pre-positioning for effective resolution of bank failures

Journal of Financial Stability 3 (2007) 324–341

Available online at www.sciencedirect.com

Pre-positioning for effective resolutionof bank failures�

Ian Harrison ∗, Steve Anderson, James TwaddleReserve Bank of New Zealand, New Zealand

Received 18 July 2006; received in revised form 15 June 2007; accepted 2 August 2007Available online 17 August 2007

Abstract

Large bank failures are often handled differently to other firm failures because suddenly closing a large bankand consequently freezing otherwise liquid claims raises financial stability concerns. As a result, substantialpublic funds are often used as part of the resolution process, which can undermine market discipline andlonger-term financial stability. We propose a resolution scheme that enables the good portion of creditors’claims to be quickly made available to them in way that maintains market discipline while managing theliquidity effects of large bank failures. We report on a New Zealand study into making the scheme work inpractice.© 2007 Elsevier B.V. All rights reserved.

JEL classification: G21; G33

Keywords: Bank failure; Crisis management; Financial restructuring

1. Introduction

Authorities have often handled large bank failures differently to failures of other firms andsmall banks. A non-financial firm that fails and has no ready buyer is usually liquidated. Thefailure of small banks is often handled through liquidation, though liquidation is seldom used forlarger banks (OECD, 2002).

One reason for the potential difference in treatment of large bank failures by authorities is thepotential impact of a large bank failure, or multiple bank failures, on the financial system. Some

� The views expressed in this paper are those of the authors and do not necessarily reflect the views of the Reserve Bankof New Zealand.

∗ Corresponding author. Tel.: +64 4 4713756; fax: +64 4 4723262.E-mail address: [email protected] (I. Harrison).

1572-3089/$ – see front matter © 2007 Elsevier B.V. All rights reserved.doi:10.1016/j.jfs.2007.08.001

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I. Harrison et al. / Journal of Financial Stability 3 (2007) 324–341 325

studies suggest the costs of multiple bank failures could be, on average, as high as 15–20% of GDP(e.g., Hoggarth and Saporta, 2001). Even if the damage from bank failures in more developedcountries is expected to be lower than these estimates, the illiquidity of depositors’ claims after thebank is closed can create fear and uncertainty about the potential damage to the financial systemand lead to political pressure to use public funds to bail out the bank’s creditors and resolve thefailed bank (Kaufman and Seelig, 2002). Moreover, as Kane and Klingebiel (2004) point out,authorities’ fear of getting blamed for a bank’s difficulties can lead them to bail out creditorswithout regard to the longer-term consequences of doing so. As such, “closed bank” resolutionoptions, where the bank is closed at the point of failure and there can be a delay of weeks ormonths until the bank’s creditors receive what is left of their claims, have often been seen byauthorities as unacceptable for large or multiple bank failures.

For these reasons, authorities have preferred “open bank” resolution options for large or mul-tiple bank failures (e.g., OECD, 2002). Open bank resolution in this context means the bankremains open to conduct a material part of its normal activities, even though the bank may havefailed financially. To achieve an open bank resolution, and so keep the bank in operation, publicfunds are often used to protect some bank stakeholders from some of their potential loss.

The use of public funds to keep a bank open almost certainly reduces the immediate damageto the financial system from the bank’s failure, but at the potential cost of longer-term damage.In protecting some bank stakeholders from some of their loss the authorities are reducing bothinternal and external stakeholders’ incentive to monitor and discipline the bank in the future,which can weaken the longer-term stability and efficiency of the financial system. The use ofpublic funds to resolve a failed bank also does not necessarily address underlying banking systemproblems, such as poor risk management, and comes at a potentially significant fiscal cost.

This paper proposes a scheme for managing bank failures that avoids some of these drawbacksand reports on a Reserve Bank of New Zealand (Reserve Bank) case study into whether thescheme can be made to work in practice.1 Other authors have proposed similar schemes (e.g.,Kaufman, 2004), but there has been relatively little analysis of the practical complications thatneed to be overcome if these schemes are to be used by the authorities. Reserve Bank investigationssuggest that identifying the legal, operational, and financial arrangements that need to be in placefor the scheme to work in practice – the “pre-positioning” required to manage a bank failure– is as important as developing the high-level characteristics of the scheme. Understanding thepre-positioning required also provides important insights into the failure management process.

The scheme uses pre-positioned arrangements to quickly close the insolvent bank, reserve aportion of creditors’ claims to meet potential losses, and, when the bank re-opens the next day,release the remaining portion of creditors’ claims and provide normal facilities to the bank’sdebtors. The reserved portion of creditors’ claims will remain frozen and available to absorb anylosses, should that be necessary. A government guarantee of non-frozen claims will ensure thebank’s continued participation in the payment system, while central bank liquidity support willfacilitate creditors withdrawing the non-frozen portion of their claim.

The scheme is an “open bank” resolution option in that, except for a short period on theday of its failure, the bank remains open for its core transactions business. It is designed toavoid the unpalatable choice between minimising the near-term costs of a large bank failure by

1 Staff at the Reserve Bank of New Zealand have been working on the scheme since 1998 (Harrison, 2005, provides anearlier summary of the scheme) as part of a review of several failure management options. The scheme has been referredto as the “haircut” scheme and the Bank Creditor Recapitalisation (BCR) scheme.

326 I. Harrison et al. / Journal of Financial Stability 3 (2007) 324–341

using government bailout versus minimising the long-term costs by using more conventional firminsolvency resolution techniques.

Section 2 reviews the options typically used by authorities to resolve failed banks and somerelevant resolution options that have been proposed in the literature. Section 3 outlines the keyfeatures of the scheme and reports in detail on the Reserve Bank’s work on how it could work inpractice. Section 4 concludes.

2. Options for managing bank failures

2.1. Options that are typically used

There are four broad options for managing an insolvent bank2: private sector-based solutions,forbearance, liquidation, and official financial assistance.3 This section briefly reviews each ofthese options.

