Oct 2007

As part of the Government's review of the Regulation of Financial Products and Providers, and with the backdrop of the continuing maelstrom around the beleaguered finance company sector, Cabinet has made some major policy decisions on regulating non-bank deposit takers. Andrew Harkness and Peter Eady examine the Cabinet Paper released on 12 September for implications.

How we got here

One of the emerging proposals arising out of the Review of Financial Products and Providers is the regulation of the non-bank sector - a sector the Reserve Bank estimates to control some $9bn. In deposits. Highly publicised finance company failures over the past eighteen months have added pressure for urgent reform in this area. The focus of the reform is on entities to be known as Registered Deposit Takers (RDTs) - encompassing finance companies, credit unions and building societies.

The objectives of this reform are to:

• ensure all RDTs meet a transparent set of prudential requirements designed to promote sound governance and risk management in RDTs and to promote depositor confidence
• provide depositors with a clearer basis for distinguishing between lower-risk and higher-risk RDTs 
• resolve RDT distress or failure in an orderly and timely manner, with minimum disruption to depositors and the financial system.

Defining and licensing ‘deposit takers’

It will be unlawful to be a deposit taker without either being licensed by the Reserve Bank as a RDT or as a Registered Bank. The Cabinet Paper provides the following definition of a “deposit-taker”:

“entities other than registered banks and other specified categories, that offer debt securities to the public and that are in the business of lending money or providing other financial services, and includes building societies and credit unions.”

This definition is set for refinement. It is broad, with building societies and credit unions specifically covered. In addition, the Bill is almost certain to allow room for the Reserve Bank to designate individual entities, or a class of entities, as deposit-takers through regulation to reduce opportunities for ‘innovative’ business structures and product development to skirt regulation.

Are there any exemptions?

The definition contemplates the ability for specified categories of entities to be excluded. This recognises the potential for unintended consequences in such a broad definition. There would also appear to be a need to distinguish between entities involved in discrete issues of debt securities (such as special purpose finance subsidiaries raising funds for general corporate purposes), and those making continuous issues raising funds for on-lending to the public (popularly known as finance companies). This refinement is expected to be made at the Bill stage.

Another ‘non target’ group caught in the move to regulation are minor deposit-taking entities such as some charities, religious organisations and potentially, budget advisory services. It is proposed the Reserve Bank, on consultation with the Securities Commission, will have authority to grant (or revoke) exemptions. This though raises a cost dimension to bodies which may not be well placed to meet such added expense.

What is required? - the licensing and regulation of RDTs

The Cabinet Paper makes it clear there will be a transition period (to be specified by Order in Council), during which non-exempted deposit-takers must apply to be licensed as RDTs and, by the end of which period, must comply with RDT requirements. Overall, the Cabinet Paper proposes a new regime along the following lines:

• the RDT applicant must have a trust deed registered, or eligible to be registered, by the Companies Office that complies with the minimum prudential requirements of the RDT legislation
  
  
• the RDT applicant must have an investment statement and a prospectus registered, or eligible to be registered, by the Companies Office, each of which must comply with the requirements of the Securities Regulations as they will relate to RDTs
  
  
• an RDT applicant must have been registered, or be eligible to be registered, by the Registrar of Financial Service Providers as a financial service provider (when this is introduced)
  
  
• RDT directors and senior management must meet suitability and integrity criteria prescribed by legislation (i.e. no serious criminal conviction). The proposal is for the Reserve Bank to “ have the power to dis-approve proposed appointees and remove incumbents if already appointed”
  
  
• legislation will provide for the ability to set under regulation, RDT board size, composition and even the constitution. As higher standards is clearly an intended outcome, the Reserve Bank has noted that, “RDT directors must also attest in all offer documents whether the RDT is complying with its trust deed and regulatory requirements; whether they are satisfied that the RDT has sufficient capital, governance and risk management systems for the nature of its operations; and whether related party and other business dealings have been conducted on commercial terms and are not detrimental to the interests of RDT depositors”
  
  
• trustees of RDT applicants will be required to attest to the Reserve Bank that the “trustee is satisfied an RDT applicant has sufficient capital relative to the size and nature of the applicant’s business, governance, and risk management systems and internal controls to manage its proposed business, consistent with the level of risk represented to depositors in the prospectus and investment statement.” There will be a limit set in relation to the RDT’s capital, on exposures to related parties. Related party exposures will be measured on a basis to be set out in regulation. Legislation will also enable regulations to be made for liquidity risk management across the RDT sector (and liquidity requirements will need to be included in all trust deeds)
  
  
• a minimum tier one capital of $2m will be set for RDTs (other than credit unions), measured by a standardised capital adequacy framework (to be varied by regulation). Every RDT must also include a minimum capital ratio in its trust deed(s), the ratio to be determined by the RDT and their trustee. A simplified form of the new Basel II capital framework is favoured at this stage. This is to ensure RDTs have sufficient capital reserves in relation to their lending and investment risk profile. Regulation will also provide for the ability to set a minimum capital ratio for all RDTs (or classes of RDT), should market discipline fail
  
  
• unless exempted (only applicable where an entity has assets of less than $10m), the RDT applicant must have obtained a credit rating from an approved rating agency. If exempted, the RDT is required to disclose the fact it has no credit rating. RDTs will, furthermore, be prohibited from disclosing ratings from non-approved agencies.
  

RDTs will also be subject to enhanced Securities Act requirements emerging from the second phase of the Review of Financial Products and Providers. More on this is due at year’s end.

