by the r a t i o n a l e of p o l i t i c a l b e n e f i t to go beyond the p r o t e c t i o n of small d e p o s i t o r s — by implementing other forms of b a i l o u t assistance. In the CCB and Northland cases, f o r example, the government was concerned about 16 The whole issue of deposit insurance i s a complex one. A v a r i e t y of proposals has been made on reform of the deposit insurance system which includes recommendations to change the insurance c e i l i n g , co-insurance, and r i s k - r e l a t e d premiums. Reform of the deposit insurance system i s relevant to the t o p i c of t h i s paper, but beyond i t s scope. 77 f i n a n c i a l i n s t a b i l i t y and perceived a r i s k of a d e s t a b i l i z i n g bank r u n . 1 7 Furthermore, the b a i l o u t d e c i s i o n i n these cases can be explained by the government 1s i n t e r e s t i n p r o t e c t i n g regional economic development. ° These r a t i o n a l e motivated the government's actions i n implementing a rescue program i n the CCB case and, u l t i m a t e l y , i n b a i l i n g out the uninsured depositors of CCB and Northland. These forms of government int e r v e n t i o n were not provided f o r i n the government's authorizing l e g i s l a t i o n , n e c e s s i t a t i n g the implementation of s p e c i a l enabling l e g i s l a t i o n . I t i s submitted, therefore, that i n the face of one or more of the r a t i o n a l e f o r b a i l o u t s which j u s t i f y saving a bank or compensating i t s uninsured depositors and c r e d i t o r s , the l e g i s l a t i v e s t ructure under which the government has been authorized to resolve bank insolvencies has proven inadequate and i s i n need of r e f o r m . 1 9 The challenging aspect of t h i s conclusion l i e s i n developing broader and more f l e x i b l e powers to deal with insolvency and an i n s t i t u t u i o n a l structure f o r c a r r y i n g out such powers. The process of i d e n t i f y i n g the r a t i o n a l e f o r b a i l o u t s and the Canadian government's attempts at implementing broader so l u t i o n s i n three recent case studies, has h i g h l i g h t e d some of the c r i t e r i a which reformed l e g i s l a t i o n should meet. The following i s a l i s t of functions which, on the basis of 17 Proceedings, supra, chapter 3, note 37 at 31:46. 18 Ibid, at 31:7. 19 The reforms which the government has already implemented i n t h i s area are discussed i n chapter 7 i n f r a . 78 t h e p r e c e d i n g a n a l y s i s , reformed bank i n s o l v e n c y l e g i s l a t i o n s h o u l d f u l f i l : i ) m a i n t a i n t h e s t a b i l i t y o f t h e f i n a n c i a l system; i i ) p r o t e c t s m a l l d e p o s i t o r s ; i i i ) p r o t e c t t h o s e l o c a l , r e g i o n a l and n a t i o n a l i n t e r e s t s t h e p r o t e c t i o n o f which i s i n t h e n a t i o n a l i n t e r e s t ; i v ) m a i n t a i n a degree o f market d i s c i p l i n e s u f f i c i e n t t o c o n t r o l e x c e s s i v e r i s k - t a k i n g by bank management;20 v) promote economic e f f i c i e n c y ( i . e . p r o t e c t t h e d e p o s i t i n s u r a n c e f u n d ) ; v i ) e s t a b l i s h an a u t h o r i z e d l e a d e r w i t h : c o n t r o l over th e making and implementation o f d e c i s i o n s ; a c c e s s t o adequate i n f o r m a t i o n f o r t h e f u l f i l l m e n t o f such r e s p o n s i b i l i t i e s ; and broad and f l e x i b l e powers t o r e s o l v e a c t u a l o r t h r e a t e n e d bank i n s o l v e n c i e s ; v i i ) c r e a t e a mechanism whereby e q u i t y i n t e r e s t s a r e d e a l t w i t h i n c a s e s o f d i r e c t government a s s i s t a n c e t o a v o i d b a i l i n g out s h a r e h o l d e r s ; and v i i i ) p r o v i d e some measure o f c e r t a i n t y f o r persons and i n s t i t u t i o n s a f f e c t e d by bank f a i l u r e . H aving i d e n t i f i e d t h e s e c r i t e r i a f o r reformed l e g i s l a t i o n , the next s t e p i s t o d e v e l o p a model embodying as many o f t h e c r i t e r i a as p o s s i b l e . Two s o u r c e s o f i d e a s have been p a r t i c u l a r l y s i g n i f i c a n t i n the s e a r c h f o r such a model and a r e d i s c u s s e d below: th e American approach t o bank i n s o l v e n c y and r e c e n t p u b l i c s t u d i e s o f t h e Canadian system. 20 Note t h a t a c o r o l l a r y of t h i s c r i t e r i a i s the need f o r i n c r e a s e d d i s c l o s u r e . I f l a r g e d e p o s i t o r s and c r e d i t o r s are t o be expected t o e x e r c i s e market d i s c i p l i n e , adequate f i n a n c i a l i n f o r m a t i o n must be made a v a i l a b l e t o them. The form which such d i s c l o s u r e s h o u l d t ake i s an important i s s u e , but one t h a t i s beyond the scope of t h i s paper. 79 CHAPTER 5 . AMERICAN APPROACH TO BANK INSOLVENCY: THE FDIC MODEL The American banking system i s d u a l i n n a t u r e . In e v e r y s t a t e , two s e t s o f commercial banks c o - e x i s t : n a t i o n a l banks c h a r t e r e d by the C o m p t r o l l e r o f t h e Currency and s t a t e banks c h a r t e r e d by s t a t e r e g u l a t o r y o f f i c i a l s . The c h a r t e r i n g a g e n c i e s , i n a d d i t i o n t o t h e i r c o n t r o l o v e r c h a r t e r a p p l i c a t i o n s , have r e g u l a t o r y c o n t r o l o v e r t h e banks e s t a b l i s h e d under them. Fo r example, th e a g e n c i e s i s s u e r u l e s r e g u l a t i n g c a p i t a l r e q u i r e m e n t s , l e n d i n g p r a c t i c e s , powers, inv e s t m e n t s , e t c . w i t h r e s p e c t t o t h e s e banks and examine t h e i r r e c o r d s and o p e r a t i o n s t o ensure l e g a l and sound o p e r a t i o n . 1 Every n a t i o n a l bank i s r e q u i r e d t o be a member o f t h e F e d e r a l Reserve system, which i s governed by t h e F e d e r a l Reserve A c t . The A c t c r e a t e s a F e d e r a l Reserve Board which a c t s as the n a t i o n ' s c e n t r a l bank and e s t a b l i s h e s a F e d e r a l Reserve Bank i n each o f 12 d i s t r i c t s i n t h e U n i t e d S t a t e s . S t a t e - c h a r t e r e d banks may a p p l y f o r F e d e r a l Reserve membership and f o r such banks, the F e d e r a l Reserve Bank i s t h e p r i m a r y r e g u l a t o r . As such, i t r e g u l a t e s r e s e r v e and c a p i t a l r e quirements and c a r r i e s out i n s p e c t i o n s o f s t a t e member banks. 1 Kenneth E . S c o t t , "The Dual Banking System: A Model o f C o m p e t i t i o n i n R e g u l a t i o n " (1977) 30 Stan L. R e v . l a t 3. 30 A l l n a t i o n a l and s t a t e banks which a r e members o f the F e d e r a l Reserve must be i n s u r e d by t h e F e d e r a l D e p o s i t I n s u r a n c e C o r p o r a t i o n (the " F D I C " ) . 2 S t a t e banks which are not F e d e r a l Reserve members may a p p l y f o r coverage by the FDIC. The f u n c t i o n o f t h e FDIC, l i k e t he CDIC, i s t o i n s u r e d e p o s i t o r s a g a i n s t l o s s e s a r i s i n g from bank i n s o l v e n c y . To f a c i l i t a t e i t s i n s u r a n c e f u n c t i o n , the FDIC i s g i v e n d i r e c t s u p e r v i s o r y and r e g u l a t o r y powers ov e r i n s u r e d s t a t e banks which a r e not members o f t h e F e d e r a l Reserve. A l t h o u g h the FDIC does not d i r e c t l y s u p e r v i s e f e d e r a l l y - c h a r t e r e d banks and s t a t e - c h a r t e r e d member banks, i t has a c c e s s t o t h e r e p o r t s o f i n s p e c t i o n s made t o t h e C o m p t r o l l e r o f the Curr e n c y and t o t h e F e d e r a l Reserve Bank and i s a d v i s e d by t h e s e a g e n c i e s as t o any changes i n d e p o s i t l i a b i l i t i e s . 3 The C o m p t r o l l e r , the F e d e r a l Reserve and the FDIC use f o u r b a s i c methods i n e x e r c i s i n g t h e i r s u p e r v i s o r y r e s p o n s i b i l i t i e s . F i r s t , banks a r e r e q u i r e d t o p r o v i d e a number o f r e g u l a r R e p o r t s o f C o n d i t i o n , t h e most important o f which i n d i c a t e f i n a n c i a l c o n d i t i o n . 4 Secondly, t h e r e g u l a t o r s conduct o n - s i t e examinations t o determine s a f e t y and soundness, compliance w i t h laws, e t c . and employ a g r a d i n g system t o i n d i c a t e l o a n q u a l i t y . 5 A s a f e t y and soundness e x a m i n a t i o n produces a bank r e p o r t t o be a n a l y z e d by r e g u l a t o r s and a bank r a t i n g which i n d i c a t e s the bank's 2 E s t e y , supra, c h a p t e r 1, note 1 a t 386. 3 I b i d , a t 387. 4 I b i d , a t 390. 5 I b i d , a t 390-391. 81 l e v e l of safety and soundness. T h i r d l y , computer-assisted s u r v e i l l a n c e systems are used to monitor f i n a n c i a l condition of banks and provide e a r l y warning of p o t e n t i a l problems. 7 F i n a l l y , these regulatory agencies have enforcement powers, in c l u d i n g powers to issue cease and d e s i s t orders, suspend or remove d i r e c t o r s and o f f i c e r s , terminate insurance, impose c i v i l monetary p e n a l t i e s , and revoke a bank c h a r t e r . 8 The c h a r t e r i n g agency of a bank has the sole authority to determine i t s insolvency. The FDIC can p e t i t i o n the charteri n g agency to declare an insured bank i n s o l v e n t . 9 When the Comptroller becomes s a t i s f i e d of the insolvency of a na t i o n a l bank, i t has the power under the Federal Deposit Insurance Act (12 U.S.C. s.191), a f t e r due examination of the bank's a f f a i r s , to appoint a r e c e i v e r who i s to proceed to close up the bank. The statute does not provide a d e f i n i t i o n of insolvency and the Comptroller i s given the sole d i s c r e t i o n to make such a determination. This determination i s f i n a l and not subject to j u d i c i a l review (except i f made a r b i t r a r i l y or i n bad f a i t h ) . 1 0 The re c e i v e r functions under the d i r e c t i o n of and reports to the C o m p t r o l l e r . 1 1 In the case of nat i o n a l l y - c h a r t e r e d banks, the FDIC i s automatically appointed by the Comptroller to 6 Ibid, at 391. 7 Ibid, at 392. 8 Ibid, at 392. 9 Edward J . Kane, "Correcting Incentive Problems i n Deposit Insurance: The Range of A l t e r n a t i v e Solutions" i n Ziegel, supra, chapter 2, note 21 at 421. 10 Re American C i t y Bank & Trust Co., N . A . 1975, D.C.Wisc. 11 89 Pine In. v. European American Bank, (1976, DC N Y ) 424 F.Supp.908. 82 act as r e c e i v e r (12 U.S.C. s.1821(c)). State bank regulators are not obliged to appoint the FDIC as re c e i v e r of insolvent state banks but, i n p r a c t i c e , u s u a l l y do s o . 1 2 As r e c e i v e r , the FDIC pursues one of three b a s i c courses of act i o n under 12 U.S.C. s.1821 et.seq.: 1) l i q u i d a t i o n and payoff; 2) a purchase and assumption t r a n s a c t i o n ; or 3) d i r e c t f i n a n c i a l assistance. 1. L i q u i d a t i o n and Payoff This procedure involves closure of the insolvent bank, payoff of insured depositors ( i . e . deposits to a maximum of $100,000) and l i q u i d a t i o n of the bank's assets by the appointed r e c e i v e r . Under section 1821(f) of the Federal Deposit Insurance Corporation Act, whenever an insured bank i s closed f o r reason of the bank's i n a b i l i t y to meet the demands of i t s depositors, the FDIC i s obliged to pay o f f insured depositors as soon as possi b l e by cash or by making a t r a n s f e r r e d deposit i n another bank a v a i l a b l e to each depositor. I f determined to be advisable, the FDIC may organize a new national bank to assume the insured deposits of a closed bank. The FDIC makes a v a i l a b l e to the new bank an amount equal to the insured deposits of the closed bank plus operating expenses. The Corporation may decide to o f f e r c a p i t a l stock of the new bank for sale which shareholders of the closed bank w i l l be given a f i r s t option 12 W i l l i s R.Buck, "Comments, Bank Insolvency and Depositor S e t o f f " (1984) 51 U. of Chicago L.R.188 at 201 [hereinafter "Buck"]. 