In market-based economies it is natural that private sector-based methods for resolving insol-vent banks are preferred. If market participants buy part or all of an insolvent bank the need forthe authorities to get extensively involved in exiting the failed bank from the financial systemis reduced and appropriate market incentives are maintained. Regulatory pressure is sometimesused to encourage private sector-based solutions, for example, by promoting industry lifeboats orusing the threat of closure to motivate shareholders to support or sell the bank.

Despite the attraction of private sector-based solutions, they cannot be relied on to deal witha large bank failure. There are only a limited number of banks that are likely to be big enoughto buy a large, potentially insolvent bank. Competition and regulatory concerns about increasedconcentration in many banking systems may further limit the pool of potential buyers. Even if thereis a potential buyer for the bank, the limited time available in a failure situation and significantuncertainty about the value of the troubled bank may prevent a deal being reached.

The effectiveness of regulatory pressure to prompt private sector-based solutions is likelyto be limited in financial systems with significant foreign ownership of banks. Foreign-ownedbanks might be less responsive to regulatory pressure because circumstances in the group’s homejurisdiction, such as economic conditions or the rules of the parent bank’s regulator, may makethe bank’s interests less linked to those of the local financial system.

Forbearance, which is where authorities let a potentially insolvent bank continue to operate bywaiving regulations, could allow further time for a buyer for the bank to be found, for the bank toraise additional capital, or for corrective action to be taken to restore the bank to health. The useof forbearance in OECD countries has not had much success, with the US savings and loan crisesusually cited as an example of its drawbacks (OECD, 2002). Forbearance can create incentives forthe bank’s management to “gamble for resurrection”, which can make the situation at the failingbank worse and negatively affect healthy banks via competition from the failing bank. It can alsocreate a moral obligation for the authorities to protect from loss creditors who remained at theinsolvent bank while regulatory requirements were waived.

When private sector-based solutions are not available and forbearance is not used, authoritiescan either liquidate the insolvent bank or provide financial assistance to keep it operating and/or

2 Hoggarth et al. (2003) and OECD (2002) provide useful summaries of the options that authorities have used to resolvelarge or multiple bank failures.

3 This classification is adapted from OECD (2002).


cover its net asset deficiency. Liquidation is how most failed firms exit the market. The firmcloses, its assets are realised, and what is left of creditors’ claims is paid out. The delay increditors receiving what is left of their claim is determined by the time taken to realise thefirm’s assets. Closure and ultimate liquidation or sale has been used in many countries, butmore often for small and medium-sized banks than for larger banks (Andrews and Josefsson,2003).

If the authorities have advance warning that a small bank is nearing insolvency and decide toliquidate it, they might be able to take steps to pay creditors’ the “good” or deposit-insured portionof their claims quickly. For example, the US Federal Deposit Insurance Corporation (FDIC) reportsthat when it gets advance warning of insolvency it can arrange for the prompt payout of insureddepositors’ claims when the bank closes (FDIC, 1998).4 Developing such arrangements at thetime of a large bank failure is less practical. If there was a delay in payout while arrangements forpayout were developed it could generate uncertainty about how much damage the bank failuremight cause and the impact on the wider financial system. Kaufman and Seelig (2002) say that“the great fear of bank failures and the magnitude of any damage that such failures impose onother sectors of the economy are triggered as much if not more by losses in liquidity as by creditlosses in the value of uninsured deposits” (pp. 27–28).

For large banks, the complexities and perceived risks of significant damage from effectivelyclosing a large part of the financial system, caused by among other things a delay in paying outcreditors their good funds, mean liquidation has rarely been seen by authorities as a preferredoption for resolving large banks (OECD, 2002). As a result, official assistance has often been usedfor managing large bank failures and/or systemic crises (OECD, 2002; Hoggarth et al., 2003).

Official assistance can occur in a number of ways. For example, authorities could provide equitycapital or discounted finance to the bank and keep existing shareholders in place; if authoritieshave extensive powers in a failure they could remove existing shareholders and management,take control of the bank, and then provide additional funds; or they could nationalise the bankto effectively remove existing shareholders and then provide additional funds. Official assistancecan ensure the bank does not technically fail, or if it does that counterparties continue to deal withit because they are assured of getting payment, and thereby reduce any near-term damage to thefinancial system.

There are a number of drawbacks to official assistance. First, the assistance must ultimatelybe financed by taxes, which creates a deadweight cost. Second, the assistance reallocates wealthacross groups in society, which may be inequitable and if the reallocation is to foreign parties thenit can be a net loss to the country. Third, demonstration by the authorities of a willingness to protectcreditors of one failed bank can undermine the incentives of all bank creditors to monitor anddiscipline banks, which can flow through to overall system stability. Moreover, if an expectation offuture bailouts is created it can lead to a replacement of market disciplines with more onerous andless efficient official supervision as the authorities seek to manage their potential future liability.Fourth, there are dynamic efficiency and competitive implications from treating large banks thatare in difficulties in a more favourable way than small banks in the same situation.

4 An alternative to closing the bank’s operations is a bridge bank, which is where the authorities or deposit insurertemporarily acquire the bank so that the bank’s customers can continue to be serviced (FDIC, 1998). It is designed to“bridge” the period between failure and a new owner being found. If the bank can only be sold by the deposit insurer ata loss greater than the cost to the insurer of liquidating the bank and paying depositors the insured portion of their fundsthen the authorities will have protected creditors beyond their insured amount.


2.2. Other potential options

The unattractive choice between liquidation and extensive official assistance has stimulatedseveral authors to propose alternative schemes for managing large bank failures. Of interest aresome largely similar schemes proposed by Kaufman (2004), Mayes (2004), Harrison (2005), andKaufman and Eisenbeis (2005).

These schemes share some of the same general steps:

(i) Prompt closure of the insolvent bank and the authorities taking control of it. This step ensuresthat authorities do not forbear or are forced to bailout the bank.5 It also reduces the potentiallosses to depositors and other creditors.