Trustee obligations and powers

Trustees will have a much enhanced role under emerging legislative proposals but will also be subject to greater oversight by the Securities Commission. Trustees will continue to be responsible for monitoring RDTs and enforcing trust deeds which will now be required to establish:

• a minimum capital requirement 
• a capital adequacy ratio 
• a related party exposure limit and liquidity requirements, as noted above.

Additional obligations of, and powers for, trustees are proposed including:

• trustees will be required by the legislation to ensure trust deeds of RDTs comply with RDT legislation and regulation
  
  
• legislation will empower the trustees (either directly or by requiring trust deeds to contain the powers) to require RDTs to provide them with information sufficient to enable the trustee to monitor compliance with the regulatory requirements, to appoint a person (at the expense of the RDT) to verify compliance, and to investigate the affairs of the RDT for the purpose of ascertaining compliance
  
  
• trustees will be under a statutory obligation to advise the Reserve Bank as soon as practicable if an RDT has failed or is expected to fail to comply with a requirement of the legislation or regulation, or where the trustee has reasonable cause to believe that non-compliance may have occurred
  
  
• the Reserve Bank may require the trustee of an RDT to provide the Bank with sufficient information to enable it to determine whether an RDT is complying with any legislative and regulatory requirements
  
  
• most controversially, the trustee of an RDT applicant will be required to attest to the Reserve Bank, prior to an RDT being licensed (and at intervals to be set by the Reserve Bank after licensing), whether the trustee is satisfied that the applicant/RDT has sufficient capital relative to its size and nature, risk management systems and internal controls, and governance to manage its proposed or actual business, consistent with the level of risk represented to depositors in the prospectus and investment statement.
  

This last point places trustees into a position of potential liability, should an RDT collapse. No doubt trustees will have their own views on this aspect of the proposals. The Government believes that trustees will be incenstivised to convey a real-world view on RDTs to the Reserve Bank. Protection of depositors in keeping with the risk profile represented to them, is the Government’s policy driver. While trustees will continue to have primary responsibility for dealing with RDT financial distress and failure, the Reserve Bank reserves the right to intervene “where the soundness of the financial system as a whole is at risk.”

Approved credit ratings as a solution

An approved credit ratings was never in any doubt, especially after the now infamous 4 star rating awarded to Bridgecorp last July by the Australian ratings firm, Property Investment Research. Their commentary, which noted that Bridgecorp had “the highest rating that had been awarded to any New Zealand finance company reviewed by PIR," underscores why only ratings from Reserve Bank approved agencies will satisfy the proposed regulations.

Ratings are an important tool for retail investors to understand more complex financial data and to distinguish higher, from lower, risk institutions. Ratings will need to be disclosed prominently on offer documents and in all advertisements for deposits or investments where these are offered to the public. As noted earlier, the requirement for ratings applies to RDTs with assets of $10m or more. RDTs exempted from this requirement must prominently disclose the lack of a rating and may be subject to additional Reserve Bank set performance requirements.

Expect, therefore, a public information blitz to increase ratings literacy. The Cabinet paper envisages this will come ‘from both the public and private sectors’ presumably led by the prudential regulator, the Reserve Bank. In practice, it will be in the interests of the approved ratings agencies and higher rated RDTs to take the lead in public education.

What happens next?

The Minister of Finance would like to introduce legislation this year, with enactment in 2008. Being a Category 4 Bill (on a prioritisation scale of 1-7), and with a limited number of sitting days left this year, it seems ambitious.

Legislative implementation will come in two phases with two separate bills:

• Reserve Bank of New Zealand Amendment Bill
• Registered Deposit-Takers Bill RDT proposals cannot be advanced until other reforms in the sector take place (financial service provider registration being a notable one).

Implications

The proposals are thorough and reflect consultation which has been ongoing before the recent high-profile collapses. The inescapable conclusion, however, is one of cost. Compliance won’t be cheap. As margins in the sector are already squeezed due to competition, this may act as a catalyst for consolidation. Unless in a defined niche, the cost of compliance makes it difficult to see how some of the smaller providers could meet the cost of being an RDT, while competing in a ratings led ‘beauty parade.’ For the larger providers, the cost and compliance element will be a factor in determining the markets in which they will operate. Borrowers will ultimately pay to provide greater certainty to depositors.

STOP PRESS STOP PRESS

Urgent amendments to the Securities Regulations 1983 will come into force on Friday 21 September. They will affect continuous issuers of securities to the public that lend or provide financial services (aka finance companies) and their trustees. They will not, however, apply to building societies, credit unions or to co-operative companies. From 21 September, new clauses will be deemed to be included in all existing and new finance company trust deeds.

The new clauses require finance companies to:

• provide regular reports to the trustee about its financial position and regularly certify trust deed compliance
• inform the trustee of matters relevant to the trustee's duties
• have the borrowing group's half-yearly financial statements audited or, if waived by the trustee, have them reviewed
• provide the trustee with copies of the borrowing group's annual and halfyearly financial statements
• consult the trustee on the appointment of auditors. If an auditor resigns or declines appointment or reappointment, the trustee must beinformed
• include specific conditions in the terms of appointment of auditors, which will give auditors responsibilities to the trustee.

The new clauses will also give trustees the power to:

• appoint an independent auditor to audit the financial statements of the borrowing group 
• appoint an expert to assist the trustee to determine the true financial position of an issuer, and recover the fees and expenses from the issuer.

This newsletter is produced by Simpson Grierson. It is intended to provide general information in summary form. The contents do not constitute legal advice and should not be relied on as such. Specialist legal advice should be sought in particular matters.