83 to purchase. I f an adequate amount of stock i s purchased, the new bank may be conformed into a nationa l bank (s.1821(g)). Upon payment to a depositor, the FDIC i s subrogated to a l l r i g h t s of the depositor against the closed bank to the extent of such payment. The FDIC i s then e n t i t l e d to share pro r a t a with uninsured depositors i n the bank's assets upon l i q u i d a t i o n . I f the assets are i n s u f f i c i e n t to meet these claims, the FDIC and uninsured c r e d i t o r s w i l l lose a portion of t h e i r investments. Even i n the event of f u l l recovery, they lose p o s t - f a i l u r e i n t e r e s t and the use of t h e i r funds throughout the l i q u i d a t i o n process. Other losses r e s u l t i n g from the closure of the bank include d i s r u p t i o n to i t s c r e d i t o r s , borrowers, employees, the community and l o s s of the bank's going concern value. An example of the FDIC's use of the l i q u i d a t i o n and payoff approach i s provided by Penn Square National Bank which f a i l e d i n 1982. In t h i s case, the FDIC paid only insured amounts i n f u l l . I t represents the only large bank ( i . e . with assets i n excess of $100 m i l l i o n ) to have been l i q u i d a t e d i n American h i s t o r y . 1 3 A review of the FDIC's approach to bank f a i l u r e between 1973 and 1982 shows that out of 124 f a i l u r e s (or threatened f a i l u r e s ) , only 25 were resolved by l i q u i d a t i o n and payoff 13 Helen A.Garten, "Banking on the Market: Relying on Depositors to Control Bank Risks" (1986) 4 Yale J.Reg.129 at 146. 84 while 99 were handled by purchase, and assumption. 4 Furthermore, since 1960, a l l f a i l u r e s of b i g banks (except Penn Square), have been resolved through purchase and assumption. 1 5 The FDIC has opted against the l i q u i d a t i o n and payoff approach i n favour of the purchase and assumption method i n so many cases i n order to avoid the cost to the insurance fund of paying the claims of insured depositors, to prevent bank runs and to maintain the s t a b i l i t y of the f i n a n c i a l system, and due to the p o l i t i c a l consequences of allowing large numbers of uninsured depositors to bear s u b s t a n t i a l l o s s e s . 1 6 The purchase and asumption method and i t s advantages and disadvantages r e l a t i v e to l i q u i d a t i o n and payoff, are discussed below. 2. Purchase and Assumption Transaction Frequently employed by the FDIC, the purchase and assumption technique involves the purchase of a f a i l e d bank's assets and the assumption of i t s l i a b i l i t i e s by a healthy i n s t i t u t i o n . Upon merger, the acquired bank i s l i q u i d a t e d . Once the FDIC decides that a purchase and assumption i s f e a s i b l e , i t canvasses the market by i n v i t i n g bids from p o t e n t i a l purchasers. Through the bidding process, the FDIC seeks the purchaser w i l l i n g to o f f e r the 14 Harry Waddell, "FDIC's F i r s t 50 Years" A.B.A. Banking Journal, (October, 198 3) at 52. 15 Steve Cocheo, "How Four Large Depositors Rate Market D i s c i p l i n e " A.B.A. Banking Journal (July, 1983)at 64. 16 G.J.Benston, P.A.Eisenbeis, P.M.Horvitz, E.J.Kane, G.G.Kaufman, ed., Perspectives on Safe and Sound Banking: Past, Present and Future (Cambridge: The MIT Press, 1986) at 101 [hereinafter "Benston"]. 85 highest premium f o r the f a i l i n g bank's assets, the premium representing the value of the bank as a going concern. The premium i s paid by the acquiring bank accepting assets worth l e s s than the value of l i a b i l i t i e s assumed. 1 7 I f the value of the assets t r a n s f e r r e d i s l e s s than the value of the l i a b i l i t i e s minus the premium, the FDIC must make up the di f f e r e n c e by way of subsidy. T y p i c a l l y , there are nonperforming assets which the acquiring i n s t i t u t i o n i s u n w i l l i n g to accept. These assets are sold by the FDIC (as receiver) to the FDIC i n i t s corporate capacity. The purchase p r i c e i s the amount of the subsidy which the FDIC i s required to pay to the acquiror. These assets are then l i q u i d a t e d by the FDIC ( i n corporate ca p a c i t y ) , with proceeds being used to reimburse the FDIC (receiver) f o r the costs of l i q u i d a t i o n and the remainder divided among the f a i l e d bank's remaining c r e d i t o r s . 1 8 The FDIC has the authority to arrange the sale of a d i s t r e s s e d bank's assets to the acquiring i n s t i t u t i o n and to the FDIC (corporate capacity) on an overnight basis, to enable the bank to provide uninterrupted s e r v i c e s . 1 9 Valuation of a f a i l i n g bank's assets by in t e r e s t e d p a r t i e s (which i s necessary i n order f o r them to tender a b i d ) , i s a time-consuming process. I t i s sometimes avoided by the FDIC having the acquiring i n s t i t u t i o n assume a l l the 17 Ibid, at 95. 18 Michael A.Burgee, "Purchase and Assumption Transactions Under the Federal Deposit Insurance Act" (1979) 14 Forum 1146 at 1155 [hereinafter "Burgee"]. 19 Rosenberg, supra. chapter 3, note 1 at 296. 86 l i a b i l i t i e s of the f a i l e d bank i n exchange f o r a cash settlement from the FDIC equal to these l i a b i l i t i e s l e s s the premium agreed upon. 2 0 Although s i m p l i f y i n g and shortening the bidding process, t h i s approach does require a greater cash outlay by the FDIC and leaves i t with the task of disposing of the f a i l e d bank's assets. In some cases, an acquiring i n s t i t u t i o n w i l l demand an indemnity from the FDIC, due to concern about the contingent l i a b i l i t i e s which i t may be assuming. The indemnity protects the acquiror from l i a b i l i t i e s unknown at the time of the a c q u i s i t i o n and s h i f t s the burden of these p o t e n t i a l l i a b i l i t i e s to the FDIC. 2 1 In the Penn Square case, one reason f o r the FDIC's d e c i s i o n to pay o f f the claims of insured depositors and l i q u i d a t e rather than, attempt a purchase and assumption was the existence of a large number of contingent l i a b i l i t i e s . 2 2 When arranging a purchase and assumption, i t i s e s s e n t i a l f o r the FDIC to accurately appraise expected losses, but i n Penn Square the s i z e of the contingent l i a b i l i t i e s made such an ap p r a i s a l i n f e a s i b l e . 2 3 An example of the FDIC's use of purchase and assumption to resolve a bank insolvency i s provided by F r a n k l i n National Bank. Fran k l i n , the twentieth l a r g e s t bank i n the U.S.A., was declared insolvent by the Comptroller i n 1974, r e s u l t i n g i n the appointment of the FDIC as re c e i v e r . A f t e r canvassing the market, the FDIC determined that sale of a 20 Benston, supra, note 16 at 95-96. 21 Ibid, at 97. 22 Buck, supra, note 12 at 207. 23 Ibid, at 207. 87 s u b s t a n t i a l p o r t i o n of the bank's assets was the best method of r e s o l v i n g i t s f i n a n c i a l d i f f i c u l t i e s . 2 4 While a t r a n s a c t i o n was being negotiated, the bank's solvency was maintained by loans from the Federal Reserve Bank. 2 5 F r a n k l i n was eventually sold to European-American Bank and Trust Company. The assets were sold f o r an amount equal to the bank's deposit l i a b i l i t i e s at the time of the re c e i v e r s h i p l e s s the premium paid by European-American. The remaining assets were used by the FDIC to repay the Federal Reserve. 2 6 The FDIC's l e g i s l a t i v e authority to arrange and f i n a n c i a l l y a s s i s t purchase and assumptions i s found i n U.S.C. s.1823(c)(2): In order to f a c i l i t a t e a merger or c o n s o l i d a t i o n of an insured bank...with an insured i n s t i t u t i o n or the s a l e of assets of such insured bank and the assumption of such insured bank's l i a b i l i t i e s by an insured i n s t i t u t i o n , or the a c q u i s i t i o n of the stock of such insured bank, the Corporation i s authorized, i n i t s sole d i s c r e t i o n and upon such terms and conditions as the Board of Directors may prescribe: i) to purchase any such assets or assume any such l i a b i l i t i e s ; i i ) to make loans or contributions to, or deposits i n , or purchase the s e c u r i t i e s of, such insured i n s t i t u t i o n or the company which controls or w i l l acquire c o n t r o l of such insured i n s t i t u t i o n ; i i i ) to guarantee such insured i n s t i t u t i o n ...against loss by reason of such insured i n s t i t u t i o n merging or con s o l i d a t i n g with or assuming the l i a b i l i t i e s and purchasing the assets of such insured bank... 2 7 24 In Re F r a n k l i n National Bank, 381 F.Supp. 1390 (E.D.N.Y.1974) 25 Garten, supra, note 13 at 147. 26 In Re F r a n k l i n National Bank, supra, note 23. 27 Note that s.1823 (c) (2) authorizes the FDIC to a s s i s t mergers and consolidations as well as purchase and assumptions. In p r a c t i c e , however, i t has only a s s i s t e d 83 Under s. 1823 (c)(4 (A)) , the FDIC i s p r o h i b i t e d from providing such assistance to insured banks unless (a) i t i s determined by the Corporation to be l e s s c o s t l y than the l i q u i d a t i o n a l t e r n a t i v e , or (b) the Corporation determines the continued operation of the d i s t r e s s e d bank to be " e s s e n t i a l to provide adequate banking services i n i t s community". Thus, before opting f o r the purchase and assumption option, the FDIC must determine that t h i s approach w i l l •minimize costs. The lower the q u a l i t y of the f a i l e d bank's assets and the lower i t s going concern value, the more fed e r a l assistance w i l l be required by the acquiring i n s t i t u t i o n before i t w i l l agree to assume the l i a b i l i t i e s . The required f e d e r a l assistance must be l e s s than the value of the f a i l e d bank's insured deposits, otherwise, l i q u i d a t i o n and payoff would be the cheaper a l t e r n a t i v e . 2 8 In determining cost, the FDIC examines the f a i l e d bank's contingent l i a b i l i t i e s , the amount of deposits exceeding the insurance l i m i t and the s i z e of the premium o f f e r e d . 2 9 In most cases, the purchase and assumption works out to be the l e a s t c o s t l y approach, due to the premium paid by the acquiring bank and the f a c t that the FDIC avoids the d i r e c t costs associated with a payoff, l i q u i d a t i o n expenses and i n the l a t t e r type of transaction, perhaps because i n a purchase and assumption, the acquiror assumes only s p e c i f i e d l i a b i l i t i e s ; while i n a statutory consolidation or merger, i t i s deemed to have assumed a l l l i a b i l i t i e s of the closed bank. See: B r a i n s i l v e r , supra, chapter 2, note 17 at 331. 28 Garten, supra, note 13 at 149. 29 Rosenberg, supra. chapter 3, note 1 at 297. 89 p o t e n t i a l losses. The purchase and assumption has several additional advantages over the payoff approach. F i r s t , i t provides protection for uninsured depositors and other cre d i t o r s of the f a i l e d bank (they become cre d i t o r s of the acquiring i n s t i t u t i o n ) . This i n turn helps to preserve s t a b i l i t y and confidence i n the banking market. Secondly, the bank i n question stays open, hence, c r e d i t arrangements remain i n t a c t , customers are not inconvenienced, employees' jobs are not disrupted and the bank's going concern value i s pre s e r v e d . 