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Open Bank Resolution - broadening the government's options to deal with a bank failure

Background Feature by Reserve Bank Deputy Governor Grant Spencer.

The global financial crisis has provided a worldwide reminder that banks can fail. It also highlighted the potential size of the financial burden that can be faced when governments step in to guarantee a nation's banking system. A glaring example of this is Ireland. Bank failures are very rare in New Zealand and we do not expect this to change. In addition, New Zealand's financial system remains stable. Nevertheless, it is important to have robust policies in place to deal with such unlikely, but potentially damaging events.

Open Bank Resolution (OBR) is a process for dealing with a failing bank quickly to enable the bank to re-open for business the next business day.

Without OBR, the options for responding to a bank failure are liquidation, government bail-out or takeover by a competitor. If takeover is not an option, then the Government is left to choose between liquidation and bail-out.

Neither option is appealing. Government bail-out carries with it potentially huge costs to taxpayers. Liquidation is complex and time-consuming, and results in the bank's customers not having access to any of their money for a lengthy period. In the case of a large bank, this could lead to serious disruption of the wider economy.

OBR works by allowing the failing bank to remain open under the control of a statutory manager. In contrast to liquidation, deposit holders have full or partial access to their accounts, while a long-term solution is worked out.

The first losses of a failing bank are borne by the bank's shareholders and subordinated creditors, as they would under liquidation. Under OBR however, a portion of depositors' and other unsecured creditors' funds are frozen to meet any remaining losses, while the unfrozen part is subject to a government guarantee to give depositors confidence in the re-opened bank.

The Reserve Bank is currently working with banks to make OBR a fully viable policy option in the government's financial emergency toolkit. This follows the government confirming last year that it was considering a number of permanent options – including Open Bank Resolution – to manage any future financial market difficulties and maintain confidence in the financial system.

This pre-positioning work involves ensuring banks' IT and other systems can implement the necessary processes, something banks are required to have completed by 30 June 2013. The OBR scheme has been designed to reduce the risk of severe disruption to customers and the wider economy from a bank failure, and to minimise the need for government bail-outs. The policy creates time for a full analysis to be carried out and the best course of action to be determined.

Importantly, OBR strengthens the incentives for bank management to act prudently and for creditors to closely scrutinise bank management – something that will be eroded if it is assumed government will bail-out a failing bank.

The OBR policy also aligns New Zealand with the latest best practice in this area globally, as set down by international agency the Financial Stability Board.

Under the OBR policy, all locally incorporated banks with over $1 billion dollars of retail deposits will be required to participate, and therefore pre-position their internal systems for it. All other registered banks are able to opt in if they choose to.

The OBR policy will give the government a more palatable middle ground for dealing with the unlikely event of a bank failure, minimising the impact on the broader economy and the New Zealand taxpayer.