Government bails on bail-in, ditching the opportunity to give the Reserve Bank a tool to shield taxpayers in the event of a bank becoming distressed

The Government has changed its mind and decided not to give the Reserve Bank (RBNZ) statutory bail-in powers that would protect taxpayers if a bank became distressed.

Cabinet, in October, decided statutory bail-in would not be included in a piece of legislation being written as a part of a major review (which started in 2018) of the Reserve Bank Act 1989. This followed Cabinet in April saying bail-in would in fact be included in the Deposit Takers Act.

Statutory bail-in is designed to help authorities recapitalise a failing financial institution quickly by imposing losses on creditors. This shields the public purse and means the institution can keep its doors (at least partially) open.

The statutory power can recapitalise the institution by writing down and converting unsecured liabilities, like bonds, to equity. The RBNZ can make institutions maintain a certain amount of these bail-in-able instruments.

However, Finance Minister Grant Robertson said writing rules to accommodate for this, so that investors who buy certain bank bonds, for example, know these could be converted to equity if the bank runs into trouble, is “complex” and could delay the introduction of other provisions in the Deposit Takers Act, like the deposit insurance scheme.

“Statutory bail-in powers would require a significant reworking of the rules the Reserve Bank sets around the liabilities of deposit takers (for example, the wide range of eligible liabilities would all have to acknowledge the bail-in power in their terms and conditions),” Robertson said in an October Cabinet paper.

He suggested officials report back to him two years after the Deposit Takers Act is enacted (likely in 2023) on whether statutory bail-in is in fact needed.

A missed opportunity

Lawyer, Ross Pennington - a proponent of bail-in, who advised the RBNZ and Treasury on the matter as a part of their big review of the Reserve Bank Act 1989 - sees this as a missed opportunity.

“Bank failure is complicated, so does that mean you should have fewer or more tools to deal with it?” he told interest.co.nz, saying it’ll realistically probably be another 30 years before the matter is addressed again.

“The fact that it’s complicated is why you do it in advance [of a potential bank failure].”

Pennington said the mechanics of how statutory bail-in would work could be ironed out in regulation after the Deposit Takers Bill is passed. Hence, the detailed work required doesn’t need to slow the passage of the Bill.

Pennington noted Treasury and RBNZ officials had already done a mountain of work on bail-in, drawing on experience from the United Kingdom, Hong Kong and the European Union. 

These jurisdictions have bail-in, so the international debt markets New Zealand banks participate in understand it.

Pennington said bail-in is “straight forward best practice”, recommended by the Financial Stability Board - a Swiss-based international body established in the wake of the 2008 Global Financial Crisis.

Not only does it protect the public purse, but it is transparent, can be done quickly, and incentivises sophisticated creditors to monitor banks to prevent a collapse in the first place, he said.

RBNZ focused on requiring banks to hold more equity

However, Robertson, in the October paper, recognised the RBNZ’s focus is preventing collapses by requiring banks to hold more capital - albeit “at significant cost to industry”.

He proposed “contractual bail-in” be introduced via the capital rules - but only after the beefed-up new capital requirements are fully implemented in seven years’ time.

While statutory bail-in would empower the regulator to convert the troubled bank’s bonds to equity straight away, contractual bail-in would mean this could only be done if detailed contractual terms and conditions were met.

So, the RBNZ would tell banks they have to hold X number of bail-in-able instruments to comply with the capital rules.

This approach aligns with that used in Australia.

A criticism of contractual bail-in is that when you have conversion based on detailed contractual terms, and investors with deep pockets, you risk being legally challenged over whether the terms and conditions have in fact been met. 

Nonetheless, the RBNZ is happy to “kick the can down the road”, in Pennington’s words.

“The prepositioning of bail-in-able instruments is not expected for some time given the Reserve Bank’s current focus on boosting common equity capital levels within the banking system,” the RBNZ said in an explanatory note accompanying an exposure draft for the Deposit Takers Bill.

The RBNZ also claimed it already has resolution powers to impose losses on creditors.

In the event of a deposit taker collapsing, it could shift certain creditors and assets to another company or vehicle that is legally distinct from the deposit taker.

The pinch is, this process would take much longer than bail-in.