3 1 Thirdly, the FDIC avoids the obl i g a t i o n of making a large and immediate payout to insured depositors and the tying up of i t s funds for long periods of time. These advantages are summed up by Michael B.Burgee, senior counsel to the FDIC i n 1979: The chief advantage of the Purchase and Assumption transaction i s that, with FDIC's f i n a n c i a l assistance, a sound, insured bank provides uninterrupted banking services to the community previously served by the f a i l e d bank. FDIC's a b i l i t y to structure and to e f f e c t Purchase and Assumption transactions quickly and smoothly provides the greatest protection to our monetary system and to in d i v i d u a l depositors.32 Despite i t s advantages, the purchase and assumption i s open to the c r i t i c i s m that i t does not encourage market d i s c i p l i n e . When employed, a purchase and assumption has the e f f e c t of providing 100 percent insurance to a l l depositors and unsecured c r e d i t o r s . The FDIC i s e n t i t l e d 30 Benston, supra. note 16 at 95. 31 Buck, supra. note 12 at 202. 32 Burgee, supra. note 18 at 1160. 90 under s e c t i o n 1823(c)(2) t o arrange a purchase and assumption whenever i t i s t h e l e a s t c o s t l y r e s o l u t i o n t o a f a i l u r e . E x t e n s i v e use o f purchase and assumptions by the FDIC i n r e c e n t y e a r s has c r e a t e d t h e p u b l i c e x p e c t a t i o n t h a t a l l d e p o s i t o r s and c r e d i t o r s w i l l be f u l l y p r o t e c t e d i n the event o f bank f a i l u r e . T h i s i s e s p e c i a l l y t r u e i n t h e case o f a l a r g e b a n k — t h e p u b l i c p e r c e p t i o n b e i n g t h a t the FDIC cannot a f f o r d t o l e t a l a r g e bank f a i l . 3 3 I f l a r g e d e p o s i t o r s f e e l t h a t t h e i r funds a r e not a t r i s k , t h e y w i l l base investment d e c i s i o n s on y i e l d a l o n e . 3 4 In o r d e r t o o f f e r h i g h y i e l d s , and t h e r e b y a t t r a c t l a r g e d e p o s i t o r s , bank management must a c c e p t h i g h e r r i s k . 3 5 I t i s e x c e s s i v e r i s k - t a k i n g which i n c r e a s e s t h e r i s k o f bank f a i l u r e — t h e l o s s from which i s borne by t h e FDIC (and, t h e r e f o r e , t h e u s e r s o f f i n a n c i a l s e r v i c e s ) r a t h e r than t h e u n i n s u r e d d e p o s i t o r . Thus, d e p o s i t o r s have no i n c e n t i v e t o d i s c i p l i n e banks f o r e x c e s s i v e r i s k - t a k i n g . 3 6 In r e c e n t y e a r s , t h e FDIC has been c a l l i n g f o r i n c r e a s e d market d i s c i p l i n e i n o r d e r t o make l a r g e d e p o s i t o r s p e r c e i v e t h a t t h e i r funds are a t r i s k and t h e r e b y f o r c e them t o examine banks more c a r e f u l l y w i t h the aim of a v o i d i n g h i g h r i s k s . 3 7 T h i s was one reason f o r the FDIC's d e c i s i o n t o opt f o r p a y o f f and l i q u i d a t i o n o f Penn Square, 33 Benston, supra. note 16 a t 102. 3 4 Robert W.Norcross, J r . , " T h e Bank I n s o l v e n c y Game: FDIC Superpowers, The D'Oench D o c t r i n e , and F e d e r a l Common Law" (1986) 103 The Banking Law J o u r n a l 316 a t 320 [ h e r e i n a f t e r " N o r c r o s s " ] . 3 5 I b i d , a t 3 20. 36 Benston, supra. note 16 a t 175. 37 Rosenberg, supra, c h a p t e r 3, note 1 a t 299. 91 r a t h e r than a purchase and assumption. As W i l l i a m I s a a c , Chairman of t h e FDIC a t t h a t time, put i t : " I f we had b a i l e d everyone out, we would have been abandoning any hope o f a more d i s c i p l i n e d b anking s y s t e m . " 3 8 Another approach which th e FDIC has adopted i s t h e m o d i f i e d p urchase and assumption (or m o d i f i e d p a y o u t ) , one v a r i a t i o n o f which was implemented f o r t h e f i r s t time i n 1984 on t h e Seminole S t a t e N a t i o n a l B a n k . 3 9 T h i s t e c h n i q u e i n v o l v e s c l o s u r e o f an i n s o l v e n t bank, payment o f i n s u r e d c l a i m s immediately by t h e FDIC but o n l y p a r t i a l advances t o u nsecured c r e d i t o r s and u n i n s u r e d d e p o s i t o r s . 4 0 The payment made t o u n i n s u r e d d e p o s i t o r s i s based upon th e FDIC's e s t i m a t e as t o t h e v a l u e o f a s s e t s t o be r e c o v e r e d upon l i q u i d a t i o n . 4 1 R e c e i v e r s h i p c e r t i f i c a t e s a r e i s s u e d t o t h e h o l d e r s o f any r e m a i n i n g c l a i m s and a l l amounts r e a l i z e d i n excess o f t h e FDIC's e s t i m a t e a r e d i s t r i b u t e d pro r a t a t o t h e h o l d e r s o f such c e r t i f i c a t e s . 4 2 The funds advanced by t h e FDIC a r e r a i s e d by a t r a n s f e r o f some o f t h e f a i l e d bank's a s s e t s t o another i n s t i t u t i o n . 4 3 The b e n e f i t o f the m o d i f i e d payout i s i t s e f f e c t on market d i s c i p l i n e : By i n t r o d u c i n g an element o f l o s s - s h a r i n g i n t o a bank f a i l u r e , the m o d i f i e d P & A s h o u l d make l a r g e c r e d i t o r s and i n v e s t o r s more r i s k - s e n s i t i v e and more 38 P e t e r W. B e r n s t e i n , "Turnabout a t the FDIC" (1984) 110 F o r t u n e a t 178 [ h e r e i n a f t e r " B e r n s t e i n " ] . 39 N o r c r o s s , supra, note 34 a t 348. 40 I b i d , a t 349. 41 I b i d , a t 349. 42 I b i d , a t 349. 43 I b i d , a t 349. 92 s e l e c t i v e i n t h e i r choice of banks and, therefore, should increase market d i s c i p l i n e s i g n i f i c a n t l y . 4 4 The modified purchase and assumption can be viewed as a compromise between the payoff and purchase and assumption approaches. While i t i n s t i l s a greater degree of market d i s c i p l i n e than a purchase and assumption, i t provides uninsured depositors and unsecured c r e d i t o r s with an immediate payout (based on the FDIC's estimate) which they would not have received i n a l i q u i d a t i o n and payoff s i t u a t i o n . 4 5 Therefore, i n the American experience, the purchase and assumption has proven to be an extremely u s e f u l technique f o r r e s o l v i n g bank i n s o l v e n c y — with many advantages over the l i q u i d a t i o n and payoff method. However, because i t has the e f f e c t of b a i l i n g out a l l depositors and c r e d i t o r s , i n d i s c r i m i n a t e use of t h i s approach could s e r i o u s l y impair market d i s c i p l i n e . In an e f f o r t to restore market d i s c i p l i n e , the FDIC has developed a modified purchase and assumption which has great p o t e n t i a l as a t o o l which a l l e v i a t e s some of the disadvantages of the payoff and l i q u i d a t i o n method but at the same time imposes d i s c i p l i n e on the market. 44 Ibid, at 322. 45 There are p o t e n t i a l problems with the FDIC's use of the modified purchase and assumption, i n the context of U.S. laws. For example, i t might prevent the use of the FDIC's "superpowers" as debtor defences. See Norcross at 349-350. 93 3. D i r e c t F i n a n c i a l Assistance A t h i r d a l t e r n a t i v e open to the FDIC i s that of d i r e c t f i n a n c i a l assistance to banks which remain a going concern. This can be provided by the FDIC i n the form of loans to, deposits i n , assumption of l i a b i l i t i e s of, purchase of the assets or s e c u r i t i e s of, or contributions to any insured bank (s.1823(c)(1)). This assistance can be made provided that i t i s necessary to: 1) prevent the c l o s i n g of an insured bank or 2) to restore a closed bank to normal operation or 3) to prevent extraordinary r i s k to the deposit insurance fund under a threat of i n s t a b i l i t y . A further p r e r e q u i s i t e i s that i t be the l e a s t expensive a l t e r n a t i v e open to the FDIC unless i t i s determined by the FDIC that the continued operation of the insured bank i s " e s s e n t i a l to provide adequate banking services i n the community" (s.1823(c)(4). There are no c r i t e r i a s t i p u l a t e d i n the Act according to which the FDIC i s to make a determination of e s s e n t i a l i t y . The FDIC used i t s d i r e c t assistance power i n 1984 i n the case of Continental I l l i n o i s National Bank and Trust Company of Chicago ("Continental I l l i n o i s " ) . This represents the l a r g e s t bank rescue i n American h i s t o r y . The s i z e of the bank l i m i t e d the FDIC's options i n handling i t — no banks were both large enough and s u f f i c i e n t l y i n t e r e s t e d i n a cquiring i t . 4 6 Thus, the FDIC was unable to arrange a 46 Benston, supra. note 16 at 97. 94 purchase and assumption. Furthermore, the bank was experiencing a run on deposits which the government wanted to s t o p . 4 7 F e e l i n g that use of a modified purchase and assumption would further unnerve uninsured depositors and i n t e n s i f y the run, the FDIC temporarily abandoned t h i s technique and i n May, 1984, guaranteed that a l l depositors and c r e d i t o r s would be made whole. The d i r e c t government assistance provided to Continental I l l i n o i s consisted of a $7.5 b i l l i o n loan to the bank from the Federal Reserve and the FDIC, the assumption by the FDIC of $3.5 b i l l i o n of the bank's troubled loans and the co n t r i b u t i o n of $1 b i l l i o n of c a p i t a l to the bank. 4 9 The e f f e c t of the assistance was that a l l depositors and c r e d i t o r s of Continental I l l i n o i s were b a i l e d out and i t s shareholders suffered a s i g n i f i c a n t , but not t o t a l l o s s . 5 0 The FDIC j u s t i f i e d the assistance on the basis that Continental I l l i n o i s was an " e s s e n t i a l " bank. 5 1 A c r i t i c i s m of the d i r e c t f i n a n c i a l assistance method i s that i t has the e f f e c t of b a i l i n g out shareholders as well as uninsured depositors and c r e d i t o r s . As discussed i n chapter 2 supra, i t i s conceptually defensible to b a i l out small bank depositors and, i n some circumstances, large depositors and c r e d i t o r s , but never shareholders. When a bank i s returned to or kept i n operation by d i r e c t 47 Ibid, at 98. 48 Estey, supra. chapter 1, note 1 at 395. 49 Ibid, at 395-396. 50 Benston, supra, note 16 at 101. 51 Estey, supra, chapter 1, note 1 at 395. 95 assistance, shareholders b e n e f i t as d i r e c t l y as do depositors. The FDIC has devised ways to prevent t h i s enrichment of shareholders i n cases of d i r e c t f i n a n c i a l assistance. For example, i n the case of Continental I l l i n o i s , the FDIC received non-voting preference shares i n exchange f o r i t s investment. 5 2 These preference shares were con v e r t i b l e i n t o voting shares which would amount to 8 0% of the company's outstanding s h a r e s . 5 3 In addi t i o n , the FDIC was granted an option to acquire the remaining shares at a nominal cost i n the event the FDIC suffered a lo s s on i t s purchase of Continental's problem l o a n s . 5 4 In the r e s u l t , Continental's shareholders suffered a s i g n i f i c a n t ( a l b e i t not t o t a l ) l o s s and the FDIC was given the r i g h t to p a r t i c i p a t e i n any future p r o f i t s made as a r e s u l t of i t s assistance. Therefore, d i r e c t f i n a n c i a l assistance can be a us e f u l t o o l to prevent large losses from being incurred by the FDIC or to avoid d i s r u p t i o n of the f i n a n c i a l system. In circumstances where a purchase and assumption i s i n f e a s i b l e and i t i s considered important to keep a bank operating or to reopen a closed bank, d i r e c t f i n a n c i a l assistance i s u s e f u l . However, the use of d i r e c t f i n a n c i a l assistance has the e f f e c t of b a i l i n g out a l l depositors and c r e d i t o r s of an 52 John D.Hawke, J r . , Commentaries on Banking Regulation (Washington, D.C.: Law & Business Inc./Harcourt Brace Jovanovich, 1985) at 77. 53 Ibid, at 77. 54 Ibid, at 77. 