(ii) Determination of the proportion of creditors’ claims that will promptly be made available tothem. Here there is some difference among the schemes, but in general the idea is to separatecreditors’ claims into a portion that will remain frozen and available to absorb losses and aportion that will be quickly released to creditors upon the bank’s re-opening.

(iii) Prompt re-opening of the bank. The bank is re-opened the next business day to minimisethe potential for systemic impacts and the risk of government seeking to use public funds tobring about a quick re-opening.

Kaufman and Eisenbeis (2005) note that the US FDIC arrangements for resolving insolventsmall banks have similarities to this type of scheme. However, the FDIC arrangements haveyet to be tested for a large, money-centre bank in difficulties (Kaufman, 2004). The US FDICrecently issued proposals designed to modernize their treatment of large bank failures, saying thatprocedures currently used may “result in unacceptable delays if used for FDIC-insured institutionswith a large number of deposit accounts” (FDIC, 2005, p. 73652).

The scheme that we propose in this paper has many similarities to the schemes discussed inthis section. All the schemes focus on freezing a portion of creditors’ funds to cover losses, andthen re-opening the bank for core business shortly thereafter.

3. Proposed resolution scheme

We propose a scheme for use when market solutions are not available and that provides theauthorities with an option other than liquidation or official financial assistance. This section brieflyoutlines the key elements of the scheme, before reporting on Reserve Bank work exploring howthe scheme could be implemented so that it is legally, operationally, and financially robust.

In discussing the scheme being applied in New Zealand, it is useful to note several importantfeatures of the New Zealand banking system that have influenced the scheme’s development:

• Banks are a significant part of the New Zealand financial system, accounting for approximately75% of financial system assets.

• Most banks in New Zealand are foreign owned, and the two New Zealand-owned banks accountfor only a small proportion of banking system assets.

• Most locally incorporated banks’ assets are retail loans to households.

5 Kaufman (2004) and Mayes (2004) both suggest using prescribed benchmarks for closure, such as the US PromptCorrective Action framework.


• The banking supervisor has considerable powers in a failure to manage the affairs of the failedbank.

These features impact on how the scheme has been designed to work in practice. The extent towhich these features are shared by other countries may influence the applicability of the schemeto those countries.

3.1. Overview of the scheme

The problem that the scheme is designed to overcome is that in a conventional liquidationthe portion of creditors’ claims not required to absorb losses is illiquid, and working capitaland other facilities are unavailable, while the bank is resolved. If the good portion of creditors’claims remains liquid and working capital and other facilities continue to be available there is lesstemptation for governments to provide extensive financial assistance. Put differently, the objectiveis an open bank resolution option that maintains market incentives.

Under the scheme, upon a bank becoming insolvent the authorities place it under statutorymanagement, or some similar arrangement. Placing the bank in statutory management in NewZealand will legally freeze the bank’s liabilities and allow the authorities to direct the operationsof the bank (see the discussion in Section 3.2). The authorities will then determine the proportionof creditors’ claims that should remain frozen and ready to absorb any losses, with the remainderbeing unfrozen and released to creditors.

The bank will re-open the next business day. Creditors with savings and transaction accountswill get access to the non-frozen portion of their claims and debtors’ access to their facilities. Agovernment guarantee of the non-frozen portion of creditors’ claims will be used to reinforce tocounterparties that the bank is safe to transact with in future and central bank liquidity supportused to cover any illiquidity. In the following days other creditors will get access to their non-frozen claims. Under the scheme, authorities have the choice about whether to incent the bank’sshareholders to support the bank before it becomes insolvent by effectively extinguishing share-holders’ residual interest. The authorities have a range of options for how the bank’s operationscontinue. Any creditors’ frozen claims not needed to absorb losses will be returned to them.

The scheme is relatively simple in theory, but actually implementing it raises some complicatedlegal, financial, and operational issues. The case study discussed in the following subsectionsdraws on Reserve Bank investigations and work with a large bank on how the scheme couldbe implemented into that bank’s systems. The bank, which is typical of the large banks in NewZealand, has a large retail portfolio and extensive domestic and international interconnections.The subsections are arranged according to when they will occur in the execution of the scheme.

3.2. Pre-positioning in normal times

To be able to execute the scheme there are a number of arrangements that need to be in placebefore the failure occurs – the pre-positioning required to manage a bank failure. Appropriatelegal and operational capacity is required to execute the scheme, and financial capacity is neededto make it successful.

3.2.1. Legal capacityFor the authorities to carry out the scheme they need appropriate legal powers – to close the

bank, to freeze creditors’ claims and then release a portion, and to effectively extinguish existingshareholders’ interests. Legal arrangements for dealing with failed banks vary across countries.


In some jurisdictions banks can only be dealt with under the standard company insolvency frame-work; in others the authorities have conservatorship or statutory management arrangements thatgive the authorities considerable power to manage and restructure the affairs of the bank.

New Zealand’s legal arrangements give considerable power to the authorities to resolve afailed bank and these powers are sufficient to carry out the scheme.6 It could be that in manycountries the authorities do not have the legal powers needed to carry out the scheme, particularlyin jurisdictions where failed banks are dealt with under standard company resolution frameworks.

The New Zealand bank failure management framework is based around a statutory manager,who can be appointed on the advice of the Minister of Finance in accordance with a recommenda-tion of the Reserve Bank.7 A statutory manager has similarities to conservators or administratorsin other jurisdictions.

A statutory manager can be appointed in a broad range of circumstances, the key ones relating tothe bank being insolvent, its business not being conducted in a prudent manner, or its circumstancesbeing prejudicial to the soundness of the financial system. The Reserve Bank can also, with theconsent of the Minister of Finance, give directions to the bank in these circumstances, or if astatutory manager has been appointed give directions to the statutory manager.

In exercising his or her powers the statutory manager is required to have regard to:

(a) The need to maintain public confidence in the operation and soundness of the financial system.(b) The need to avoid significant damage to the financial system.(c) To the extent it is not inconsistent with considerations (a) and (b), the need to resolve as

quickly as possible the difficulties of that registered bank.(d) To the extent it is not inconsistent with considerations (a), (b), and (c), preserving the position

of creditors and maintaining the ranking claims of creditors.(e) The advice of the Reserve Bank.

