Following the contract between the bank and its customers, a bank fails when insolvency causes a failure to meet its obligations towards the creditors. Such a mismatch between the available liquidity and the outstanding financial commitments can be resolved rather quickly, but often needs early intervention and recovery planning in close cooperation with an external regulation. Even though bank failure traditionally was caused by solvency challenges, financial institutions these days also fail after regulatory intervention initiated by intense legal and regulatory violations of the bank.
The objective of a regulator when a bank is failing or likely to fail (FOLTF) is to serve the public interest by avoiding bank panic that ultimately triggers a financial crisis. To stabilize the bank and limit risk for creditors and society, Central Banks and other regulators have different tools to ensure a smooth transition from failure to resolution. These tools can include government stabilisation and nationalisation, bail-in, the sale of the business, the formation of a bridge bank, and the separation of asset classes via an asset management vehicle. The decision for one of the tools is influenced by the principle that no creditor should be worse off than under a liquidation of the bank (NCWOL).
Banks are interconnected and therefore failure of one financial institution can cause a contagious and systemic effect. To avoid financial crises, failing banks are isolated and a resolution plan is formulated. The global financial crisis and European debt crisis caused international havoc and governments had to intervene at the expense of local tax payers. In the aftermath of these crises, rules have changed and to avoid tax payer input to rescue failing banks, and hold financial institutions responsible for their own mistakes, bank failure and liquidation are seen as an isolated and internal matter where the banks creditors participate in the banks losses.
Recovery processes in bank failure and liquidation contain different stages. Each stage allows creditors to submit their proof of debt and proof of claim and qualify for a capped repayment. Especially depositors need to act with care because their position as an unsecured creditor in a bank liquidation takes into account a payment under the depositor protection regulation.
For creditors it is crucial to distinguish the restart of the banks activities and the winding down of the business unit or complete financial institution. In all situations, the creditor hierarchy determines the position of a creditor. Hence the reason that creditors need to be proactive and stay on top of the developments to safeguard their position and avoid missing out on any of the stages during the recovery process. Another reason to avoid missing out on staged recovery is that at the end of the liquidation procedure, only expensive arbitration or civil litigation is open for duped creditors. During such a legal procedure, causality between the losses experienced by creditors and the actions or omissions of the bank must be proven.
Bank failure and liquidation is a long-term process that can often take several years. Depending on the account balance and creditor position, repayments to creditors are made at different moments. The liquidity position and assets of the financial institution clarify the recovery potential for creditors. Privately owned financial institutions publish limited financial and accounting records thus making it difficult to ascertain the exact financial position of the bank. Furthermore, the discovery and realization efforts of an administrator or liquidator can lead to further delay when assets are held in other jurisdictions, sometimes even with different legal systems.