96 i n s o l v e n t bank (as w e l l as s h a r e h o l d e r s u n l e s s t h e FDIC d e v i s e s a method f o r " p e n a l i z i n g " them). The o n l y l e g i s l a t i v e c o n d i t i o n f o r i t s use i s a d e t e r m i n a t i o n by the FDIC t h a t i t i s t h e l e a s t c o s t l y a l t e r n a t i v e o r t h a t t h e s u b j e c t bank i s " e s s e n t i a l " . I n d i s c r i m i n a t e use o f such an approach c o u l d s e r i o u s l y i m p a i r market d i s c i p l i n e and may have t h e e f f e c t o f u n j u s t l y e n r i c h i n g s h a r e h o l d e r s . C o n c l u s i o n C l e a r l y , t h e American approach t o bank i n s o l v e n c y i s a more h i g h l y s t r u c t u r e d , comprehensive and f l e x i b l e approach than t h a t c u r r e n t l y i n f o r c e i n Canada. When measured a g a i n s t t h e r e f o r m c r i t e r i a s e t out i n c h a p t e r 4, i t f a i r s w e l l . Through d e p o s i t i n s u r a n c e , the i n t e r e s t o f consumer p r o t e c t i o n i s p r o t e c t e d ( p r o v i d e d , o f co u r s e , t h a t s m a l l d e p o s i t o r s p l a c e t h e i r funds i n i n s u r e d i n s t i t u t i o n s ) . The F e d e r a l D e p o s i t Insurance A c t p r o v i d e s t h e FDIC w i t h the a u t h o r i t y t o t a k e c o n t r o l o f a s i t u a t i o n o f p o t e n t i a l f a i l u r e , t h e r e b y e l i m i n a t i n g the type o f problem encountered i n t h e CCB r e s c u e attempt where no agency had the a u t h o r i t y t o implement and monitor the r e s c u e program. The FDIC has the d i s c r e t i o n t o take i n t o c o n s i d e r a t i o n and p r o t e c t important i n t e r e s t s such as the s t a b i l i t y o f the f i n a n c i a l system through the f l e x i b l e " e s s e n t i a l bank" d o c t r i n e . When the d e c i s i o n i s made t o b a i l out a bank, the FDIC has the f l e x i b i l i t y t o choose among a number of a l t e r n a t i v e 97 approaches and has made e f f e c t i v e use of purchase and assumption transactions and d i r e c t f i n a n c i a l assistance. However, there are several aspects of the American system which f a i l to meet the s p e c i f i e d c r i t e r i a . F i r s t , the f a c t that the FDIC does not d i r e c t l y supervise the banks that i t insures (other than insured state member banks which i t supervises d i r e c t l y ) means that i t has only i n d i r e c t access to the f i n a n c i a l information upon which i t must base i t s d e c i s i o n s . The FDIC i s e n t i t l e d to be advised by the Comptroller of the Currency and the Federal Reserve as to any changes made i n respect of deposit l i a b i l i t i e s , but i t i s arguable that the FDIC would be better able to make informed and timely decisions i f d i r e c t l y responsible f o r supervision. Combination of the two functions within one agency would also give the regulator greater i n c e n t i v e to take more immediate action v i s a v i s a d i s t r e s s e d bank, since f a s t e r a c t i o n would minimize losses suffered by the agency i n i t s capacity as insurer. A second aspect of U.S. bank insolvency l e g i s l a t i o n which has proven problematic i s the b a i l o u t technique of d i r e c t f i n a n c i a l assistance. The lack of a statutory mechanism f o r dealing with the i n t e r e s t s of equity holders has created uncertainty and c r i t i c i s m with respect to the FDIC's handling of shareholders i n d i r e c t f i n a n c i a l EC assistance cases. J 55 See, f o r example, John D. Hawke's c r i t i c i s m of the way the FDIC handled the Continental c r i s i s , supra, note 52 at 77-81. 98 A t h i r d c r i t i c i s m of the American system a r i s e s from the FDIC's p r e d i l i c t i o n f o r the purchase and assumption tr a n s a c t i o n . The frequent use of t h i s technique f o r r e s o l v i n g bank insolvencies has created an expectation i n depositors ( e s p e c i a l l y of large banks) that they w i l l be b a i l e d o u t . 5 6 The l e g i s l a t i o n authorizes the FDIC to arrange a purchase and assumption i n any s i t u a t i o n where a purchase and assumption i s more c o s t - e f f i c i e n t than payoff and l i q u i d a t i o n (or i f a bank i s deemed " e s s e n t i a l " ) . The e f f e c t of t h i s p r o v i s i o n i s to encourage purchase and assumptions— at the expense of market d i s c i p l i n e . A f i n a l comment with respect to the American system involves the broad d i s c r e t i o n granted to the FDIC i n the bank insolvency p r o c e s s — not only i s the Corporation responsible f o r devising and implementing r e s o l u t i o n s to bank f a i l u r e , but i t i s given the sole authority to make the underlying d e c i s i o n to rescue a bank or to l e t i t f a i l . To make t h i s fundamental d e c i s i o n requires that a number of c o n f l i c t i n g i n t e r e s t s be balanced. On the one hand, i s the goal of cost-minimization, which i s often (but not always) best served by a purchase and assumption. On the other hand, i s the importance of maintaining market d i s c i p l i n e , which i s best achieved through l i q u i d a t i o n and payoff. An o v e r r i d i n g f a c t o r that must be considered by the FDIC i s e s s e n t i a l i t y — a vague term which allows the FDIC to take int o account a v a r i e t y of i n t e r e s t s , i n c l u d i n g consumer 56 Norcross, supra. note 34 at 319. 99 p r o t e c t i o n , f i n a n c i a l s t a b i l i t y and the dependence of a community on a bank. These concerns would be best served, i n many circumstances, by d i r e c t f i n a n c i a l assistance or a purchase and assumption. The broad language of the Act provides l i t t l e guidance f o r the FDIC's d e c i s i o n which r e s u l t s i n unpredictable decisions and, therefore, uncertainty. In addition, the l e g i s l a t i v e s t ructure creates a s i t u a t i o n where an e s s e n t i a l l y p o l i t i c a l d e c i s i o n ( i . e . whether or not to b a i l out a bank) i s being made by an administrative body. I t i s submitted that i n the Canadian p o l i t i c a l environment, i t would be more appropriate f o r a p o l i t i c a l l y - a c c o u n t a b l e body to make t h i s fundamental d e c i s i o n . Out of t h i s d i s c u s s i o n on the American approach to bank insolvency, several conclusions can be made with respect to the model f o r reform of the Canadian system: i) The cr e a t i o n of a strong, c e n t r a l i z e d agency l i k e the FDIC, with the authority and the broad powers to arrange and oversee r e s o l u t i o n s to bank insolvencies i s de s i r a b l e . However, the f a c t that the FDIC lacks d i r e c t and on-going access to the information on which i t must act i s i n e f f i c i e n t . i i ) In the Canadian context, i t would be inappropriate f o r an adminstrative agency such as the FDIC to possess the power to decide whether or not to b a i l out a bank— t h i s d e c i s i o n should be the r e s p o n s i b i l i t y of an electe d o f f i c i a l who i s accountable to the p u b l i c . However, the expertise of the administrative agency should be recognized by g i v i n g i t the r e s p o n s i b i l i t y of recommending a course of action to an elected body. i i i ) The FDIC has made s i g n i f i c a n t use of three techniques f o r r e s o l v i n g bank f a i l u r e s which would be use f u l i n the Canadian context: the purchase and 100 assumption transaction, the modified purchase and assumption and d i r e c t f i n a n c i a l assistance. However, due to the deleterious e f f e c t of purchase and assumptions and d i r e c t f i n a n c i a l assistance on market d i s c i p l i n e , t h e i r use should be l e g i s l a t i v e l y c o n t r o l l e d . iv) A statutory mechanism f o r dealing with equity i n t e r e s t s i n d i r e c t f i n a n c i a l assistance cases i s required. This model f o r reform i s further developed by examining recent proposals f o r reform made i n the Canadian context. 101 CHAPTER 6. CANADIAN PROPOSALS FOR REFORM Two recent p u b l i c studies have recommended s i g n i f i c a n t reforms to the bank insolvency process i n Canada and, i n p a r t i c u l a r , the CDIC's r o l e i n t h i s process: the Estey Report and the F i n a l Report of the Working Committee on the Canada Deposit Insurance Corporation submitted to the Mi n i s t e r of State (Finance) on A p r i l 24, 1985 (the "Wyman Report"). Both reports recommended s t r u c t u r a l as well as fu n c t i o n a l reforms to bank insolvency l e g i s l a t i o n . Their proposals w i l l be discussed and evaluated below i n l i g h t of the reform c r i t e r i a set out i n chapter 4. 1. Wyman Report The Wyman Committee examined the operation and structure of the CDIC and made recommendations regarding the objects of the Corporation; the supervisory, enforcement and examination powers i t should possess; funding, organization and s t a f f i n g of the Corporation; and pos s i b l e methods to improve market d i s c i p l i n e . Of s i g n i f i c a n c e here are the Committee's proposals regarding the CDIC's r o l e i n the bank insolvency process. a) Proposals re: S t r u c t u r a l Reform The Wyman Report accepted the current structure of the bank regulatory system, includ i n g the basic d i v i s i o n between the OIGB as the primary regulator and the CDIC as insurer. 1 0 2 However, i t d i d recommend an enhanced supervisory and regulatory r o l e f o r the CDIC. In the event of f a i l u r e , Wyman recommended that the CDIC be granted broad powers to cope with the insolvency i n a c o s t - e f f i c i e n t manner. To f a c i l i t a t e the f u l f i l l m e n t of i t s broader r e s p o n s i b i l i t i e s , the Committee recognized the CDIC's need f o r greater access to information, to be provided by: i) the CDIC maintaining i t s own data base of current information about insured banks and i i ) the CDIC r e c e i v i n g copies of a l l reports and correspondence made f o r or by the OIGB with respect to problem banks. Furthermore, i t proposed that the CDIC conduct i t s own inspection of problem banks. Wyman1s proposal f o r s t r u c u t u r a l reform represents a p a r t i a l step toward the cr e a t i o n of a powerful agency to cope with bank f a i l u r e . However, i t has the drawback of inv o l v i n g a d u p l i c a t i o n of information-gathering e f f o r t s (by the OIGB and the CDIC), an i n e f f i c i e n c y which could be eliminated by the combination of regulatory and insurance functions i n one agency. This issue i s addressed i n the Estey Report and i s discussed i n greater d e t a i l below. b) Proposals re: Functional Reform Wyman's proposal f o r f u n c t i o n a l reform of the bank insolvency process i s based on an expanded r o l e f o r the CDIC. For example, the Report recommends that the C D I C be given the power to i n i t i a t e l i q u i d a t i o n proceedings. Currently, the CDIC i s granted t h i s power by v i r t u e of 103 s e c t i o n 2 9 of the Canada Deposit Insurance Corporation Act: where the CDIC i s of the view that a bank i s or i s about to become insolvent, i t can take any proceeding which a c r e d i t o r can take, i n c l u d i n g having the bank wound up. The problem with the CDIC having the authority to i n i t i a t e winding-up proceedings i s that t h i s d e c i s i o n i s a complex one which i s c l o s e l y l i n k e d to the b a i l o u t d e c i s i o n . I f the bank i s not wound up, w i l l i t be rescued through government funds? I f i t i s wound up, w i l l i t be wound up i n such a way that uninsured depositors are compensated? As discussed i n the American context, these decisions involve the balancing of a number of i n t e r e s t s such as consumer protec t i o n , f i n a n c i a l s t a b i l i t y , regional economic development, market d i s c i p l i n e , c o s t - e f f i c i e n c y , etc. The Wyman Report recognized that broad p o l i c y f a c t o r s must be considered when an insured i n s t i t u t i o n i s faci n g insolvency. As examples of such f a c t o r s the Report c i t e d : confidence i n the f i n a n c i a l system and the e f f e c t of f a i l u r e on the n a t i o n a l or regional economy or on the i n t e r n a t i o n a l perception of Canada's f i n a n c i a l i n s t i t u t i o n s . 