A statutory manager has wide-ranging powers in relation to the registered bank. The ones mostrelevant to the scheme are:

• Management of the bank is vested in the statutory manager;• The creditors’ rights against the bank are essentially frozen at the point of statutory management;• The statutory manager has the ability to suspend the repayment of any deposit, debt, or discharge

any obligation;• The statutory manager can pay creditors and make any compromise with any creditor; and• The statutory manager can restructure the bank and transfer the assets and liabilities of the bank,

in whole or in part, to another legal entity, including a legal entity that the statutory managerhas set up and allotted shares in to people of his or her choice.

These powers are sufficient to do the key parts of the scheme:

• The combination of the Reserve Bank being able to give directions (to the bank or the statutorymanagement) and the authorities being able to appoint a statutory manager enables them toclose and re-open the bank;

6 The scheme could in principle be applied to a branch bank, though the potential uncertainty about whether particularassets and liabilities relate to the branch or not is likely to complicate its execution.

7 All the relevant statutory management powers are contained in part V of the Reserve Bank of New Zealand Act.


• That creditors’ rights are frozen at the point of statutory management freezes all creditor claims,while the ability of the statutory manager to pay creditor claims allows for him or her to payout the “good” portion of creditors’ claims.

• The ability of the statutory manager to transfer some or all of the assets of the bank to acompany that the statutory manager has incorporated effectively allows the statutory managerto extinguish shareholders’ claims if he or she chooses to do so (see Section 3.3 for furtherdiscussion).

The remaining legal power required is the power to require a bank to put in place the pre-positioned operational arrangements to carry out the scheme (discussed in the next subsection).New Zealand authorities have the ability to make regulations on a range of issues, which includescrisis preparedness of this nature.

New Zealand has no depositor preference arrangements, so all unsecured creditors would betreated according to parri passu principles and have the same portion of their funds frozen, thoughauthorities are not obliged to do so if non-parri passu treatment is consistent with the factors theymust consider when exercising their powers (see Section 3.4 for a possible non-parri passutreatment). Depositor preference arrangements can be accommodated within the scheme, or otherarrangements for non-parri passu treatment, by simply altering the operational arrangements putin place.

In New Zealand there is also no deposit insurance. However, a legal framework that includesdeposit insurance can be accommodated by the scheme: deposit insurance only changes the portionof depositors’ funds that are frozen and the types of accounts that pre-positioning is required for,not the pre-positioning itself.

3.2.2. Operational capabilityThere is a need to have operational arrangements to support the exercise of the legal pow-

ers. Without the operational capacity to execute the scheme the legal powers are of limitedvalue and the scheme starts to look more like a conventional liquidation, where the bank isclosed and creditors’ claims are paid upon the liquidation of the assets that support thoseclaims.

The scheme requires the operational capacity to carry out a number of actions for a largenumber of accounts in a short time frame be available. The bank needs to be closed, creditors’claims separated into parts that will remain frozen and that will be released, and the bank re-opened the next banking day. At an individual customer level, a bank can carry out these actionseasily: stop account access, place a hold on part of a creditors’ account balance or debit some oftheir balance to a suspense account, and give a creditor access to their money.

Executing these actions in a short time is probably impossible for a large bank unless thereare pre-positioned arrangements in place. While coordinating simple actions for a small bankin a short time might be possible because of the limited number of accounts and computersystems involved, for a large bank it is unrealistic.8 Large banks have more accounts, a muchlarger network of transactions to manage, and more complex computer and accounting arrange-ments.

8 FDIC (1998) outlines the FDIC’s process for resolving insolvent institutions, which typically anticipates as much as100 days prior warning of a failure. Advance warming provides an opportunity for arrangements to be put in place tomanage the failure and suggests a lesser need for pre-positioned arrangements for smaller banks.


Therefore, the Reserve Bank concluded that pre-positioned arrangements would be necessaryto ensure the scheme could be executed.9 A similar conclusion appears to have been reached bythe US FDIC, who recently proposed using pre-positioned arrangements to help in the resolutionof large, insolvent banks (FDIC, 2005).

The cost of putting in place pre-positioned arrangements needs to be weighed up against thebenefits from quickly being able to release a portion of customers’ claims. The harm caused bya lack of access to their claims or facilities is likely to vary by customer group, as is the costof pre-positioning. The distinction that many banks make in their operations between retail andwholesale customers is useful in determining what to pre-position for.

Retail and small- and medium-sized enterprises, who are generally individuals or small firmsthat the bank provides standardised products to and manages on a pooled basis, do not typicallyhave alternative liquidity sources and are the group for which lack of access to claims will probablycause the greatest damage. They also represent the greatest volume of accounts that need to bemanaged during the bank’s resolution. Both these considerations suggest pre-positioning for retailcustomers.

Conversely, wholesale customers, who tend to be larger firms that the bank individually man-ages its relation with, may be able to survive without access to their claims for a period becausethey often have multiple banking relationships and will often manage their risk if they knowthe maximum extent of their possible loss. There are also fewer accounts and more tailoring ofproducts to customer needs, which suggests more bespoke treatment might be required. Theseconsiderations suggest less need for pre-positioning for wholesale customers.

With these factors in mind, the pre-positioning in the scheme is for transaction and savingsaccounts. These account types usually have funds on call and are used for meeting the day-to-day liquidity needs of retail customers, though the pre-positioning would be for both retail andwholesale transactions and savings accounts. The specific features of this pre-positioning arediscussed in Sections 3.3 and 3.4.

Reserve Bank investigations indicated that pre-positioned arrangements for transaction andsavings accounts could be put in place at a cost of less than 0.005% of a large bank’s total assets,plus an incremental cost each year to test and maintain the arrangements. The main driver of pre-positioning costs is the number and complexity of computer systems that are used to record accountdetails and transactions. Comparing these costs to the potential costs of bank failures mentionedearlier, and estimates of the probability of bank failure,10 the costs do not seem unreasonable.