For readers interested in the details, see these snippets from the October Cabinet paper and the RBNZ’s explanatory note accompany the Deposit Takers Bill exposure draft:

Cabinet paper:

"Bail-in, in the most general sense, provides that certain creditors of a failed deposit taker absorb losses in order to reduce the risk that the deposit taker requires public support. Bail-in can be achieved in a variety of ways – including by drafting liability contracts with explicit clauses that provide for bail-in in certain circumstances (contractual bail-in), a formal statutory power that imposes losses on creditors (statutory bail-in), and through the use of resolution powers that cause certain creditors to absorb losses. An example of relevant resolution powers are the transfer powers available in resolution to shift certain creditors and assets into another company or vehicle that is legally distinct from the deposit taker. These transfer powers are being carried over (with appropriate adaptations) from the 1989 Act.

"In April I asked Cabinet to agree to a series of proposals that would be drafted into a statutory bail-in regime [DEV-21-MIN-0079 refers]. I have subsequently decided that it is preferable to initially focus on contractual bail-in and transfer powers. Statutory bail-in powers would require a significant reworking of the rules the Reserve Bank sets around the liabilities of deposit takers (for example, the wide range of eligible liabilities would all have to acknowledge the bail-in power in their terms and conditions). In other countries these changes have been developed in detail at the same time as statutory powers are designed. The design of statutory bail-in powers, however, is also complex, and could delay the introduction of the broader provisions of the DTA.

"If ongoing policy development (which will happen as the Reserve Bank develops resolution plans and the Statement of Resolution Approach after the passage of the initial Deposit Takers Act) leads to a view that statutory bail-in powers are needed to implement effective resolution strategies, they can be legislated then with more clarity about how to design them. I will direct officials to report to the Minister of Finance on this within two years of the passage of the DTA.

"Contractual bail-in is a simple approach to loss absorbency where the conversion of the instruments occurs following rules established by the contractual terms of the debt, and can occur prior to resolution commencing. This would be coupled with rules requiring deposit takers to issue minimum amounts of ‘bail-in’ debt, which is subordinated to senior debt such as deposits, and has contractual terms that allow the Reserve Bank to convert it. The mechanism used to trigger this conversion would be a direction to the deposit taker (using the direction power set out in the April paper). This is how I propose the law should provide for what was described in the April paper as a deposit taker being “resolved in an open state”.

"This framework could be used to boost loss absorbency in a way that could be useful in working with a foreign regulator of the parent of a New Zealand deposit taker (such as APRA) to stabilise the parent and subsidiary without triggering formal resolution powers. However, I note that other simpler forms of loss absorbency are currently the priority for the Reserve Bank. Specifically, the Reserve Bank is gradually imposing significant increases in equity requirements on the banking sector. These increases in common equity requirements were introduced as part of a major consultation with the banking sector that has recently been completed and will be implemented over the next 7 years, at significant cost to industry, and will lead to large increases in loss absorbing capital across the implementation period. Requiring debt with contractual bail-in features would most naturally follow after those common equity requirements are fully implemented. The framework I am proposing in this paper would therefore provide the scope for the Reserve Bank to add contractual bail-in terms to debt instruments as part of prudential capital requirements in the future."

RBNZ explanatory note:

"The April Cabinet paper envisaged a statutory bail-in regime (a power in the Bill that could write down or convert certain liabilities without relying on contractual provisions in those liabilities). However, in October 2021, Cabinet decided that the initial resolution regime would rely on two other paths for imposing losses on creditors.

"Firstly, within resolution the broad transfer powers available to the Reserve Bank can be used to impose losses. Secondly, the Bill provides for a preresolution direction power that can be used to require deposit takers to exercise contractual rights to bail-in prepositioned bail-inable instruments.

"This second approach is broadly similar to the tier-2 debt regime used in Australia. The prepositioning of bail-inable instruments is not expected for some time given the Reserve Bank’s current focus on boosting common equity capital levels within the banking system. In the future, the prepositioning could occur via the introduction of standards mandating minimum levels of suitable liabilities. Also, a future review will consider whether statutory bail-in (as seen in the UK regime, for example) is necessary alongside the two paths provided for in the DTA."

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