1 Although the Report recommended that the consideration of these f a c t o r s remain outside the mandate of the CDIC, 2 i t d i d not suggest how these fac t o r s should come to play a r o l e i n the regulatory process. I t would seem, however, that i f p o l i t i c a l and s o c i a l factors are to influence the deci s i o n to wind up or b a i l out a bank, 1 Wyman, supra, chapter 2, note 48 at 14. 2 Ibid, at 15. 104 then an elected o f f i c i a l should have the ultimate authority to make t h i s d e c ision, rather than an administrative body such as the CDIC. On the basis of t h i s reasoning, s e c t i o n 29 of the Canada Deposit Insurance Corporation Act should be amended to give the M i n i s t e r of Finance the ultimate decision-making power to wind up a bank. 3 S i m i l a r l y , the power to decide whether a bank should be b a i l e d out should be vested i n the Mi n i s t e r of Finance. The CDIC's i n t e r e s t and expertise i n t h i s area should be recognized by g i v i n g i t the power to recommend a course of act i o n to the M i n i s t e r when faced with an insolvent or p o t e n t i a l l y insolvent bank. 4 Wyman also recommended that the CDIC be given the r i g h t to become, i f i t so e l e c t s , the l i q u i d a t o r of an insolvent bank. Presently, the l i q u i d a t o r i s court-appointed and i s subject to the approval of the bank's shareholders and c r e d i t o r s . However, the CDIC i s authorized to act as the curator or l i q u i d a t o r i f i t i s duly appointed to act as such. In the USA, the Comptroller of the Currency i s obliged to appoint the FDIC to act as the r e c e i v e r of nat i o n a l l y - c h a r t e r e d banks. I t i s arguable that a c o n f l i c t of i n t e r e s t could a r i s e when the deposit insurance agency acts as insurer (and, therefore, creditor) and l i q u i d a t o r 3 The Estey Report makes t h i s argument at 32 6. 4 Wyman d e a l t i n some d e t a i l with a r e l a t e d i s s u e — the need to c l a r i f y the t e s t of insolvency and to sp e c i f y which a u t h o r i t i e s have the power to determine insolvency. This issue has important r a m i f i c a t i o n s f o r a bank (upon a de c l a r a t i o n of insolvency, the Mi n i s t e r s h a l l appoint a curator) and for the CDIC (insolvency i s the point at which ultimate insurance claims against the Corporation are measured). While important, the issue of a revised insolvency t e s t i s beyond the scope of t h i s paper. simultaneously. However, i t i s submitted that t h i s concern i s overridden by the advantages to such an approach. For example, i t i s d e s i r a b l e to develop the expertise to conduct bank l i q u i d a t i o n s within one agency. Furthermore, as argued by Wyman, the deposit insurance corporation has a s p e c i a l and s u b s t a n t i a l f i n a n c i a l i n t e r e s t i n the insolvency proceeding which should be recognized. Also, there are c o s t l y delays associated with the court-appointed process which could be avoided by automatic appointment of the CDIC. For these reasons, Wyman's proposal to grant the CDIC the r i g h t to become l i q u i d a t o r of an insolvent bank would be a des i r a b l e feature i n revised bank insolvency l e g i s l a t i o n . As a fur t h e r component of i t s proposal to create a stronger r o l e f o r the CDIC, the Wyman Committee examined the purchase and assumption transaction. I t recognized the considerable advantages to t h i s technique, which include avoiding the costs of l i q u i d a t i o n , preventing the d i s r u p t i o n of on-going c r e d i t r e l a t i o n s h i p s and maintaining the going concern value of the bank. The Wyman Report recognized the CDIC's present lack of l e g i s l a t i v e authority to arrange a purchase and assumption tr a n s a c t i o n and recommended that the Canada Deposit Insurance Corporation Act be amended to remedy t h i s omission. The American experience has i l l u s t r a t e d the u t i l i t y of and the be n e f i t s to be derived from the purchase and assumption transaction. I t was concluded i n that context 5 Estey, supra, chapter 1, note 1 at 3 39. 106 t h a t t h e CDIC s h o u l d have the l e g i s l a t i v e a u t h o r i t y t o a r r a n g e such a t r a n s a c t i o n . However, th e use of t h i s t e c h n i q u e s h o u l d be c o n s i s t e n t w i t h t h e r a t i o n a l e f o r b a i l i n g out banks d i s c u s s e d i n . c h a p t e r 2: because i t has t h e e f f e c t o f b a i l i n g out u n i n s u r e d d e p o s i t o r s and unsecured c r e d i t o r s , i t s h o u l d not be used i n t h e absence o f one o f t h e r a t i o n a l e f o r t h i s t y p e o f government i n t e r v e n t i o n . T h i s i s e s p e c i a l l y i mportant i n l i g h t o f t h e p o t e n t i a l e f f e c t which f r e q u e n t use o f t h e purchase and assumption may have i n b r e a k i n g down market d i s c i p l i n e . 6 T h e r e f o r e , l e g i s l a t i o n p r o v i d i n g f o r t h e implementation o f a purchase and assumption t r a n s a c t i o n by the CDIC s h o u l d c l e a r l y s t i p u l a t e t h e c o n d i t i o n s f o r i t s use. I t s h o u l d be a v a i l a b l e as an a l t e r n a t i v e t o l i q u i d a t i o n and p a y o f f when t h e r e e x i s t s an i n t e r e s t i n b a i l i n g out u n i n s u r e d d e p o s i t o r s and c r e d i t o r s which o v e r r i d e s the i n t e r e s t o f market d i s c i p l i n e . In c h a p t e r 2, two c i r c u m s t a n c e s which j u s t i f i e d such a b a i l o u t were i d e n t i f i e d : 1) t h e e x i s t e n c e o f a c l e a r r i s k o f a d e s t a b i l i z i n g bank run which c o u l d not be c o n t r o l l e d by d e p o s i t i n s u r a n c e a l o n e and 2) t h e e x i s t e n c e o f an i n t e r e s t , t h e p r o t e c t i o n o f which i s i n t h e n a t i o n a l i n t e r e s t . An a d d i t i o n a l c r i t e r i o n f o r the use o f a purchase and assumption s h o u l d be c o s t - e f f i c i e n c y — i f t h e r e i s a l e s s e x p e n s i v e way t o a c h i e v e the same r e s u l t , then the i n t e r e s t o f c o s t - e f f i c i e n c y would d i c t a t e t h a t the l e s s e x p e n s i v e approach be taken. 6 Goodman, supra. c h a p t e r 2, note 29 a t 160. 107 I t i s submitted, therefore, that the CDIC be granted the l e g i s l a t i v e authority to implement a purchase and assumption. . However, the agency's power to implement such a course of ac t i o n to the M i n i s t e r and the Min i s t e r ' s d i s c r e t i o n to decide upon such an approach, should be l i m i t e d by express l e g i s l a t i v e c r i t e r i a i n order to provide some measure of c e r t a i n t y to those a f f e c t e d by the decision, to maintain market d i s c i p l i n e and to ensure c o s t - e f f i c i e n c y . The Wyman Committee summarized i t s proposals aimed at strenthening the CDIC's power to act i n a s i t u a t i o n of bank insolvency, with a broad recommendation that the Corporation be given broad and f l e x i b l e powers to protect small depositors and administer the insurance fund i n the most e c o n o m i c a l l y - e f f i c i e n t way. The powers to be granted the CDIC would include the power to make d i r e c t f i n a n c i a l assistance to a d i s t r e s s e d i n s i t i t u t i o n : Contributions to the r e h a b i l i t a t i o n of an i n s t i t u t i o n i n d i f f i c u l t y , designed to avoid a greater loss at a l a t e r date, are only one example of the types of act i o n that should be permissible, i f CDIC's Board concludes they w i l l contribute to i t s object.7 As concluded i n the discussion on the U.S. system, d i r e c t f i n a n c i a l assistance i s an important t o o l to be possessed by the CDIC. However, because i t has the e f f e c t of rescuing a bank (and b a i l i n g out i t s c a p i t a l s u p p l i e r s ) , i t s use should 7 Wyman, supra, chapter 2, note 48 at 23. 108 be structured and c o n t r o l l e d . This issue i s examined i n d e t a i l by the Estey Report and i s discussed below. 2. Estey Report a) S t r u c t u r a l Recommendations The Estey Commission recommended broader s t r u c t u r a l reforms than those proposed i n the Wyman Report. Estey concluded that the most l o g i c a l approach would be a c o n s o l i d a t i o n of the OIGB and the CDIC int o a new body, to be named the Canadian Deposit Insurance Commission (the "Commission"). The Commission would be managed and d i r e c t e d by three f u l l - t i m e appointees: one from the audit i n g p r o fession with f i v e years' experience i n bank auditing; one with senior banking experience; and the t h i r d with senior management experience i n the insurance industry with general business, p r o f e s s i o n a l or senior p u b l i c service experience. I t i s submitted that the c r e a t i o n of a small, highly-experienced, f u l l - t i m e group to carry out the e s s e n t i a l l y administrative tasks of the Commission would be much more e f f e c t i v e than the present approach of a Crown corporation administered by a part-time board. The p r i v a t e sector composition of such a Commission would bring to i t an understanding of the banking and insurance i n d u s t r i e s , and the experience necessary to i d e n t i f y and solve p o t e n t i a l problems. 109 The Commission would have deposit insurance r e s p o n s i b i i t i e s s i m i l a r to those possessed by the CDIC as well as regulatory and supervisory powers broader than those c u r r e n t l y possessed by the OIGB. The Estey Report discussed the advantages of t h i s approach to reform of the present bank regulatory structure, as follows: ...by p u t t i n g the insurer i n a p o s i t i o n to protect i t s e l f e f f e c t i v e l y through c o n f i d e n t i a l supervision of the insured banks, t h i s a l t e r n a t i v e recognizes and appeals to natural human i n s t i n c t s . I t recognizes that the insurer has the i n c e n t i v e to act on information received to reduce to a minimum the r i s k s i t faces i n any f a i l u r e . I t i s p r e c i s e l y t h i s i n c e n t i v e or w i l l to act which was so g r a p h i c a l l y i l l u s t r a t e d to be l a c k i n g i n the i n s t i t u t i o n a l forms of the e x i s t i n g regulatory scheme.8 Furthermore, co n s o l i d a t i o n of the regulatory and insurance functions i n one body would overcome the informational b a r r i e r c u r r e n t l y faced by the CDIC when attempting to perform i t s insurance function. As regulator, the Commission would have f i r s t - h a n d and on-going access to the information needed to make recommendations to the M i n i s t e r and implement solu t i o n s expeditiously and e f f i c i e n t l y . Combining the two functions would have the a d d i t i o n a l advantage of avoiding the d u p l i c a t i o n of information- gathering and regulatory e f f o r t s which would be a r e s u l t of the Wyman Committee's s t r u c t u r a l proposal. For these reasons, the creation of a c e n t r a l i z e d agency possessing both supervisory and insurance r e s p o n s i b i l i t i e s 8 Estey, supra. chapter 1, note 1 at 2 77. 