Early Warning Indicators, Deposit Insurance, And Methods for Resolving Failed Financial Institutions

This paper draws on COIC's experience with deposit-taking institutions during the 1980s and 1990s and presents a number of early warning indicators of financial distress. Early warning indicators do not eliminate bank failures. However, they should lead to early intervention and consequently help reduce losses to deposit insurance funds or governments. To be effective, early warning indicators should be used in conjunction with professional judgement. Judgement must be exercised in choosing the relevant indicators and in interpreting the data derived from the early warning measures. The effectiveness of an early warning indicator also depends on the quality of the data. For example, many deposit-taking institutions that failed in Canada had inadequate information systems that generated unreliable data. The inaccurate data led management (and regulators) to believe the institution was healthy, resulted in poor decision making, delayed intervention by regulatory agencies, and eventually led to failure. Also, traditional cost valuation methods for preparing accounting information may not be appropriate for early warning data. For example, a "marked-to-market" valuation of assets and liabilities of financial institutions can lead to sounder decision making and is more appropriate for assets such as marketable securities and derivativei products. Furthermore, for an early warning indicator to be effective, indicators need to be supplemented by information that is not of a financial nature. On-site examinations provide crucial first-hand information onmanagement's strategy and competence, the adequacy of internal controls and the accuracy of financial reporting. Moreover, macro- and micro-economic data, market trend indicators (i.e., real estate values, stock market indices) and industry-specific data can explain how external forces have affected the institution in the past and how they can affect it in the future. Finally, early warning systems must cover all the key functions of a bank's operations and potential areas of risk, namely (among many others) internal audit, cash management and liquidity, securities operations, loan portfolio, other assets, deposit liabilities, capital adequacy, profit and loss and market risks, This paper provides early warning signs and indicators for the above dimensions.