Pre-positioned arrangements can be put in place for banks of any size. The focus in developingthe scheme was on large banks because it is for those banks that the systemic effects are likely tobe greatest. If it is cost-effective to do so, pre-positioning could be done for small banks to allowcreditors to get prompt access to a portion of their claim. Nothing in the design of the schememakes it solely for large banks and for competitive neutrality reasons it might be desirable toextend it to all banks.

Being able to use pre-positioned operational arrangements to resolve a failed bank rests onthe assumption that the technology systems that are required, and the people who will manage

9 An alternative to pre-positioned arrangements that was considered but rejected is to allow creditors to withdraw theirentire claim, but with the obligation to repay some of the funds to the bank at a later date. In practice, such an arrangementwould be unworkable because of political pressure for creditors not to pay the money back. Additionally, it might beadministratively difficult to collect the money and it incents creditors to repatriate funds to jurisdictions where it mightbe difficult for authorities to recover them from.10 See, for example, Fitch Ratings (2002).


the arrangements, are available when the bank is being resolved. The bank needs the capacityto continue to operate should it become insolvent, whether particular systems or expertise is in-house or by a third party. The increasing incidence of outsourcing, particularly across borders, isfocusing regulatory attention on the robustness of outsourcing arrangements to bank or serviceprovider dysfunction (e.g., Bollard, 2004; Joint Forum, 2005).

In banking systems where subsidiaries of foreign banks play a significant role, outsourcing toforeign parent banks creates additional complexities. If the parent bank provides crucial servicesto its subsidiary it might decide not to provide those services if the subsidiary is put into statutorymanagement, thereby compromising the ability of local authorities to apply the scheme. Anotherimpediment could be if the parent bank’s regulator prohibited or delayed the parent bank fromproviding services to the subsidiary in a crisis. These concerns are significant in New Zealand,where the four largest banks are foreign owned, and has led to the development of an outsourcingpolicy that addresses, among other things, outsourcing to parent banks so that New Zealandauthorities can manage the failure of the subsidiary using a range of options (Ng, 2006). Robustoutsourcing arrangements in a crisis are just as important to this scheme as they are for otherfailure management options.

3.2.3. Financial capacityTo ensure the re-opened bank is seen by potential counterparties as financially robust there will

need to be a government guarantee of the non-frozen portion of creditors’ claims and of futureclaims on the bank. Without a guarantee counterparties might refuse to transact with the bank forfear of further losses, undermining the objective of re-opening the bank as a vehicle for customersto access the payment system.

Central bank liquidity support might also be required to provide the re-opened bank, whichwill be solvent, with liquidity. The central bank or banking regulator will also need to be readyto enter into financial market contracts on the behalf of the bank so that the bank’s risks could bemanaged, e.g., derivatives contracts to manage the bank’s interest rate risk. The central bank orbanking regulator can then pass the market risk associated with those positions to the failed bank.The central bank or banking regulator will retain the credit risk associated with the exposure whenacting on behalf of the bank, which in practice does not change the authorities’ overall credit riskbecause they have already guaranteed the failed bank’s future obligations.

3.3. Closing the bank

3.3.1. When to apply the schemeThe scheme is flexible as to when it is applied to a failed or failing bank: it could be applied

either before or after the bank shows negative equity. There is an extensive literature on theimportance of pre-insolvency closure for effective resolution and to minimise losses to creditors(e.g., Kaufman, 1997). These lessons from the literature would also hold for our scheme. Ifthe scheme is applied after many creditors have become aware of the insolvency of the bankand withdrawn their funds the scheme can still work, but a higher proportion of the remainingcreditors’ claims will remain frozen and ready to absorb losses. Such an outcome might be seenas unfair and jeopardise political support for the scheme.

3.3.2. Shutting customer access channelsImposing statutory management will legally freeze the bank’s liabilities, but will not opera-

tionally freeze them. If the bank is not physically closed around the time it goes into statutory


management creditors’ account balances might reflect the effect of transactions that occurred afterthe statutory management began, which the authorities are not allowed to freeze to use to absorbpotential losses.

Determining which transactions are legally considered pre- and post-statutory managementtransactions can be complicated because it is not always clear when a transaction is legallycompleted because of lags between transaction initiation and completion and the ability in somecircumstances to revoke a payment. In New Zealand the degree of clarity about the legal statusof a transaction varies by the payment system it passes through:

(i). The status of transactions that pass through real-time gross settlement systems is relativelystraightforward to determine.

(ii). For net deferred systems the status can be unclear because the transactions are usuallycompleted well after they are initiated. Exactly when a payment legally occurs could be afunction of legislation, payment system rules, contracts, or banks’ transaction processingarrangements.

(iii). For payments between two customers of the same bank (“intra-bank” transactions) the legalstatus can be unclear. There may not be any legislation that specifies the status, leavingcontracts and banks’ transaction processing arrangements to determine status.

It is important that authorities are aware of the legal status of different transaction types sothat they can quickly determine creditors’ account balances at the point the bank is put intostatutory management. They need to be able to communicate to tell the public in general termshow payments around the time of the failure will be treated to avoid uncertainty and confusionthat might jeopardise the perceived fairness of the scheme. That is not to say there needs to becomplete certainty, because small misclassifications are inevitable and can be rectified later.

The Reserve Bank’s investigations with a large bank suggest that closing all the channels thatcustomers use to access their claims could take around 2 hours. Closure will require some pre-positioning because of the need to coordinate the closure of a range of different channels, e.g.,branches and electronic channels. A faster closure time might be possible if some channels weremore permanently disabled, but that might jeopardise the re-opening of the bank.

In New Zealand, one way to minimise the extent of transactions “in the pipeline” whenstatutory management is declared is for authorities to use their direction-giving powers (seeSection 3.1) to direct the bank to close its customers’ access channels prior to it being put intostatutory management. Fewer transactions “in the pipeline” at the point of statutory manage-ment reduces the scale of any sorting of transactions into pre- and post-statutory managementgroups.

