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Money: 10 things you need to know about bank failure in New Zealand

04 Apr 2018

A bank is just a business, set up like most businesses as a limited liability company, and just like any business, it can fail.

In the past the government has stepped in when a bank has got into trouble putting taxpayer’s money into the bank to keep it going. This is an example of the government acting as a guarantor for what is a commercial enterprise and many people, quite rightly, frown on this sort of thing. It could lead to banks taking unreasonable risks to increase their profits at the expense of sensible risk management, all the while knowing that the tax-payer will rescue them if it all goes wrong.

That conundrum is referred to as a ‘moral hazard’.

Well, said the wallahs in Wellington, “We can’t have that.” And so, a set of regulations have been developed called Open Bank Resolution or OBR which is designed to keep a bank running after a crisis rather than shutting up shop or using taxpayer’s money to keep it going. It involves bank customers taking a ‘haircut’ on their deposits at the bank.

How does it work?

  1. The minister of finance can choose to use OBR, or not. It is just one tool in the tool kit.
  2. A bank in trouble could, for example, be taken over by another, stronger bank.
  3. If there are no better options, the minister of finance can implement OBR and get the bank open for business very rapidly after a failure event (the next business day in fact - there would be no sleep for the wallahs in Wellington).
  4. A statutory manager from outside the bank is put in charge of the bank and all the bank’s money is frozen.
  5. This statutory manager then unfreezes a portion of each bank account for the next business day, so customers can continue getting access to some of their money.
  6. The unfrozen funds become government guaranteed so bank customers are persuaded to leave their money in the bank if they don’t need it immediately and that reduces the pressure on the bank to find cash they don’t have.
  7. The frozen money that bank customers can’t access can now be used by the bank as its own money to try and get them back into shape. This is what is known as a ‘haircut’. Get it? Every depositor has ‘donated’ some of their money to the bank, at least temporarily. In the worst case, their money or some of it has gone forever to re-finance the bank.
  8. Bank customers like us are unsecured lenders to the bank but there are others who lose their money before us. Shareholders’ funds are used up first in supporting the bank (you may be a bank shareholder as well – most of us are through KiwiSaver). Then comes what are called subordinated lenders who lose their money next, and then unsecured lenders (all the regular bank customers like us), who rank equally with each other. There will also be some secured lenders and they are in the best position, but they could also lose out too if there is not enough money to go around.
  9. Term depositors get the same sort of haircut, they are unsecured bank customers too, and the unfrozen portion would be released as the terms mature.
  10. OBR has been in place since 30 June 2013 and is topical as it is being reviewed now by the government.

As the Reserve Bank says, the fact is that bank depositors’ funds are at risk and we are all responsible for assessing the credit-worthiness of the banks we use. That is what the bank’s credit ratings are for.

Do you know the credit rating of your bank?

More on credit ratings next time.

Keep asking great questions …

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