INTERNATIONAL ASSOCIATION OF DEPOSIT

INSURERS(IADI)

AFRICAN REGIONAL COMMITTEE WORKSHOP ON

RESOLUTION OF PROBLEM BANKS:

PURCHASE & ASSUMPTION OPTION

MAY 9-13, 2011

ABUJA, NIGERIA

A PAPER ON

OVERVIEW OF PURCHASE AND ASSUMPTION

(P&A) TRANSACTION

BY

AYUBA NICHOLAS IBRAHIM

DEPUTY DIRECTOR

ASSET MANAGEMENT DEPARTMENT

NIGERIA DEPOSIT INSURANCE CORPORATION

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OUTLINE

Introduction

objective of the Paper

Definition of Purchase & Assumption (P&A) Transaction

Types of P&A Transactions

Advantages and Disadvantages of P& A Transactions

Implementation Challenges for P&A Transaction

Conclusion

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1.0 INTRODUCTION

Bank failure is inevitable. For everything else to work properly and facilitate effective bank resolutions, there is need to have:

Strong institutional framework

Operationally independent deposit insurer

Resolution powers aligned with mandate

A legal system capable of dealing with systemically important banks

Intervention powers vary across countries and early intervention can

lower the cost of resolution

The purchase and assumption transaction (P&A) is one of the

resolution methods used by deposit insurers in resolving failed banks.

The others include deposit reimbursement (or payout), Open Bank

Assistance, Asset Purchase and Bridge Bank.

2.0 OBJECTIVE OF THE PAPER

To enable participants have a broad understanding of P&A failure

resolution method

To identify the types of P&A transactions

Identify the advantages and disadvantages of each type of P&A

Identify the strengths and challenges in implementing the P&A

transactions

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3.0 PURCHASE AND ASSUMPTION

A purchase and assumption transaction or resolution is defined as one in which a

healthy bank or group of investors assume some or all of the obligations, and purchase

some or all of the assets of a failed or failing bank

Typically , a healthy bank purchases assets and assumes deposit liabilities of the failed

bank, similar to Mergers and Acquisitions

A failed bank could be split to make it attractive to banks that wish to enhance market

penetration or establish new branches where the failed bank had branches

Acquirer is chosen on the basis of the highest premium offered during biding

Deposit insurer or government would put cash/securities for the difference. Such could

be recovered from bad assets of the failed bank

A standard P&A provision allows the assuming institution to required the deposit insurer

to repurchase any acquired loan that has forged or stolen instruments

The price is based on appraisal that is mutually acceptable to the deposit insurer and

the acquirer

The liabilities assumed by the acquirer include the deposit liabilities covered by

insurance

Critics observed that customers with uninsured deposits rarely suffer losses in P&A

transactions, it is like providing unlimited insurance coverage to depositors, and thus

destroy market discipline. P& A appear to provide inequitable protection for uninsured

depositors in large institutions.

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4.0 WHY ADOPT P&A

The main reasons for adopting the P&A resolution method are:

(a) Cost: When the cost for adopting P&A is less than the estimated loss arising from a

payout

(b) Stability of Banking Industry: The P&A is considered to be less disruptive to

depositors, borrowers and the payment system when compared to a

payout;

(C) Interest of stakeholders: P&A is considered to be in the best interests of

bank’s depositors as they are protected, and would aid the reconstruction of

the bank or the dispositions of its assets in an expeditious manner

Other Merits

Continuity in rendering banking services thereby sustaining public confidence in the

banking system

Other creditors might not be paid, thus providing some form of market discipline

Shareholders are wiped out and inefficient bank closed

The Demerits include:

Large and uninsured depositors are protected, thus eroding market

discipline

It could be costly especially if fund from Central Bank/Government/Deposit Insurer is

used to fill the gap between total deposits and assets purchased is significant

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5.0 TYPES OF P&A

The P&A structure involved over time to incorporate procedures and

incentives to entice acquirers to take more assets of the failed

institution. Some of the variations of the P&A transactions include:

(a) Whole Bank P&A

(b) Partial P&A

(c) Loss sharing P&A

(d) Bridge Bank

The assets acquired vary, depending on the type of P&A as some

assets are purchased outright while others may be subject to an

exclusive purchase option by the assuming institutions for varying

periods.

