The OBR is not meant to be a replacement for deposit guarantees

I’ve noticed an interesting interpretation of the Open Bank Resolution going around New Zealand, and the world, where it is seen as a replacement for the lender of last resort function and deposit guarantees.

This has caused outrage among some – even I’ve received some emails and facebook messages from people on it.  But the OBR and implicit/explicit deposit insurance are actually two incredibly different issues.

The OBR is a scheme that helps to ensure that, when a financial institution fails, it is wound down in an orderly fashion – it is like an addition to standard bankruptcy law specifically for financial institutions.  The OBR takes the fact that, if debt has “gone bad” there are a range of creditors, and the loss needs to be attributed between them.  This is great, it makes what is going on transparent, and helps reduce the interruptions associated with the collapse of a large financial institution!

But it doesn’t say anything about the government’s willingness to allow depositors to lose out from a failure.  Any implicit government guarantee that existed still exists.  In Table 1 of the RBNZ’s recent bulletin article on the OBR this is made relatively clear – the idea of inherent insurance is not applicable to the scheme.

Now I think the logic people are taking onboard is as follows:

  1. When it is clear how a bank will be shut down, it is more likely that the government will do so instead of bailing it out.
  2. Therefore, by setting all this up, it is less likely depositors will be bailed out.

While this is true, I think that it inherently misses the point for extremely large financial institutions – such as the big banks in NZ.  Governments have an incentive to bail out depositors, and there may well be a presumed “social preference” for a risk free place to save that doesn’t lose value which is where this is coming from (given that the value of cash depreciates over time).  If we really want the government to be able to commit to not bailing out deposit, and we want society to be comfortable with it, we need to face these issues – which are separate issues from the appropriate focus of the OBR.

Personally, I think the OBR is great – I just think people’s view of its “purpose” has been stretched out of proportion.

  • Eric Crampton

    In the absence of deposit insurance, and with its coming in as the prior scheme
    winds down, OBR sure seems to be a substitute for deposit insurance. Whether it is or not de facto depends on credibility that some future government would not renege. That depends on what the actual haircut rate would wind up being I suppose.

    • Matt Nolan

      There will be a set of financial institutions that would not have been shut down, but now will due to the organisation. However, there are a set of financial institutions that will not in either case, and a set that will be shut down in both cases.

  • Eric Crampton

    Ok, I’m looking at that table and I’m totally not seeing what you’re there seeing. Table 1 says that depositors are exposed to losses, that there is no depositor preference or insurance in New Zealand. There is a government guarantee for the initial unfrozen portion, and they need to make clear that that guarantee is only on the initial unfrozen portion for depositors who were there at the time so that funds don’t rush to that bank from others post-freeze. But I’m not seeing any implicit insurance in there except in the case that they screw up by freezing too small a portion of the assets at the start.

    • Matt Nolan

      My view was simply that this is saying the OBR is irrelevant when looking in the space of deposit protection – it does not tell us anything about the implicit guarantee given by government.

      It is a scheme that makes the process of winding down institutions more transparent, it doesn’t define the full government response – the OBR is part of the story, not the whole policy framework.

      And this is key – if a large bank fails, the government will intervene. Unless they find some way to commit to not intervening, I want them to acknowledge this.

      • Eric Crampton

        Maybe they intervene, but looks like it would be after they burn the assets of those who should have been monitoring. So odds of any bailout drop.

        But I would welcome something going into the Reserve Bank Act saying the Bank can’t bailout beyond what’s in OBR and into Fiscal Responsibility Act saying the government can only bail out the banks if the Minister of Finance and Prime Minister are shot in the face as part of the process.

        • Matt Nolan

          Indeed, it lowers the odds of a bailout by increasing transparency, which lowers the potential for spillover and meddling. But this is a side-effect, not the primary purpose of the OBR – the OBR is part of the management of failure in financial markets, not the entire policy.

          I’d also note that, although the RBNZ helped to design the OBR, it is still the minister/government’s responsibility to pull the trigger – and to determine what other policies are put in place. I don’t believe the existence of an OBR is sufficient to avoid government bailouts when they are occurring overseas, or when it is one of the big 4 banks that are in trouble. If that is indeed that case, this is something that should be accounted for over and above OBR regulation.

          Just to be clear, I wasn’t criticising anything you’ve written – as I don’t believe you put it as “one or the other”. I just saw that Bernard was starting to do that, and had seen Cowen’s post being interpreted on other blogs as suggesting an almost full replacement, and wanted to point out that this wasn’t the case.

          • Eric Crampton

            I’d say “I hope this is in lieu of deposit insurance, and that government does more to make that credible.”

            • Matt Nolan

              Well they really need to actually do something then – as people are forming expectations on the basis that they expect deposit insurance in the face of the failure of a bank. Even if they aren’t going to bail it out – if expectations are not set by private agents in a way consistent with that we risk an extremely harmful situation, and further generalised overinvestment.

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