110 would appear t o be a l o g i c a l and e f f i c i e n t s t r u c t u r e t o c a r r y out t h e b r o a d e r powers which such an agency must p o s s e s s i n o r d e r t o cope w i t h bank i n s o l v e n c y . b) F u n c t i o n a l Recommendations The E s t e y Report recommended t h a t t h e Commission be g i v e n t h e power t o recommend t o t h e M i n i s t e r one o f t h r e e c o u r s e of a c t i o n when f a c e d w i t h a f i n a n c i a l l y - t r o u b l e d bank: l i q u i d a t i o n , merger w i t h a h e a l t h y i n s t i t u t i o n o r the implementation o f a bank a s s i s t a n c e p l a n . E x t e n s i v e p r o p o s a l s were made w i t h r e s p e c t t o bank a s s i s t a n c e p l a n s and t h e s e a r e examined below. The o b j e c t o f a bank a s s i s t a n c e program would be t o keep an i n s o l v e n t bank i n o p e r a t i o n w h i l e r e o r g a n i z i n g i t w i t h a view t o r e t u r n i n g i t t o p r i v a t e ownership o r merging i t w i t h a v i a b l e bank. The program would be d e s i g n e d , implemented and monitored by t h e Commission. Funding would be p r o v i d e d through p r i v a t e and/or p u b l i c s o u r c e s ( f o r example, through t h e purchase o f u n s a t i s f a c t o r y l o a n s by the Commission). The Report recommended t h a t d i r e c t o r s and management o f the bank be a t l e a s t p a r t i a l l y r e p l a c e d , as a c o n f i d e n c e - r e s t o r i n g measure. A s i g n i f i c a n t f e a t u r e of t h e E s t e y Commission's p r o p o s a l f o r bank a s s i s t a n c e programs i s i t s mechanism t o d e a l w i t h t h e problem o f e x i s t i n g i n v e s t o r s i n the bank's c a p i t a l . As d i s c u s s e d i n c h a p t e r 5, the problem w i t h the FDIC's ad hoc system o f d e a l i n g w i t h s h a r e h o l d e r s i s the I l l p o t e n t i a l f o r c r i t i c i s m from the p u b l i c (when i t i s perceived that shareholders are being u n j u s t l y enriched by the government aid) and from the bank's shareholders (when the FDIC attempts to "penalize" them). The Estey Commission proposed a statutory mechanism which would allow these issues to be j u d i c i a l l y determined. I t recommended that i n cases where a bank i s insolvent or where insolvency i s imminent or i n e v i t a b l e , the bank assistance program contain a term c a n c e l l i n g the i n t e r e s t s of the c a p i t a l investors (which would include debt and share components of the bank's c a p i t a l ) . 9 This i s j u s t i f i e d on the basis that, once insolvent, a bank's c a p i t a l has been exhausted and, therefore, the investors i n that c a p i t a l have ceased to have any i n t e r e s t i n the bank. To preserve the bank's co n t i n u i t y , a nominal number of Treasury shares would be issued to the Commission, which would be s o l d back to the p u b l i c once the bank had recovered. Estey a n t i c i p a t e d the p o s s i b i l i t y of a claim by investors that the bank was not i n f a c t i nsolvent at the time the assistance program was i n s t i t u t e d (meaning that the investors' i n t e r e s t had not been extinguished). In that event, Estey proposed a statutory mechanism whereby investors whose i n t e r e s t s had been cancelled could apply to a court to determine whether 9 Note that Estey uses the term " c a p i t a l " as i t i s defined i n the Bank Act , i . e . , to include common shares, preference shares and long-term, subordinated, unsecured debt i n the nature of a simple bond. Estey's concern i n t r e a t i n g a l l c a p i t a l a l i k e i s to prevent one c l a s s from blocking the rescue of a bank, and thereby f o r c i n g i t s l i q u i d a t i o n . See Estey at 329. 112 or not the bank was insolvent at the c r i t i c a l time. I f i t i s determined that i t was not, the value of t h e i r i n t e r e s t s i n the c a p i t a l would be estimated and the Commission ordered to compensate them f o r t h e i r l o s s . I f , on the other hand, insolvency i s established, the investors would not and should not be compensated. They took a r i s k and they l o s t . This j u d i c i a l mechanism represents an e f f e c t i v e and j u s t way to deal with the i n t e r e s t s of c a p i t a l investors i n the event of bank f a i l u r e . I t i s submitted that i t i s an e s s e n t i a l feature of the regulator's power to implement a bank assistance program. Estey's proposal also dealt with the p o t e n t i a l f a i l u r e of a bank assistance program. In t h i s s i t u a t i o n , the Report recommended that a l l depositors and debt-holders (other than c a p i t a l - i n v e s t o r s ) be f u l l y compensated. The p o l i c y reason behind t h i s recommendation i s that the success of a rescue plan depends on the maintenance of depositor confidence i n the d i s t r e s s e d bank. In order to induce depositors and p r i v a t e sources to lend funds to the bank, the government must stand behind the assistance program and v i r t u a l l y guarantee i t s success. To turn around i n the face of f a i l u r e and allow those who have r e l i e d on government assurances to lose t h e i r funds would be p o l i t i c a l l y inconceivable. The Estey Commission recommended that the ultimate d e c i s i o n to implement a bank assistance program be the r e s p o n s i b i l i t y of the Mi n i s t e r of Finance. However, the 113 d e c i s i o n would be based on the CDIC's recommendation. The Report concluded that i n making i t s recommendation, the CDIC should consider: "a wide range of f a c t o r s , i n c l u d i n g the n a t i o n a l i n t e r e s t i n the s t a b i l i t y of the banking system as well as the l i k e l i h o o d of loss to i t s e l f . This would formally recognize i n the system the s o - c a l l e d • e s s e n t i a l bank concept' as a conscious step i n the administrative process of serious l i q u i d i t y and solvency problems i n a bank. The Estey Report d i d not propose any more s p e c i f i c c r i t e r i a f o r the CDIC's recommendation, or the M i n i s t e r ' s d e c i s i o n , to implement a bank assistance program. I t i s submitted that i n the i n t e r e s t of c e r t a i n t y and i n order to ensure that the c o n f l i c t i n g i n t e r e s t s which operate i n a s i t u a t i o n of bank f a i l u r e are expressly considered, the power to implement a bank assistance program be l i m i t e d by express l e g i s l a t i v e c r i t e r i a . Because a bank assistance plan (as proposed by Estey) and a purchase and assumption have e s s e n t i a l l y the same b a i l o u t e f f e c t s ( i . e . the compensation of uninsured depositors and c r e d i t o r s ) , they should be based on s i m i l a r l e g i s l a t i v e c r i t e r i a (see c r i t e r i a proposed i n the d i s c u s s i o n on the purchase and assumption, supra). In most s i t u a t i o n s , the purchase and assumption would be the more c o s t - e f f i c i e n t s o l u t i o n (due to the premium paid by the acquiring i n s t i t u t i o n ) . However, the CDIC's power to implement a bank assistance program should r e f l e c t the f a c t that i n some circumstances, a purchase and assumption w i l l be unavailable or inappropriate (for example, i f the 114 M i n i s t e r deems i t t o be i n the n a t i o n a l i n t e r e s t t o r e s c u e a bank i n o r d e r t o p r o t e c t the r e g i o n a l bank concept, but t h e o n l y merger c a n d i d a t e s f o r t h e bank a r e l a r g e , n a t i o n a l banks o r f o r e i g n b anks). In t h e s e c i r c u m s t a n c e s , t h e M i n i s t e r s h o u l d have t h e a u t h o r i t y t o d i r e c t t h e CDIC t o implement a bank a s s i s t a n c e p r o g r a m — r e g a r d l e s s o f t h e c o s t s a v i n g which c o u l d have been a c h i e v e d by a purchase and assumption. T h e r e f o r e , two a s p e c t s o f t h e E s t e y Commission's recommendations on Canadian bank r e g u a l a t i o n a r e o f p a r t i c u l a r s i g n i f i c a n c e t o the development o f a model f o r re f o r m . The f i r s t i s t h e Commission's recommendation t o combine t h e OIGB and t h e CDIC t o c r e a t e a c e n t r a l i z e d agency w i t h d i r e c t a c c e s s t o t h e i n f o r m a t i o n needed t o c a r r y out i t s r e s p o n s i b i l i t i e s i n t h e event o f bank f a i l u r e . The second i s t h e d e t a i l e d p r o p o s a l f o r bank a s s i s t a n c e programs, which d e a l s w i t h t h e problems which have been e x p e r i e n c e d by bo t h the Canadian government ( i n the CCB r e s c u e attempt) and by the FDIC. C o n c l u s i o n : A Model f o r Reform On t h e b a s i s of the r a t i o n a l e f o r bank b a i l o u t s d i s c u s s e d i n c h a p t e r 2, the c r i t e r i a f o r r e f o r m e s t a b l i s h e d i n c h a p t e r 4, and u s i n g a s p e c t s of the American approach as w e l l as t h e p r o p o s a l s c o n t a i n e d i n the Wyman and E s t e y R e p o r t s , i t i s now p o s s i b l e t o o u t l i n e a model f o r r e f o r m of Canadian bank i n s o l v e n c y l e g i s l a t i o n . I t i s proposed: 115 i) that a new administrative agency (the "Agency") be created which would act as deposit insurer and as the primary regulator of banks. The Agency would be managed by a Committee of f u l l - t i m e appointees, with experience i n or r e l a t e d to the f i e l d s of banking, au d i t i n g and insurance. i i ) that i n a s i t u a t i o n of actual or p o t e n t i a l insolvency, the M i n i s t e r of Finance possess the ultimate decision-making authority as to an appropriate course of a c t i o n . The Agency would be responsible f o r canvassing the a v a i l a b l e options, conducting cost- analyses and recommending a course of a c t i o n to the M i n i s t e r . i i i ) that the M i n i s t e r ' s d i s c r e t i o n i n deciding the fate of a bank and the CDIC's power to recommend a course of a c t i o n be l i m i t e d by l e g i s l a t i v e c r i t e r i a (set out i n paragraphs i v , v and v i below) which w i l l r e f l e c t the i n t e r e s t s of consumer pr o t e c t i o n , f i n a n c i a l s t a b i l i t y , market d i s c i p l i n e , c o s t - e f f i c i e n c y and l o c a l , r e g ional and national i n t e r e s t s of n a t i o n a l concern. iv) that l i q u i d a t i o n and payoff be the general r u l e i n the event of insolvency. Deposit insurance would be retained i n order that small consumers are protected and some measure of f i n a n c i a l s t a b i l i t y i s ensured. A modified purchase and assumption (which has the same e f f e c t as l i q u i d a t i o n and payoff, i . e . , of b a i l i n g out insured depositors only) would be an acceptable a l t e r n a t i v e , providing i t i s f e a s i b l e and l e s s c o s t l y than l i q u i d a t i o n and payoff. v) that a second option be a v a i l a b l e i n an insolvency s i t u a t i o n : purchase and assumption. The use of t h i s technique would be l i m i t e d by the following l e g i s l a t i v e c r i t e r i a : a) the existence of a c l e a r r i s k of a d e s t a b i l i z i n g bank run which could not be c o n t r o l l e d by deposit insurance alone; or b) the existence of an i n t e r e s t , the p r o t e c t i o n of which i s i n the n a t i o n a l i n t e r e s t and which would be best served by a purchase an assumption. vi) that a t h i r d option be a v a i l a b l e i n an insolvency s i t u a t i o n : d i r e c t f i n a n c i a l assistance i n the form of a bank assistance program. The l e g i s l a t i v e conditions f o r i t s use would be as follows: a) the existence of a c l e a r r i s k of a d e s t a b i l i z i n g bank run which could not be c o n t r o l l e d by deposit insurance alone; or b) the existence of an i n t e r e s t , the p r o t e c t i o n of which i s i n the national i n t e r e s t and which would be best served by a bank assistance program. The l e g i s l a t i o n would provide a statutory 116 mechanism f o r the r e s o l u t i o n of the i n t e r e s t s of the bank's c a p i t a l investors i n the event a bank assistance program i s implemented. This model f o r reform i s not aimed at preventing future bank insolvencies, but rather, at providing a more comprehensive statutory mechanism f o r dealing with such f a i l u r e s when they occur. Based on the American model, i t creates an agency with d i r e c t and on-going access to the information needed to recommend a course of a c t i o n to the M i n i s t e r and the broad powers to implement the M i n i s t e r ' s d e c i s i o n . The statutory scheme provides as a general r u l e that only insured depositors w i l l be b a i l e d out i n the event of f a i l u r e but allows f o r wider compensation i n circumstances which j u s t i f y greater government in t e r v e n t i o n . The model i s also designed to promote the i n t e r e s t s of cost- e f f i c i e n c y and market d i s c i p l i n e . As a f i n a l step, the reforms to the Canadian bank insolvency l e g i s l a t i v e framework which the f e d e r a l government rec e n t l y enacted, w i l l be examined i n l i g h t of the model f o r reform which has been proposed herein. 