Questions and Answers on Proposals for Regulation of Non-Bank Deposit Takers

Prepared by the Reserve Bank of New Zealand

June 2007

What will be the role of the Reserve Bank of New Zealand?

Cabinet has decided that the Reserve Bank will become the single prudential regulator for New Zealand. This would widen the scope of the Reserve Bank’s prudential functions to include the prudential regulation of non-bank deposit takers (NBDTs) and the regulation and supervision of insurance companies.

This Q and A covers NBDT regulation only, where policy decisions have already been taken by Cabinet: insurance regulation is included within the next phase of work on the Review of Financial Products and Providers, with a report back to Cabinet by 30 November 2007.

What is a Non-Bank Deposit-Taker (NBDT)?

An NBDT has been defined in the Discussion Document on NBDTs, issued in September 2006, as a financial institution whose core business involves borrowing money from the public (mainly in the form of deposits or debentures, whether secured or unsecured) and the lending of money or provision of other financial services. (The term “public” has the same meaning as in the Securities Act 1978.)

The definition of an NBDT does not include entities that provide financial services, including lending, but which fund solely from non-public sources (eg from wholesale markets, related parties and the like). It also excludes entities that issue debt securities to the public, but whose core business does not include, directly or indirectly, the provision of financial services or lending.

NBDTs can take a number of different legal forms and include finance companies, building societies and credit unions:

For the purposes of the NBDT proposals, a finance company is an entity incorporated under the Companies Act 1993 which issues debt securities to the public and lends money or provides other financial services - directly or indirectly - to the public.
A building society is incorporated and registered under the Building Societies Act 1965. Funds are raised by the issue of shares or deposits. Traditionally, building societies have held most of their assets in the form of loans secured against residential property, but they also provide a wide range of other financial services.
A credit union is established and registered under the Friendly Societies and Credit Unions Act 1982. A credit union is a member-owned co-operative financial organisation set up to provide savings and loan facilities for its members. A common bond must exist among the members - for example, residing in a particular geographical location or having a common place of employment.

What is being proposed?

A one-tier regulatory framework is proposed, where all NBDTs continue to be supervised by trustee corporations under the enhanced trust deed requirements for debt issuers, and are subject to some additional requirements:

All NBDTs will be required to be licensed by the Reserve Bank and will be subject to minimum prudential, governance and fit and proper requirements set and enforced by the Reserve Bank in consultation with the Securities Commission.
NBDTs will be subject to enhanced public disclosure requirements under the Securities Act. Proposals on disclosure requirements will be taken to Cabinet under Phase 2 of the RFPP reforms, later this year.
Subject to final Cabinet approval later this year, it is proposed that NBDTs will be required to obtain and disclose a credit rating from an approved rating agency.
The Reserve Bank will be responsible for administering the credit ratings regime and will have the capacity to intervene in situations of NBDT distress or failure where the soundness of the financial system is at risk.
The Securities Commission will authorise and supervise trustee corporations, and will set and enforce public disclosure requirements for NBDTs, in consultation with the Reserve Bank.

Why are these reforms being proposed?

The Discussion Document on NBDTs, issued in September 2006, noted that the current regulatory arrangements for NBDTs, while not fundamentally flawed, are inadequate in several respects. The deficiencies highlighted included inconsistency in regulatory requirements and supervision across different NBDTs, the absence of minimum entry requirements for NBDTs, lack of governance requirements and insufficient information to enable depositors to assess and compare the risks of depositing with NBDTs.

The weaknesses in the current regulatory arrangements create a number of risks for depositors and for the soundness and efficiency of the financial system:

The absence of a licensing requirement for NBDTs, including fit and proper requirements for directors and senior management, creates a risk that an NBDT could be owned and controlled by entities or persons who may not manage the NBDT in a manner consistent with the interests of depositors, exposing them to an excessive risk of loss.
The absence of standardised minimum prudential requirements creates a risk of inadequate supervision of NBDTs.
Existing disclosure arrangements do not provide a satisfactory basis to enable depositors to identify and compare risks of NBDTs. This impedes the ability of depositors to evaluate the trade-off between risk and return and may lead to depositors taking greater risks with their money than they would take were they aware of the risks.
There is a potential for contagion within the NBDT sector, where the failure of some NBDTs could trigger wider-spread financial distress in the NBDT sector. The current regulatory arrangements do not adequately address this risk, given that existing disclosure arrangements and the lack of credit ratings do not enable depositors to readily distinguish between the risks of different NBDTs.

Why should NBDTs be subject to a special form of regulation?

NBDTs have special features that warrant a form of regulation that goes beyond that required for other debt issuers. These features include the following:

Many NBDTs perform bank-like functions, including providing on-call or short-term deposit facilities and the provision of payments services. These functions suggest that NBDTs should be regulated in some respects in a manner similar to that applicable to banks, while still facilitating continued diversity, flexibility and competitiveness in the NBDT sector.
Unlike corporate bond and other debt issues, in which the funds are used to finance an issuer’s own business, NBDTs lend to many clients. This makes it difficult for depositors to ascertain the true risk of an NBDT and provides a justification for additional prudential and disclosure-based regulation.
NBDTs are potentially vulnerable to contagion risk, whereby the distress or failure of some NBDTs could trigger acute distress or failure in others. This suggests the need for enhancements to the standard regulation of debt issuers, such as in respect of public disclosure requirements, ratings and distress management arrangements.