3.3.3. Removing existing shareholdersIf the scheme is applied to a bank that is nearing or actually is insolvent then it is likely that

shareholders’ funds will be exhausted from absorbing the bank’s losses. In New Zealand theauthorities have the option of effectively extinguishing shareholders’ residual interests by usingtheir powers to incorporate a new company, transfer the sum of the assets and liabilities of thebank to it, and allot shares in the new bank to whomever they chose provided it is consistentwith the considerations the statutory manager must have regard to in exercising his or her powers.If the authorities extinguished shareholders’ interest it would strengthen the incentives for thebank’s shareholders to support the bank prior to its failure. Otherwise shareholders might choosenot to support the bank in the knowledge that if the bank is resolved successfully they have an


option on the residual value of the bank. It also eliminates shareholders’ ability to try to gamethe freezing of claims by overstating asset values to protect any of the bank’s liabilities that theyhold.

For subsidiary banks the parent bank will have had the option to provide additional capital,but clearly chose not to. For banks with a widely dispersed ownership it could be argued thatit is difficult for owners to source additional capital in the limited time available. However, theowners appoint directors to act in their interests and could have delegated to them the ability tosource additional capital in extreme circumstances, so it is unclear why a dispersed ownershipbase should receive a treatment different to a more concentrated one.

Shareholders are not likely to be materially worse off from having their claim extinguishedbecause under the alternative of liquidation they will get no money back and under a governmentequity injection their shareholding will be heavily diluted.

It is possible that after repaying creditors’ the full nominal value of their claims and the expensesassociated with the statutory management there might be residual value in the bank. Of the moneyleft over some would go to the government for the cost of the government guarantee, which evenif not drawn upon may have been valuable to the bank and exposed the government to the risk ofloss. It is unlikely that there will be any funds surplus after creditors have been paid in full, thegovernment has been compensated for the value of its guarantee, and the costs of the statutorymanager have been met. As the assets and liabilities of the failed bank will have been transferredto another legal entity by the statutory manager in the course of managing the failing bank, whicheffectively extinguishes any claims by shareholders of the failed bank, it is to the shareholder(s)of the new entity that any surplus accrues.

3.4. Estimating losses and unfreezing claims

3.4.1. Proportion remaining frozenOnce the bank is closed and creditors’ claims are frozen, creditors’ balances at the point of

statutory management are determined. Following that, the proportion of creditors’ claims thatshould remain frozen and be available to absorb any losses needs to be determined.

An issue that the Reserve Bank thought would be challenging in designing the scheme wasdetermining the size of the bank’s net asset deficiency. However, if it is accepted that in the limitedtime available the significant uncertainty about the value of the bank’s assets will prevent an overlyprecise estimate from being derived, then authorities can simply use a conservative estimate ofthe net asset deficiency and release more of creditors’ claims as they refine their estimates. Thealternative is for the authorities to wait until they have a high degree of certainty on the net assetdeficiency, which could close the bank for weeks and is inconsistent with the objectives of thescheme.

The need for a conservative estimate of the net asset deficiency, rather than the most accurateestimate available, is because, while frozen claims can always be released to creditors in laterweeks, attempting to re-freeze already released claims will lack credibility. If authorities have asecond attempt at freezing creditors’ available claims, aside from being legally and operationallydifficult, it will introduce uncertainty into the process and create fear among the bank’s creditorsthat they might lose more of their money and lead to a run on the bank. The Reserve Bank’sinvestigations indicate that in the weeks following the bank re-opening it should be relativelystraightforward to release a further portion of creditors’ claims that were previously frozen.

Therefore, authorities will make a quick, rough, conservative estimate of the bank’s net assetdeficiency. A generous allowance for prospective losses and a further substantial buffer will be


added because of uncertainty about the value of the failed bank’s assets and experience that hassuggested that released losses can often exceed initial estimates. Indeed, setting the estimate willlikely involve a choice of whether 10, 20, 30, or 40% of creditors’ claims should remain frozen.Such a broad assessment should be possible for most banks, though it may be difficult for somebanks that are almost completely focused on wholesale activities and mostly engage in complextransactions.

The most straightforward way to set the proportion of creditors’ claims that will remain frozenis as a percentage of the claim. However, there are variations to this:

(i) A de minimus limit below which all claims are released and creditors do not suffer any loss. Forexample, the first $20,000 and 70% of balances over this amount could be released, with theremaining 30% above $20,000 remaining frozen. Using a de minimus limit could effectivelydeal with a large number of small accounts that would be costly and time-consuming toseparate into frozen and released funds. In New Zealand the statutory manager has the powerto impose a de minimus limit and have a non-parri passu treatment (see Section 3.2) providedit is consistent with the considerations he or she must have regard to when exercising his orher powers.

(ii) The government might want to share losses with creditors. The proportion of creditors’ claimsthat remain frozen could be capped at a level less than that required to meet the estimated netasset deficiency and the government could absorb the losses above that cap.

These variations give the government choices about how losses are allocated over creditors’and taxpayers. Deposit insurance could easily be incorporated, with the insurance affecting theproportion of insured depositors’ claims that remain frozen. Reserve Bank discussions with alarge bank indicate that these variations could be accommodated in pre-positioned arrangementsat minimal extra cost.

3.4.2. Separating claimsOnce authorities have determined the portion of creditors’ claims that will remain frozen and

the portion that will be released, the pre-positioned computer algorithm separates the claims intoeach of these portions. The separation could be executed either by placing holds on the portionto remain frozen, or by debiting that portion to a holding account. This process will only occurfor transactions and savings accounts, which are the only ones with pre-positioned arrangements;all other claims will remain fully frozen. Once the claims have been separated into frozen andreleasable portions, any subsequent credits to these accounts will be available to creditors in full,i.e., no portion of subsequent transactions is frozen.11

This process will, as much as possible, respect the ranking of creditors applying in a conven-tional liquidation. Subordinated creditors will have their full claim frozen and all other creditorswill have the same proportions of their claims available for release. Non-subordinated creditorswill not suffer a loss until subordinated claims have been completely exhausted. Secured creditors,in the event that there are any, are expected to look to their security in the first instance.