117 CHAPTER 7. RECENT FEDERAL REFORM OF CANADIAN FINANCIAL MARKET REGULATION On J u l y 2 and 3, 1987, t h e f e d e r a l government p r o c l a i m e d t h e F i n a n c i a l I n s t i t u t i o n s and D e p o s i t Insurance System Amendment A c t and An A c t t o Amend C e r t a i n A c t s R e l a t i n g t o F i n a n c i a l I n s t i t u t i o n s . The two A c t s i n t r o d u c e d a number o f changes t o t h e system o f s u p e r v i s i n g f i n a n c i a l i n s t i t u t i o n s and t o t h e d e p o s i t i n s u r a n c e system w i t h the g o a l s o f i n c r e a s i n g c o m p e t i t i o n and s t a b i l i t y i n t h e f i n a n c i a l s e c t o r . I n t h e f o l l o w i n g d i s c u s s i o n , t h e r e l e v a n t p r o v i s i o n s o f t h i s l e g i s l a t i o n are examined and t h e n e v a l u a t e d i n l i g h t o f t h e model f o r r e f o r m proposed i n c h a p t e r 6. 1. L e g i s l a t i v e Framework The e f f e c t o f the F i n a n c i a l I n s t i t u t i o n s and D e p o s i t I n s u rance System Amendment Act was t o r e p e a l the Department o f Insurance A c t , t o e s t a b l i s h a new r e g u l a t o r y body and t o change th e powers and o p e r a t i o n s o f the CDIC. An A c t t o Amend C e r t a i n A c t s R e l a t i n g t o F i n a n c i a l I n s t i t u t i o n s c o n t a i n s p r o v i s i o n s which a l l o w f e d e r a l l y - r e g u l a t e d f i n a n c i a l i n s t i t u t i o n s t o own s e c u r i t i e s d e a l e r s , r e q u i r e s t h a t c e r t a i n share t r a n s a c t i o n s have the approval of the M i n i s t e r of F i n a n c e , s p e c i f i e s c i r c u m s t a n c e s under which the S u p e r i n t e n d e n t of F i n a n c i a l I n s t i t u t i o n s can o b t a i n an independent a p p r a i s a l of r e a l e s t a t e a s s e t s h e l d by any 113 t r u s t , loan or insurance company, and grants the Superintendent of F i n a n c i a l I n s t i t u t i o n s the power to make cease and d e s i s t orders. Three aspects of t h i s new f i n a n c i a l sector l e g i s l a t i o n have p a r t i c u l a r impact on the issue of bank insolvency and are examined below: a) the c r e a t i o n of the Superintendent of F i n a n c i a l I n s t i t u t i o n s ; b) the pro v i s i o n s which amend the Canada Deposit Insurance Corporation Act and create new objects and powers f o r the CDIC; and c) the pro v i s i o n s which amend the Bank Act. a) The O f f i c e of the Superintendent of F i n a n c i a l I n s t i t u t i o n s Part I of The F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance System Amendment Act creates the O f f i c e of the Superintendent of F i n a n c i a l I n s t i t u t i o n s , a co n s o l i d a t i o n of the p r e - e x i s t i n g Superintendent of Insurance (which regulated insurance, t r u s t and loan companies) and the OIGB. A Superintendent of F i n a n c i a l I n s t i t u t i o n s ("Superintendent") i s appointed by cabinet to administer the Act and report to the Mi n i s t e r on matters connected with such administration. In addition, the Act creates a Committee designed to f a c i l i t a t e consultations and exchanges of information between government regulatory agencies. The Committee co n s i s t s of the Superintendent, the Deputy M i n i s t e r of Finance, the Governor of the Bank of Canada and the Chairman of the CDIC. Each member of the Committee has 119 the r i g h t t o any i n f o r m a t i o n r e s p e c t i n g t h e s u p e r v i s i o n of f i n a n c i a l i n s t i t u t i o n s w i t h i n the p o s s e s s i o n o r c o n t r o l of any o t h e r member. The S u p e r i n t e n d e n t i s g i v e n g r e a t e r r e g u l a t o r y and enforcement powers than t h o s e p o s s e s s e d by t h e OIGB and S u p e r i n t e n d e n t o f Insurance. These i n c r e a s e d powers are p r o v i d e d by way of amendments t o t h e s p e c i f i c A c t s g o v e r n i n g i n d i v i d u a l s e c t o r s o f the f i n a n c i a l system. b) Canada D e p o s i t Insurance C o r p o r a t i o n A c t P a r t I I o f The F i n a n c i a l I n s t i t u t i o n s and D e p o s i t Insurance System Amendment A c t c o n t a i n s p r o v i s i o n s amending the Canada D e p o s i t Insurance C o r p o r a t i o n A c t . The new l e g i s l a t i o n does not a l t e r t h e b a s i c s t r u c t u r e o f t h e CDIC which remains independent from the agency p r i m a r i l y r e s p o n s i b l e f o r r e g u l a t i o n and s u p e r v i s i o n o f banks (now t h e O f f i c e o f t h e S u p e r i n t e n d e n t o f F i n a n c i a l I n s t i t u t i o n s ) . The CDIC's r o l e c o n t i n u e s t o be l i m i t e d t o t h a t o f d e p o s i t i n s u r e r . As d e p o s i t i n s u r e r , however, i t s powers a r e somewhat expanded. For example, i n s e c t i o n 57, t h e A c t p r e s c r i b e s b r o a d e r o b j e c t s f o r t h e CDIC which r e a d as f o l l o w s : "a) t o p r o v i d e i n s u r a n c e . . . a g a i n s t the l o s s of p a r t o r a l l of d e p o s i t s ; b) t o be i n s t r u m e n t a l i n the promotion of s t a n d a r d s of sound b u s i n e s s and f i n a n c i a l p r a c t i c e f o r member i n s t i t u t i o n s and t o promote and o t h e r w i s e c o n t r i b u t e 120 to the s t a b i l i t y and competitiveness of the f i n a n c i a l system i n Canada; and c) to pursue the objects set out i n paragraphs (a) and (b) above f o r the be n e f i t of persons having deposits with member i n s t i t u t i o n s and i n such manner as w i l l minimize the exposure of the Corporation to l o s s . This amendment has broadened the CDIC's objects which were previously r e s t r i c t e d to providing deposit insurance. The new Act goes on to add several s p e c i f i c powers to the i l l u s t r a t i v e l i s t of the Corporation's powers provided i n s e c t i o n 11. These include the power to manage and invest any funds accumulated as a r e s u l t of i t s operations; the power to incorporate or acquire a company f o r the purpose of f a c i l i t a t i n g the a c q u i s i t i o n , management or dis p o s a l of the assets of a member i n s t i t u t i o n that the Corporation may acquire; and the power to act as inspector of a member i n s t i t u t i o n when duly appointed to act as such. The CDIC's powers i n the area of supervision are expanded by the new l e g i s l a t i o n . Although inspections of member i n s t i t u t i o n s w i l l continue to be performed on behalf of the CDIC by the Superintendent, the CDIC i s provided with a new power to make preparatory examinations where the Corporation believes that the o b l i g a t i o n to pay an insured claim i s imminent. With the approval of the Superintendent, the CDIC may examine books, records and accounts of a member 121 i n s t i t u t i o n r e l a t i n g to i t s deposit l i a b i l i t i e s and i s e n t i t l e d to require any o f f i c i a l of the insured i n s t i t u t i o n to f u r n i s h such information as required (section 60). In additi o n , the CDIC i s given the power to make d i s c r e t i o n a r y payments to insured depositors p r i o r to winding up a member i n s t i t u t i o n where such i n s t i t u t i o n i s unable by reason of court order or an act i o n taken by a regulatory body to make any payment i n respect of the deposit, or the p o l i c y of deposit insurance i s cancelled or terminated. Another aspect of the Canada Deposit Insurance Corporation Act which i s amended by the F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance System Amendment Act i s enforcement. The Corporation i s now authorized to assess and c o l l e c t a premium surcharge from any member i n s t i t u t i o n which i s v i o l a t i n g the Corporation's by-laws (section 65). Furthermore, the CDIC's power to terminate the insurance of p r o v i n c i a l i n s t i t u t i o n s i s extended to include f e d e r a l i n s t i t u t i o n s . Thus, when a bank or other member i n s t i t u t i o n i s not following safe and sound p r a c t i c e s as prescribed by the Corporation's by-laws, the CDIC may send a report of such v i o l a t i o n to the member i n s t i t u t i o n . I f i t f a i l s to remedy the complaint to the Corporation's s a t i s f a c t i o n , i t may terminate the i n s t i t u t i o n ' s insurance, upon the lapse of a prescribed time period and subject to m i n i s t e r i a l approval. The CDIC's power to i n i t i a t e the winding-up of a bank i s retained by the new l e g i s l a t i o n , but amended to provide 122 that such a measure requires the p r i o r approval of the M i n i s t e r . c) Bank Act The F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance System Amendment Act and An Act to Amend Certain Acts Relating to F i n a n c i a l I n s t i t u t u i o n s amend the Bank Act to give stronger supervisory and enforcement powers to the Superintendent v i s a v i s banks. For example, the l a t t e r Act e n t i t l e s the Superintendent to issue d i r e c t i o n s of compliance (cease and d e s i s t orders) to banks conducting or about to conduct unsafe or unsound p r a c t i c e s . The F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance System Amendment Act o u t l i n e s two processes which can be used by the Superintendent to assume co n t r o l of a bank i n s p e c i f i e d circumstances. The f i r s t i s intended f o r emergency s i t u a t i o n s , where the Superintendent beli e v e s that the assets appearing on a bank's books are not s a t i s f a c t o r i l y accounted f o r , a bank has f a i l e d to pay any l i a b i l i t i e s that have come due or there e x i s t s a s i t u a t i o n that i s p r e j u d i c i a l to c r e d i t o r s or depositors. In such a case, the Superintendent i s e n t i t l e d to take c o n t r o l of the bank's assets f o r seven days (or longer i f necessary). While i n c o n t r o l , the Superintendent i s authorized to take a l l steps necessary to protect the bank's depositors and c r e d i t o r s and has a veto power over the bank's actions i n order to preserve i t s assets. I f the Superintendent's o f f i c e i s not convinced that a bank i s solvent or w i l l 123 remain so, i t has the power t o invoke a pr o c e d u r e which l e a d s t o more e x t e n s i v e c o n t r o l over the bank. The pr o c e d u r e i s commenced by t h e S u p e r i n t e n d e n t r e p o r t i n g t o t h e M i n i s t e r i n any case where: a bank's a s s e t s a r e i n s u f f i c i e n t ; a r e p o r t has been s e n t t o a bank's board o f d i r e c t o r s under t h e Canada D e p o s i t Insurance C o r p o r a t i o n A c t ; o r t h e r e e x i s t s a s t a t e o f a f f a i r s which may be p r e j u d i c i a l t o t h e i n t e r e s t s o f t h e d e p o s i t o r s o r c r e d i t o r s o f a bank. Upon h o l d i n g a h e a r i n g , the M i n i s t e r has a number o f o p t i o n s : r e s t r i c t t h e bank's l i c e n c e , p r e s c r i b e a time w i t h i n which t h e bank must remedy i t s d e f i c i e n c y o r p r a c t i c e s and/or d i r e c t t h e S u p e r i n t e n d e n t t o t a k e c o n t r o l o f t h e bank. When th e S u p e r i n t e n d e n t t a k e s c o n t r o l o f a bank by M i n i s t e r i a l o r d e r , the powers and d u t i e s o f t h e bank's d i r e c t o r s a r e suspended and t h e S u p e r i n t e n d e n t becomes r e s p o n s i b l e f o r the management o f t h e bank's b u s i n e s s and a f f a i r s . I f t h e i n s t i t u t i o n f a i l s t o respond s a t i s f a c t o r i l y , t h e M i n i s t e r may r e q u e s t t h e A t t o r n e y - G e n e r a l t o a p p l y f o r a winding-up o r d e r . On t h e o t h e r hand, i f t h e M i n i s t e r b e l i e v e s t h a t a bank under t h e S u p e r i n t e n d e n t ' s c o n t r o l has met a l l the req u i r e m e n t s o f the Bank A c t , the M i n i s t e r may d i r e c t the S u p e r i n t e n d e n t t o r e l i n q u i s h c o n t r o l . Through the s e mechanisms, the S u p e r i n t e n d e n t i s g i v e n l e g a l r i g h t s o f c o n t r o l over banks which go beyond the p r e v i o u s powers of the OIGB or the C D I C . 