What are the objectives of regulating NBDTs?

The proposed objectives for prudential regulation of the NBDT sector are to promote a sound and efficient financial system by:

ensuring that NBDTs meet a transparent set of prudential requirements designed to promote sound governance and risk management in NBDTs and promote depositor confidence;
providing depositors with a clearer basis for distinguishing between lower-risk and high-risk NBDTs; and
resolving NBDT distress or failure in an orderly and timely manner, with minimum disruption to the financial system and depositors.

What do the objectives not include?

The objectives do not include:

promoting a uniform level of risk across the NBDT sector;
promoting the same level of risk as for registered banks;
preventing NBDT failures; or
insulating depositors from loss in the event an NBDT fails.

What will licensing and minimum regulation of NBDTs involve?

Minimum requirements would apply to all NBDTs at the time of licensing and on an ongoing basis. It is proposed that the licensing and other requirements will comprise:

Fit and proper requirements for NBDT shareholders with control or significant influence, directors and senior management. These would be designed to ensure that NBDTs are controlled and managed by persons with appropriate capability and experience and do not have serious criminal records.
A requirement that an NBDT must demonstrate the capacity to manage its affairs prudently, in line with the nature of business it proposes to undertake.
A minimum dollar level of capital. The Discussion Document suggested a minimum of up to $2 million. The minimum amount of capital will be decided by Cabinet later this year.
A requirement that every NBDT must include in its trust deed(s) a minimum capital ratio, determined by the trustee, and that the ratio must be measured on the basis set out in regulation by the prudential regulator.
Either disclosure of, or a limit on, credit exposures to parties related to an NBDT, such as shareholders with control or significant influence, and directors. A decision on this will be made by Cabinet later this year.
Minimum governance requirements, including a minimum board size and composition, and probably a minimum number of independent directors and a non-executive or independent chairman.

Why require NBDTs to be licensed and also registered as financial service providers?

Registration with the Companies Office will be required for all financial service providers, including NBDTs. It is intended to be a mechanism for identifying the providers of financial services, determining which regulatory category they should be in, and ensuring that all owners (with control or significant influence), directors and senior management are subject to criminal and other “negative assurance” checks.

Registration is not an equivalent to licensing or authorising of a financial institution; it will not provide any kind of positive assurance assessment of fitness or involve the imposition of minimum regulatory or supervisory requirements. The licensing requirement for NBDTs will provide a basic check on fitness for purpose and fitness of owners, directors and senior management, and will involve minimum regulatory requirements.

There will be no duplication of function between financial service registration and licensing of NBDTs. Effective coordination arrangements will apply to ensure that the registration and licensing procedures are properly coordinated.

What will be the functions of trustees under the new arrangements?

The trustees will continue to be the front-line supervisors for NBDTs, much as they are now. Their functions will include:

establishing a trust deed for particular offers of securities, in agreement with the NBDT;
prescribing the financial, reporting and other covenants in the trust deed;
enforcing trust deed covenants and supervising and monitoring NBDTs; and
taking remedial actions to respond to breaches of trust deed requirements or financial distress in an NBDT, including advising the Registrar of Companies of any material breaches of trust deed covenants or emerging financial difficulties.

Trustees will be subject to greater oversight by the Securities Commission under the new regulatory arrangements, and there will be a minimum set of requirements for the content of trust deeds.

What will be the functions of the Reserve Bank?

As the prudential regulator of NBDTs, the Reserve Bank will be the authority that:

licenses and (subject to appropriate checks and balances) de-licenses NBDTs, in consultation with the Securities Commission;
prescribes and enforces compliance with the minimum regulatory prudential and governance regulatory requirements for NBDTs, in consultation with the Securities Commission;
applies the fit and proper requirements to NBDTs’ owners (with control or significant influence), directors and senior managers;
prescribes the credit rating requirements;
provides advice and recommendations to the Securities Commission on the performance of trustee corporations in the discharge of their NBDT supervisory functions; and
can intervene to manage the resolution of NBDT distress or failure in situations where the NBDT’s situation may pose a threat to the soundness of the financial system.

Why will the Reserve Bank be the prudential regulator of NBDTs?

As the Reserve Bank is the prudential supervisor of banks, and will become the prudential supervisor of insurers, there are synergies and efficiencies in the Reserve Bank also becoming the prudential regulator of NBDTs. The Reserve Bank’s position as prudential regulator of NBDTs will also facilitate achieving some consistency in prudential regulation between banks and NBDTs, including in respect of capital adequacy measurement, fit and proper requirements, ratings and corporate governance.

Will there be duplication of the functions of the Reserve Bank and trustees?

There will be no duplication of function between trustees and the Reserve Bank. The Reserve Bank’s responsibilities are largely limited to the licensing of NBDTs, setting and enforcing minimum standards across the NBDT sector, and administering the credit rating regime.