11 This process means that interest that has accrued, but not credited, at the point of statutory management would becredited in full at the normal payment date. Conceptually a portion should be frozen, but doing so could create additionaltechnical complexity and the aggregate sum involved should be relatively small.


3.5. Re-opening the bank

3.5.1. Bank registration and managementThroughout the short period that the bank is closed, and when it re-opens, the bank retains its

registration as a bank (referred to as its charter or licence in some countries). In New Zealand thestatutory management and direction-giving powers of authorities only relate to registered banksand so it is important to the success of the scheme that the bank’s registration is maintained. Evenin the absence of these legal arrangements, removing the bank’s registration might make marketparticipants doubtful about the authorities’ commitment to re-opened bank. Participants refusingto deal with the re-opened bank might diminish the effectiveness of the scheme.

Whether existing management remains in place through the execution of the scheme willdepend on their involvement with the events that lead to the bank’s insolvency and whether theircontinuing in their roles would assist the scheme being successfully carried out.

3.5.2. Payment system participationThe failed bank re-opens to the public the next payment system value day. To minimise the

potential for damage to the financial system the bank should be closed for the shortest time possible.It is primarily operational and practical management considerations that drive the decision to try tore-open the bank the next day, instead of several days later.12 Disruption is minimised if the bankdoes not miss an end-of-day settlement process in the payment system, which in New Zealandhappens just before the start of the next business day. Large amounts of unprocessed transactionsaccumulated over several days while the bank remains closed are likely to increase the liquidityimpact of the failure and take up resources that may be needed for other aspects of the scheme.

It is natural that payment system rules focus on participants that are currently solvent, andwhere participants are insolvent on suspending them from the payment system and mitigatingand apportioning losses caused by the insolvent participant. In New Zealand less thought hadbeen given to promptly allowing a suspended bank back into the payment system, or keeping aninsolvent bank in the payment system, which are important to a number of failure managementoptions.

Even if payment system rules entitle the bank to remain a participant, counterparties will beunlikely to deal with the bank if they think they are likely to suffer further losses. A governmentguarantee of non-frozen claims will be necessary to give counterparties confidence that they willnot suffer further losses from continuing to transact with the bank.13 A government guarantee alsoreduces the incentives for creditors to immediately withdraw their non-frozen money and placeit with another bank, which might undermine confidence in the financial system.14 Central bankliquidity support will also be provided so that creditors can easily access the released portion oftheir claim.

The risk to the government in providing a guarantee will be minimal because the proportionof creditors’ claims that remain frozen and available to absorb losses will be conservative. Thegovernment can alter the risk it is taking in providing the guarantee by changing the degree ofconservatism built into the proportion of creditors’ claims that remain frozen.

12 It is not clear that there would be a significant difference in economic cost from the bank being closed for a day versus2 or 3 days.13 Alternatively, the bank could collateralize all its obligations, though this would be more complicated.14 Depositors at other banks might want to deposit their funds at the re-opened bank because of the government guarantee.

This possibility could be managed by the bank not accepting deposits from new customers.


3.5.3. Customer accessCreditors with transactions and savings accounts will get access to the non-frozen portion

of their claim when the bank re-opens. Debtors of the bank (i.e., borrowers) will get access totheir normal facilities so that they can continue to transact, which is important for small- andmedium-sized enterprises that rely on their facilities for day-to-day working capital needs. Theonly exceptions are if the type of facility or specific characteristics of the debtor caused thebank’s difficulties or if contractual arrangements prevented it (e.g., possibly credit card franchiseagreements). In the weeks after re-opening the authorities can reassess the treatment of particularcredit exposures and commitments.

3.6. Other creditors’ claims

Upon re-opening, the only portions of creditors’ claims that are released are for transactionsand savings accounts; all other liabilities remain fully frozen. In the days after the bank re-opensthese other liabilities will have portions released, though subordinated liabilities will remain fullyfrozen.

The general principle in releasing other unsubordinated creditors’ claims will be to treat cred-itors equally. The same proportion of claims will remain frozen for all creditors, and the sameproportion of claims will be released.15 Wherever possible contractual maturities will be met(e.g., term deposits), subject to the time needed to separate claims into frozen and releasableportions.

When the bank re-opens a priority order will be established for releasing portions of otherliabilities that takes into account the importance of releasing a portion of the claim and thecomplexity in doing so. Determining the proportion of deposit liabilities that should be released,and separating the liability into portions to be released and remain frozen, is generally relativelystraightforward (e.g., term deposits). For non-deposit liabilities and customers where there aremore complex relationships it is not necessarily so straightforward. The complexity involvedin some of these transactions, and the importance of relationships with large, often foreign,counterparties, may mean that the scheme is less suitable for banks that focus almost completelyon wholesale activities.

Three specific features of some liabilities warrant further discussion: netting, close-out clauses,and related party liabilities.

3.6.1. NettingIn New Zealand binding netting agreements have to be recognised by a statutory manager.16

Netting raises complications because conceptually the portion of creditors’ claims that remainfrozen and available to absorb losses is based on the creditors’ net exposure to the bank. Determi-nation of the portion that remains frozen is done on a facility-by-facility basis (i.e., gross basis),

15 There may be cases where breaking this general rule is necessary to secure the on-going operation of the bank, e.g.,releasing all the claims of staff and suppliers of essential services might secure their continued cooperation in operatingthe bank, which could benefit all creditors. Alternatively, small creditors’ balances could be fully released because it iscostly and time-consuming to separate lots of small accounts into releasable and frozen portions. However, exceptionsshould be kept to a minimum to avoid undermining the perceived fairness of the scheme.16 In the absence of bilateral netting agreements, in New Zealand there is a moratorium against exercising set-off rights

in statutory management. Enforcing the moratorium against set-off with overseas counterparties might be challenging,though the extent of any problems would be limited by the fact that most major counterparties would have bilateral nettingagreements in place.


which means customers with netting agreements have a greater proportion of their net claimfrozen than other creditors because the off-setting borrowings are not taken into account. How-ever, this is only a timing problem because once the bank re-opens the creditor’s net position canbe ascertained and some of the initially frozen claim released.