The whole bank P&A with optional asset pools appear to be most

common in countries that adopt the P&A resolution method in handling

failed banks

The loss sharing transitions and bridge banks are considered as two of

the more specialized P&As

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5.1 WHOLE BANK P&A

This is a transaction involving one purchaser of all assets and branches under

one agreement

The whole bank P&A structure emerged as a result of effort to induce

acquirers of failed banks to purchase the maximum amount of a failed

institution’s assets

Bidders were asked to bid for all assets of the failed institution on an “as is“

discounted basis (with no guarantees)

The highest whole bank bid that was less costly than a pay off was accepted

5.1.1 ADVANTAGES

The merits of the whole bank P&A include the following

Continuation of banking business with new bank

Acquiring bank has opportunity for new customers

Customers with insured deposits suffer no loss

Lower cost compared to deposit pay-out

Reduced initial cash outlay by deposit insurer

Deposit insurer had no further financial obligation to the acquirer

Allowed time for due diligence after P&A was finalised

Reduces amount of assets held by deposit insurer or liquidator for liquidation.

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5.1.2 DISADVANTAGES

Some of the disadvantages are

Because a whole bank bid constitutes a one –time payment from the

deposit insurer, bidders tend to bid very conservatively to cover all

potential losses

Conservative whole bank bids could not compete with other

transactions on a least cost basis. With the introduction of the least

cost test by the FDIC for instance, the number of successful whole

bank bids declined.

Many institutions are reluctant to purchase commercial credits without

credit enhancements even if assets are purchased at a discount

Requires much pre-closing work for staff of the deposit insurer

Borrowers may have split lines of credits

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5.2 LOSS SHARING P&A

This was adopted to address problems associated with marketing large

institutions with sizeable loan portfolios

Instead of selling some or all of the assets to the acquirer at a

discounted price, the deposit insurer agrees to share in future loss

experienced by the acquirer on a fixed pool of assets

The deposit insurer absorbs a significant portion of the credit loss

(mostly up to 80%) while the acquirer assumes the remaining. Thus

large portion of the portfolio passed to acquirer.

By absorbing a portion of the loss, the deposit insurer is also

attempting to induce rational and responsible credit management

behaviour from the acquirer

The deposit insurer reimburses acquiring institutions substantial

percentage (about 80%) of expenses incurred in relation to the

collection of the shared loss assets, except overhead and personnel

expenses

Shared recovery period runs concurrently with the loss share period

and last another 1-3 years beyond the expiration of the loss sharing

period.

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5.2.1 ADVANTAGES

The depositor insurer absorbs a significant portion of the credit loss an

commercial loans and commercial real estate loans (typically 80% by

the FDIC) while the acquirer assumes the balance

Most of the failed institutions’ loans are passed to acquirer while

(acquirer) still receives a premium for the institution’s deposit franchise

The method induces rational and responsible credit management

behaviour from the acquirer

Used generally in large transactions, loss sharing P&A has been

successful in keeping most assets in the banking industry which results

in lower costs for the deposit insurer due to reduced risk

5.2.2 DISADVABTAGES

The deposit insurer and acquirer take on additional administrative

duties and costs in managing the shared loss asset throughout the life

of the P&A agreement

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Added responsibilities cause loss of interest in bidding;

It is more time-consuming as agreements last 5-7 years

Many healthy, small financial institutions may not have appropriate

experience in working out problem assets. They may therefore lose

interest or may not manage them well.

The deposit insurer does not control assets yet retains large portion of

the potential loss

5.3 PARTIAL P&A

The partial P&A is a variation of P& A transactions used under differing

circumstances as appropriate. These include basic P&As, Loan

Purchase P&As; Modified P&As; P&As with Put Options; and P&As

with Asset Pools.

Basic P&A - Assets passed to acquirers generally limited to cash and

cash equivalents

Premises and other fixed assets are often offered to acquirers on

optional basis.

Liabilities assumed generally include only the portion of deposit

liabilities covered by insurance

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Loan Purchase P&As – Winning bidders assume a small portion of the

loan in addition to cash and cash equivalents;

Assets acquired constitute only between 10-25% total

assets

Modified P&As -wining bidder purchases cash and cash equivalents, instatement

loans and all or a portion of mortgage loan portfolio

P&As with Put Options – Acquirers have option to put back assets they did not wish

to keep after a prescribed period (usually 30-60 days), or given a

period within which to cherry-pick assets desired. The FDIC discontinued

the put option in 1991 and replaced it with loss sharing option

and the loan pool structure.

P&As with Asset Pools – potential acquirers submit proposals for the

franchise (deposits) for any or all asset pools

Aimed at maximizing sale of assets and keep them in the banking

industry

The loan portfolio is broken into separate pools of homogenous loans

(pooled on the basis of similarity in characteristics such as same

collaterals, terms, history or location) and are marketed separately

Provides additional flexibility since each acquirer has a different interest

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5.3.1 ADVANTAGES

Large number of small and mortgage loan balances sold

Fewer assets are retained by the deposit insurer

Allows acquires time to complete due diligence after the P&A was

finalized.

