Letter to CEOs
29 October 2004
To [CEO's of all registered banks]
PROPOSED OUTSOURCING POLICY FOR SYSTEMICALLY IMPORTANT BANKS
The Reserve Bank is seeking comments on the "outsourcing" policy proposals set out in the enclosed paper: Proposed Outsourcing Policy for Systemically Important Banks. After considering comments on the proposed policy, we will consult with banks on any proposed new or amended conditions of registration, amendments to the Statement of Principles: Bank Registration and Supervision, or other guidance documents we see as necessary, based on the discussion in the paper and the comments received.
Growth in the use of outsourcing arrangements by banks registered in New Zealand has led the Reserve Bank to decide that a policy is necessary with regard to this activity. The purpose of the proposed policy is to promote the maintenance of a sound and efficient financial system and to avoid significant damage to the financial system that could result from the failure of a registered bank, in terms of section 68 of the Reserve Bank of New Zealand Act 1989 (the Act). We wish to ensure that any outsourcing of functionality by banks does not undermine our objective that New Zealand banks be able to be operated on a "stand-alone" basis under stress circumstances. This concept of stand-alone capability is core to the proposed policy.
The Reserve Bank intends that the proposed policy would apply to "systemically important" banks (those whose New Zealand liabilities net of amounts due to related parties exceed NZ$10 billion) only, at this stage. Systemically important banks present the greatest risk of causing significant damage to the financial system if they were to fail. However, we see a number of the issues raised here as also relevant for the sound management of banks in New Zealand that are not systemically important. Aspects of the proposed policy might be applied to non-systemically important banks at a later stage.
We note that systemically important banks are required to be incorporated in New Zealand under the Reserve Bank's local incorporation policy. Currently, one systemically important bank operates as a branch in New Zealand and we are working with that bank to see how it can comply with the local incorporation policy. We intend that the proposed outsourcing policy discussed in the enclosed paper would apply, mutatis mutandis, to all systemically important banks irrespective of whether they are operating in New Zealand as subsidiaries or as branches.
For the purposes of the proposed policy, outsourcing arrangements include (without limitation) any arrangements falling within the meaning of section 78(fb) of the Act (mutatis mutandis for any arrangements between a New Zealand branch and its "head office"), which reads as follows:
arrangements for any business, or functions relating to any business, of the applicant or registered bank to be carried on by any person other than the applicant or registered bank.
The Reserve Bank's proposed policy is set out in the enclosed paper. Recognising the efficiency and other benefits that outsourcing can bring, the proposed policy would not necessarily preclude outsourcing, nor would it specify in great detail what functionality of a bank could or could not be outsourced, or in what way. Rather, the proposed policy would require that any outsourcing that is done by a systemically important bank does not undermine the bank's stand-alone capability, and is appropriately managed in light of its materiality to the bank's ongoing viability.
Stand-alone capability
We would implement this proposed policy for systemically important banks by requiring a bank's board of directors to have legal and practical ability to control the management and operation of the New Zealand banking group's assets, liabilities and systems such that the New Zealand bank may be operated on a stand-alone basis.
Stand-alone capability is necessary for the Reserve Bank's statutory management powers to be effective in managing and containing the disruption to the financial system that a failure of a systemically important bank could cause. The main intent of the proposed policy is to ensure that any outsourcing arrangements entered into by systemically important banks are consistent with this objective. The proposed policy is also intended to promote the soundness of the financial system by requiring systemically important banks to have the capability to continue operating in the face of the failure of a service provider, and to structure and manage any outsourcing arrangements in the best interests of the New Zealand bank.
Relevant service providers for the purposes of the proposed policy include related parties (such as a parent bank or other affiliate, or a "head office" of a branch operation not included in the New Zealand banking group) as well as non-related (i.e. independent) providers.
Governance and management
The Reserve Bank views governance and management functions as essential to stand-alone capability. The proposed policy includes measures relating to reporting and accountability intended to ensure that the board and executives of a locally incorporated systemically important bank have meaningful authority, ability, and incentives to manage the New Zealand bank on an ongoing basis in its own best interests. The proposed reporting and accountability measures are also intended to ensure that under stress or failure management circumstances, the directors or a statutory manager would have unfettered legal and practical access to key staff, which would be necessary to the directors' or statutory manager's ability to manage the bank through its difficulties.
The proposed requirements regarding governance are not intended to preclude effective working relationships existing between the New Zealand bank's staff and any parent-bank (or "head office", in the case of a branch bank) counterparts. The Reserve Bank is aware that such working relationships exist to some extent currently and have the potential to benefit the New Zealand bank and financial system through the adoption of best practices developed by the parent bank, and through efficiencies and risk reduction associated with the harmonisation of risk management and other functions. However, under our proposed governance requirements, any such working relationships would not be allowed to undermine the capability of the New Zealand board and executives to test parent-bank policies for their appropriateness for New Zealand circumstances, and, in light of those tests, to modify the policies if necessary for their application in New Zealand. The Reserve Bank views such testing and review by the New Zealand directors and management as an important part of stand-alone capability.
Reserve Bank engagement with systemically important banks
The outsourcing policy proposed here would establish a major plank in the Reserve Bank's failure management framework, which we have been developing for some time. Our objective of stand-alone capability for systemically important banks received considerable focus in relation to the possible sale of the National Bank of New Zealand announced in mid-2003. Also in 2003, the Reserve Bank of New Zealand Amendment Act introduced outsourcing explicitly as a relevant matter in the exercise of the Reserve Bank's powers. We have notified individual systemically important banks that we wish to discuss with them the implications of outsourcing for their stand-alone capability in the context of their particular circumstances, drawing on the responses to our December 2003 letters and questionnaires seeking information on their current functionality arrangements. We have discussed the issues in more detail with some systemically important banks around particular proposals they have.
We expect this close engagement with banks to continue through the consultation process on the present proposals, and beyond as finalised policy is implemented. Part of the proposed compliance monitoring and assurance process would include the likely use of our powers under section 95 of the Act to require a bank to obtain an independent report on the bank's outsourcing arrangements, prepared by a person approved by the Reserve Bank, against a terms of reference based on the issues discussed in the enclosed paper. Such an independent report would be at the bank's cost. The report could assist in the directors' and the Reserve Bank's assessment of the consistency of the bank's outsourcing arrangements or plans with the stand-alone capability requirement.
We also expect systemically important banks to be mindful of the implications for stand-alone capability of any material outsourcing initiatives or changes they might be planning, in light of the thinking set out in the enclosed paper. Systemically important banks should consult with the Reserve Bank if clarity on these matters is needed.
We would welcome feedback on the proposed policy and issues discussed in the enclosed paper. Please send any comments by 31 January 2005. If you require further information or would like to meet with us to discuss this paper, please contact Tim Ng on (4) 471 3965 or ngt@rbnz.govt.nz.
Yours sincerely
Adrian Orr
Deputy Governor and Head of Financial Stability