If netting agreements are pervasive and significant enough they could influence the proportionof creditors’ claims that are frozen and available to absorb losses. For example, the balance sheetof the failed bank may not accurately reflect the proportion of creditors’ claims that should befrozen because the full extent of netting agreements might be unclear. If this is a significant issue,fuller disclosures on the impact of netting agreements under International Accounting Standardsshould mitigate it in the future.

3.6.2. Close-out clausesMany treasury transactions are written under International Swaps and Derivatives Association

(ISDA) master agreements that provide the option (sometimes automatically exercised) of close-out at the point of failure, with the net exposure being determined in accordance with the termsof the ISDA agreement.17 Under New Zealand law, as is the case in a number of other countries,the statutory manager would recognise this netting.

The complication that this causes for the scheme is how to treat the ability of counterpartiesto continue with the contract. If automatic closeout of contracts was required then any resultingliability could be treated like other netting. So where the bank’s out-of-the-money contracts (i.e.,contracts that are liabilities of the bank) are closed out by the bank’s counterparties they are treatedin the same way as other liabilities under the scheme: for any resulting liability a proportion isfrozen to cover potential losses and the remainder is released.

Where the bank’s out-of-the-money contracts are not closed out the treatment is more compli-cated. While the contract continues to run the potential liability might change in size or disappearand partial payments could be due, making determination of the portion of the final balance thatshould be frozen difficult. However, excluding these liabilities from the haircut would create anexemption that could undermine the perceived fairness of the scheme.

Kaufman (2003) proposes not closing out the bank’s out-of-the-money contracts, but insteadtransferring them to a third party at their existing market price. The counterparties to those contractswould then be charged a fee equal to the portion that would have been frozen if they had closedout the contract (i.e., they would suffer the same loss as if they closed out the contract). Kaufman’sproposal is designed to reduce any potentially destabilising effects from the sudden closing outof contracts yet avoiding the need to protect counterparties from loss.

Kaufman’s proposal appears consistent with the scheme proposed in this paper, with twopotentially important differences. First, under the scheme counterparties would still have theoption to close out the contract as New Zealand law does not give authorities the ability to forcecounterparties not to exercise their option to close out. Second, the failed bank would remain thecounterparty to the contracts rather than the contracts being transferred to a third party becausethe aim of the scheme is to keep the bank operating, albeit on a reduced scale.

As with other failure management options, if there is widespread close-out of contracts uponthe bank’s failure it might trigger uncertainty and further close-out of contracts, both of whichmay increase market volatility and cause some market participants to lose money, including thefailed bank. The risk to the failed bank in such circumstances can be managed by the authorities

17 See Bliss and Kaufman (2006) for a discussion of these issues.


entering into contracts on the bank’s behalf to manage the bank’s risk, with risk associated withthe contracts passed back to the bank. Such “intermediating” by the authorities is likely to be inthe interests of many in the market because both the bank and the bank’s counterparties are likelyto still have the same underlying exposures that they want to hedge. The authorities can reducethe potential for wider disruption by bringing together parties with an interest in contracting.

3.6.3. Related party liabilitiesRelated party liabilities will typically be the last liabilities to be dealt with. The statutory man-

ager is likely to freeze all related party liabilities initially to ensure all transactions are appropriatelyclassified and recorded, and were legitimately entered into, before releasing the good portion. Thisaction is considered necessary because of the potential for non-arms length transactions betweenrelated parties in times of distress.

3.7. Deciding the future of the bank

Once the bank has re-opened for business the authorities can consider the nature of the bank’scontinued operation and the scope and range of banking services it will provide. There are threeoptions.

3.7.1. Wind down towards liquidationLiquidity assistance from the central bank could facilitate the bank being progressively wound

down. Creditors will take the released portion of their claims and establish new banking relation-ships with other banks. The bank’s assets will be managed to maturity or sold. Creditors’ frozenclaims will absorb the losses of the bank not already absorbed by shareholders and subordinatedcreditors. If the frozen claims are greater than the net asset deficiency the difference will bereturned to creditors.

3.7.2. Sale in whole or in partPotential owners include other banks, new investors, or the government. Once again, if the sale

of the bank results in a final net asset deficiency of less than creditors’ frozen claims the differencewill be returned to creditors.

3.7.3. Debt–equity swapThe creditors could agree to swap their frozen claims for an equity holding in the bank,

effectively becoming the new owners of the bank. While having some theoretical appeal, thisoption would pose a number of practical challenges because of the need to get creditor approvalfor their debt security to be converted into equity and the treatment of creditors who choose notto convert to being equity holders. It could also prove unattractive to the authorities to have apreviously insolvent bank owned by a potentially disparate group of creditor-owners.

4. Conclusion

Much is made of the differences between banks, particularly large banks, and other firms.Notwithstanding these differences, banks and other firms are the same in that there is a needfor efficient mechanisms for exiting failed institutions from the economy. The scheme discussedin this paper exits large banks from the financial system in a way that is less disruptive than


liquidation and does not revert to the use of public funds like bailout. The scheme provides a wayof dealing with the liquidity issues created by the failure of a large bank.

Generally the scheme appears practical in New Zealand and many of the complications thathave been identified are generic issues that apply to other failure management options, albeit someare unique to the particular scheme proposed. Authorities need to ensure that they have sufficientlegal, operational, and financial capacity to execute the scheme, and are aware of how interactionswith other financial system participants during different stages of the scheme, e.g., paymentsystems, would work. Many of the lessons learned in developing this scheme are applicable toother failure management schemes.

Acknowledgements

Our thanks go to Tim Ng, Peter Katz, Alistair Henry, Adrian Orr, Brendon Riches and ananonymous reviewer for valuable comments. We take responsibility for all remaining errors andomissions.

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