2. E v a l u a t i o n of F e d e r a l Reforms 124 The f e d e r a l government's amendments to the framework fo r r e g u l a t i o n of the f i n a n c i a l sector take some s i g n i f i c a n t steps i n the d i r e c t i o n of increasing s t a b i l i t y and competition i n the f i n a n c i a l market and harmonizing the r e g u l a t i o n of f e d e r a l and p r o v i n c i a l i n s t i t u t i o n s . With respect to the more s p e c i f i c issue of the power of government i n s t i t u t i o n s to deal with insolvent banks, the amendments r e f l e c t a broader approach than that which exis t e d under previous l e g i s l a t i o n , but one which i s s i g n i f i c a n t l y l i m i t e d . a) S t r u c t u r a l Aspects of Reform The c r e a t i o n of a new regulatory body by the F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance System Amendment Act, which i s a c o n s o l i d a t i o n of the OIGB and the Department of Insurance, i s consistent with the f e d e r a l government's objec t i v e of removing the d i s t i n c t i o n s between the t r a d i t i o n a l four f i n a n c i a l p i l l a r s . 1 From the perspective of the banking sector, however, i t can be argued that the supra-regulatory approach taken by the new Act i s problematic. This concern was expressed i n a recent statement by the Canadian Bankers' Association: I t has been and continues to be the CBA's b e l i e f that an i n d i v i d u a l charged with exclusive r e s p o n s i b i l i t y f o r one p a r t i c u l a r sector would be 1 An a n a l y s i s of the methods by which the government proposes to achieve t h i s objective i s beyond the scope of t h i s paper. 125 more l i k e l y to develop the kind of expertise and d e t a i l e d knowledge necessary f o r dealing with the issues and problems unique to that sector than would a "super-regulator" charged with the much broader mandate of overseeing the r e g u l a t i o n of a l l f i n a n c i a l i n s t i t u t i o n s . 2 This concern i s a l l e v i a t e d to some extent by the p r o v i s i o n i n the Act f o r the appointment of a Deputy Superintendent who would have expertise i n and r e s p o n s i b i l i t y over the banking sector. Whether or not t h i s approach w i l l prove adequate or appropriate cannot be f u l l y assessed u n t i l the government has completed the process of i n t e g r a t i n g the four p i l l a r s . A second problematic aspect of the s t r u c t u r a l reforms introduced by the F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance System Amendment Act involves the r e t e n t i o n of the f u n c t i o n a l d i s t i n c t i o n between the primary regulator of banks and the deposit insurer. I t has been argued that i n order to i n s t i l a w i l l to act i n the regulator and to provide d i r e c t access to information about insured banks, the functions of insurance and r e g u l a t i o n of banks should be combined i n one agency. Although the new l e g i s l a t i o n gives the CDIC the power to make preparatory examinations i n s i t u a t i o n s of imminent insolvency, i t i s argued that i t would be more c o s t - e f f i c i e n t and e f f e c t i v e i f t h i s information were a v a i l a b l e to the deposit insurer on an on- going b a s i s . 2 Canadian Bankers' Association, Response to B i l l C - 4 2 : An Act Respecting F i n a n c i a l I n s t i t u t i o n s and the Deposit Insurance System (Toronto: A p r i l , 1987) at 2 . 126 A f i n a l a s p e c t of the s t r u c t u r a l amendments i n t r o d u c e d by t h e new l e g i s l a t i o n t h a t i s noteworthy i s t h e c r e a t i o n of t h e Committee l i n k i n g o f f i c i a l s o f the v a r i o u s f e d e r a l a u t h o r i t i e s . The o b j e c t o f t h i s Committee, which i s comprised of the S u p e r i n t e n d e n t , the Governor of the Bank of Canada, the Chairman o f the CDIC and t h e Deputy M i n i s t e r o f F i n a n c e , i s to p r o v i d e on-going c o n s u l t a t i o n and communication. I t i s submitted t h a t t h i s i s an improvement over p r e v i o u s f i n a n c i a l s e c t o r l e g i s l a t i o n , which l a c k e d t h i s form o f i n s t i t u t i o n a l i z e d c o - o r d i n a t i n g mechanism. b) F u n c t i o n a l Aspects of Reform The f e d e r a l government's new f i n a n c i a l s e c t o r l e g i s l a t i o n g r a n t s broader powers t o both the CDIC and the S u p e r i n t e n d e n t t o s u p e r v i s e banks and t o e n f o r c e compliance w i t h t h e Bank A c t and t h e Canada D e p o s i t Insurance C o r p o r a t i o n A c t . However, th e expansion o f t h e powers o f t h e s e i n s t i t u t i o n s t o d e a l w i t h a c t u a l o r p o t e n t i a l bank i n s o l v e n c y i s m i n i m a l — e s p e c i a l l y when compared t o the powers proposed i n the model f o r r e f o r m s e t out i n c h a p t e r 6. The amendments t o the Canada D e p o s i t Insurance C o r p o r a t i o n Act expand the CDIC's o b j e c t s beyond the p r o v i s i o n of d e p o s i t i n s u r a n c e . By s p e c i f y i n g t h a t an o b j e c t i v e of the CDIC i s t o promote sound b u s i n e s s and f i n a n c i a l p r a c t i c e s , the A c t r e f l e c t s the government's c o n c e r n i n p r o t e c t i n g f i n a n c i a l s t a b i l i t y and the i n t e r e s t s 127 of depositors and of the CDIC and recognizes the Corporation's r o l e i n t h i s process. Furthermore, the i n t e r e s t of c o s t - e f f i c i e n c y i s recognized by the requirement that the CDIC minimize i t s exposure to l o s s . Although these expanded objects provide the CDIC with a broader frame of reference, they w i l l not have a s i g n i f i c a n t e f f e c t on the CDIC's a b i l i t y to resolve bank f a i l u r e , unless backed up by wider powers to act i n an insolvency s i t u a t i o n . The amendments to the Canada Deposit Insurance Corporation Act do provide the CDIC with strengthened supervision and enforcement powers aimed at preventing insolvency. However, they f a l l short i n s o f a r as providing f o r new and f l e x i b l e powers to resolve bank insolvency. One s i g n i f i c a n t new power which i s introduced by the F i n a n c i a l I n s t i t u t i o n s and Deposit Insurance System Amendment Act i s the Superintendent * s l e g a l r i g h t to take c o n t r o l of a bank or i t s assets i n c e r t a i n circumstances. This i s an important p r o v i s i o n i n that i t grants the Superintendent the power to take temporary c o n t r o l of a troubled bank and, therefore, the opportunity to i n v e s t i g a t e the source of the trouble and to prevent further prejudice to the i n t e r e s t s of depositors or c r e d i t o r s . The r e s u l t of t h i s temporary r i g h t of c o n t r o l i s e i t h e r a c o r r e c t i o n of the s i t u a t i o n and the return of c o n t r o l over the bank's assets to bank management or a more complete taking of c o n t r o l over the bank's a f f a i r s u n t i l the unsound p r a c t i c e or state of a f f a i r s i s remedied or the bank i s wound up. 128 The new Act sets out s p e c i f i c c r i t e r i a f o r the taking of such ac t i o n by the Superintendent and gives the ultimate authority to invoke such a procedure to the M i n i s t e r . This procedure w i l l be us e f u l i n circumstances where the regulator i s concerned about a member i n s t i t u t i o n ' s solvency and wants to prevent f u r t h e r l o s s to the bank's depositors, c r e d i t o r s and to the CDIC before the bank i s wound up or i n circumstances where the i n t e r e s t s of depositors and c r e d i t o r s are threatened by an unsound p r a c t i c e or state of a f f a i r s which can be remedied. The procedure does not contemplate nor i n any way provide a mechanism whereby an insolvent bank can be b a i l e d out. Conclusion When measured against the c r i t e r i a f o r reform set out i n chapter 6, the fe d e r a l government's l e g i s l a t i v e i n i t i a t i v e f a l l s short. Like the bank insolvency l e g i s l a t i o n preceding i t , the new l e g i s l a t i o n contemplates one ultimate course of act i o n i n the event of bank f a i l u r e : l i q u i d a t i o n and payoff. I t does not address the issue of government b a i l o u t s of insolvent banks (other than providing deposit insurance f o r small depositors). Therefore, the present s i t u a t i o n w i l l c o n t i n u e — with the government continuing to b a i l out insolvent banks without the be n e f i t of the structure, c o n t r o l and p r e d i c t a b i l i t y provided by a l e g i s l a t i v e framework. 129 CONCLUSION The experience of the Canadian government i n attempting to resolve recent bank insolvencies has i l l u s t r a t e d the inadequacy of the l e g i s l a t i v e framework under which i t was authorized to act. That l e g i s l a t i o n did not recognize nor provide a mechanism for the b a i l i n g out of distressed banks. Because bank bailouts can be j u s t i f i e d i n s p e c i f i c circumstances, bank insolvency l e g i s l a t i o n should recognize t h i s form of government intervention and provide an adequate and appropriate framework fo r t h i s process. American bank insolvency l e g i s l a t i o n r e f l e c t s a highly- structured approach to the problem of actual or p o t e n t i a l insolvency and provides the deposit insurer with broad powers to decide whether a bank should be b a i l e d out or allowed to f a i l . I f the decision i s made to b a i l out, the deposit insurer possesses the authority to choose among a number of a l t e r n a t i v e approaches, i n p a r t i c u l a r , the purchase and assumption transaction and d i r e c t f i n a n c i a l assistance. The model for reform of Canadian bank insolvency l e g i s l a t i o n which i s proposed i n t h i s thesis i s based on the American approach. I t creates an agency with d i r e c t and on- going access to the information needed to recommend a course of action to the Minister with respect to a distressed bank, and the broad powers to implement the Minister's decision. 130 The model proposes a l e g i s l a t i v e scheme which would provide as a general r u l e that only insured depositors would be ba i l e d out i n the event of f a i l u r e but would allow wider compensation i n circumstances which j u s t i f y greater government intervention. The model i s designed to promote the i n t e r e s t s of c o s t - e f f i c i e n c y and market d i s c i p l i n e . When t h i s model for reform i s applied to recent federal i n i t i a t i v e s to amend f i n a n c i a l sector l e g i s l a t i o n , the conclusion i s reached that the new l e g i s l a t i o n , while a step i n the r i g h t d i r e c t i o n , does not go f a r enough. 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Trebilcock, M.; Chandler, M.; Gunderson, M.; Halpern, P.; Quinn, J . , The P o l i t i c a l Economy of Business Bailouts: Volume 1. Toronto: Ontario Economic Council, 1985. Waddell, Harry, "FDIC's F i r s t 50 Years", A.B.A. Banking Journal, October, 1983, 52. Wyman Commission, F i n a l Report of the Working Committee on the Canada Deposit Insurance Corporation. Ottawa: Minister of Supply and Services, A p r i l , 1985. Ziegel, Jacob; Waverman, Leonard; Conklin, David, eds..Canadian Fin a n c i a l I n s t i t u t i o n s : Changing the Regulatory Environment. Toronto: Ontario Economic Council, 1985.

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