The Reserve Bank will not be the supervisor of NBDTs. It will not be involved in setting trust deed covenants or monitoring NBDTs on an individual basis. Nor will the Bank be involved in the handling of NBDT distress or failure other than in the rare situation when an NBDT’s circumstances may pose a risk to the soundness of the financial system. Rather, the trustees will have these functions – the trustees will be the sole supervisors of NBDTs.

What will be the role of the Securities Commission?

As in the case of other aspects of trustee-based supervision (eg for debt issuers), it is proposed that the Securities Commission would retain responsibility for authorising and supervising trustee corporations. The Commission would also have responsibility for enforcing NBDT disclosure and advertising requirements under the Securities Act 1978, in consultation with the Reserve Bank.

Will there be overlap or duplication in functions between the Reserve Bank and Securities Commission?

The functions of the Reserve Bank and Securities Commission are distinct and will not involve duplications of responsibility. The Reserve Bank’s role relates to prudential regulation setting, while the Securities Commission’s role relates to market conduct and disclosure. In order to ensure effective coordination between the Securities Commission and Reserve Bank, there will be effective information-sharing and coordination arrangements.

Why is a mandatory credit rating being proposed?

The requirement to obtain and disclose a credit rating from a rating agency approved by the Reserve Bank would bring a number of important benefits, both to depositors and to the financial system as a whole.

Ratings provide a relatively simple metric summarising, in one measure, the risk of an NBDT defaulting on its financial obligations. A rating therefore reduces the need for investors to try to understand more complex and voluminous financial information on NBDTs. Ratings would provide the most cost-effective means of enabling depositors to distinguish between higher and lower risk NBDTs and thereby make better-informed investment decisions. This is particularly so if ratings are disclosed prominently in public offer documents and advertisements in ways that can be readily understood by non-expert investors, backed by greater initiatives to promote financial literacy among investors.

Ratings would also strengthen market disciplines on NBDTs and reduce the need for a more intrusive form of regulation and supervision, both in terms of a reduced need for prudential restrictions on NBDTs and less detailed financial public disclosure requirements. In turn, this would reduce the regulatory costs for the NBDT sector relative to the situation where there are no required ratings.

Will ratings be understood by non-expert depositors?

Currently, there appears to be quite limited public understanding of credit ratings. However, as more NBDTs acquire ratings, and as public awareness of ratings grows, the understanding and use of ratings by ordinary depositors are likely to increase. To facilitate this, a number of initiatives can be taken, both to promote more effective disclosure of ratings and to enhance public understanding of ratings, including:

clear, prominent and user-friendly disclosure of ratings;
disclosure of comparisons between the rating scales of different rating agencies;
promoting public understanding of credit ratings through explanatory information, public education initiatives and by encouraging the financial news media and other bodies to regularly highlight the importance of ratings and provide information on the ratings of NBDTs.

Government officials will be considering these and other options as part of the development of the new regulatory arrangements for NBDTs.

Will ratings be costly for NBDTs?

Requiring NBDTs to obtain and disclose a rating will involve costs for NBDTs – both in terms of the direct cost of the rating and the indirect cost of management time, systems and controls. However, the costs of mandatory ratings are expected to be modest for most NBDTs relative to their revenue, assets and liabilities. The costs could be more significant for very small NBDTs.

In the case of NBDTs that can only achieve a low rating, a ratings requirement could increase their funding costs. This could lead to consolidation or rationalisation in the NBDT sector, depending on market reaction to ratings. However, this need not be a negative development; it may be a desirable outcome of better-informed investor decision-making and efficient markets.

There are various options available to reduce the costs of ratings for NBDTs, including the possibility of exemptions for small NBDTs, the application of ratings to groups of entities (eg groups of affiliated credit unions) rather than necessarily requiring ratings to be applied to all individual entities, and the possibility of reduced fees negotiated on a collective basis with the rating agencies. Government officials will explore these options and report back to Cabinet later this year on possible options for minimising the costs of ratings.

When will the new arrangements come into force?

It is intended that legislation to give effect to the new arrangements will be introduced later this year and enacted if possible in 2008. It is proposed that the new regulatory requirements will not come into force until a later date – possibly 2010 – so that all relevant elements in the RFPP package can be brought into force as a cohesive package. It is likely that a transition period will apply after the commencement date to provide existing NBDTs with sufficient time to come into compliance with the new regulatory requirements.

Will stakeholders be consulted on the details of regulatory requirements?

Yes. Stakeholders will be consulted in the development of the proposed regulatory requirements. Consultation with some key stakeholders will occur in the preparation of legislation. Once legislation has been introduced into Parliament, it will be subject to the standard select committee process, therefore enabling any parties to express views on the proposed requirements. Any regulations prepared pursuant to the legislation will be subject to the standard consultation process.

There has already been extensive consultation with stakeholders throughout the RFPP process. The consultation papers elicited a large number of helpful submissions and proposals for the regulation of the NBDT sector have been subject to a number of important changes in the light of these.