Improves marketability of loans

5.3.2 DISADVANTAGES

Many acquirers are reluctant to acquire loans

May require much pre-closing work for the deposit insurer

Cherry-picking allows acquirer to pick assets with values above book

values

Put options could delay transfer of assets to acquirer

Deposit insurer left with mostly bad assets to liquidate.

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5.4 BRIDGE BANK

A bridge bank transaction is a type of P&A in which the deposit insurer itself

acts temporarily as the acquirer

It is a new temporary, full- service bank, designed to “bridge” the gap

between the failure of a bank and time when the deposit insurer can

implement a satisfactory acquisition by a 3rd party.

The original bank is closed by the authority and placed in receivership

Bridge bank is operated for a limited time period, with provision for limited

extensions, after which time it must be sold or otherwise resolved

Bridge bank is especially useful where failing bank is large or unusually

complex.

Before establishing a bridge bank, a cost analysis must show that the

estimated operating cost of the bridge bank is less costly than a payoff

The use of bridge banks has played a key role in the resolution of bank

failure in Korea and Japan. The USA had used bridge bank 10 times

between 1987 and 1994 by creating 32 bridge banks for 114 separate

institutions.

For the FDIC, the competitive Banking Act of 1987 provides for the

operation of a bridge bank resolution option, while the NDIC Act 2006 (S.

39) gives legal backing for the operation of a bridge in Nigeria

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5.4.1 WHY BRIDGE BANK

The goal of bridge bank is to preserve the franchise value and lessen

any disruption to banking activities

It provides the prospective purchasers time necessary to assess the

bank’s condition in order to submit offers or market the institution. Thus

it provides time needed to arrange a permanent transaction.

5.4.2 BASIC CHARACTERISTICS

Bridge bank has its own structure and governance

Separate legal entity

Has board of directors

Deposit insurer appoints officers

Delegation of authority

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Legal provisions for its capital

Business strategy

Identify care business

Maximize franchise value

Minimize value at risk

Employee strategy

Identify key employees

Implement retention strategy

Right-size organization (economize for sustainability)

Meets liquidity demands

Daily operating expenses

Retain debt obligations

Corporate funding

Deposit run-off

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5.4.3 ADVANTAGES

Provides uninterrupted service to bank customers

Allows deposit insurer sufficient time to evaluate and market the

institutions, thus providing time to arrange a permanent transaction

Provides prospective acquirer time necessary to assess the bank’s

condition in order to submit reasonable bids

Is an improvement over deposit payout or insured deposit transfer

alternatives

5.4.4 DISADVANTAGES

Duplicates resolution process: original bank and bridge bank

Takes much time and effort

Deposit insurer responsible for operation of bridge bank

Difficult to retain key employees during transition

Could lead to lower premium as economic conditions could deteriorate

Franchise value could reduce as best customers may move to more

stable environment.

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6.0 IMPLEMENTATION CHALLENGES AND SITUATIONS THAT MAKE FOR OPTIMAL UTILIZATION

(a) A major challenge in implementing P&A transaction revolves around

confidentiality and legal provisions

Poor handling of information could lead to bank run or dissipation of

assets of failing bank

The deposit insurer need adequate legal backing to support the type of

resolution option to be applied

The use of “confidentiality Agreement” (which is standard practice) could

address the challenge of maintaining confidentiality in outsourcing the

analysis of a failing bank to determine the resolution method to adopt

Deposit insurers are guided by legal provisions in deciding on resolution

options to apply

The USA started using the bridge bank only after the relevant law was

enacted in 1987.

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Taiwan was able to apply the P&A option only after the establishment of

the Financial Re-structuring Fund Act 2001 to quickly resolve the

crises when its DIF could not cope with the several insured financial

institutions failing simultaneously.

(b)The concept of ”whole Bank P&A” is in real sense, a misnomer. This is

because in reality there is hardly any “whole bank” transactions.

(c)A bridge bank could fail without achieving its objective, and therefore

aggravate the cost of resolution.

There is need for proper incisive analysis of the failing institution to

determine whether or not the bridge bank option is indeed a more

viable resolution program

(d)How would a deposit insurer ensure that in adopting any P&A method,

an acquirer purchases substantial assets of the failed bank and carry

through the resolution at the least cost?

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7.0 CONCLUSION

The P&A transaction failure resolution method has become a popular

option for resolving bank failure across jurisdictions with variations in

types of application or structure.

Although each variant has its merits and demerits, the application of

any method or type depends on the legal provisions, and the peculiar

or particular circumstance of the jurisdiction and the nature of failures

that need to be resolved.

THANK YOU FOR YOUR ATTENTION!