Regulation of Non-Bank Deposit Takers FAQs
What is prudential regulation?
Prudential, or preventative, regulation involves the imposition of rules and/or standards to govern the behaviour of regulated institutions; in this case, of deposit taking institutions. Prudential regulation is generally targeted at minimising the risk that institutions will be unable to meet the financial promises they have made, i.e. to repay depositors on time and in full.
What is the difference between regulation and supervision?
Regulation involves the development and enforcement of legislation and regulations, issuing guidelines and approving requests from regulated institutions. For Non-Bank Deposit Takers (NBDTs), the Reserve Bank is responsible for setting the prudential regulations, determining who these rules apply to and enforcing them.
In contrast, supervision involves assessing the safety and soundness of individual regulated institutions and using supervisory powers to intervene to protect the rights and interests of depositors. Trustee corporations will be the supervisors of deposit takers in the NBDT regime.
Who are trustees?
Under the Securities Act, a trustee is required for offers of debt securities to the public. This includes debentures issued by a deposit taker. The purpose of this requirement is to provide some protection to depositors and investors, whereby an independent person (trustee) supervises the issuer on behalf of depositors and investors and has the capacity to intercede where the terms of the trust deed are breached.
The trustee must be either a trustee corporation or a person approved for the purpose by the Securities Commission.
What are trust deeds?
A trust deed is a private contractual agreement between a trustee and an issuer (e.g. deposit taker) that forms the basis of the trustee’s supervision and oversight. Trust deeds typically contain a number of covenants designed to ensure that the affairs of the issuer are managed prudently, and often include provisions relating to maximum exposure concentration, minimum capital and liquidity requirements.
What is a debenture?
A debenture is a commonly used phrase to describe the type of debt security that is issued by finance companies to fund their lending activities. Typically, debentures offer a fixed rate of return (i.e. interest) to investors and carry a floating charge as security over the assets of the issuing finance company. This means that debenture holders rank ahead of ordinary creditors and other investors (e.g. bond holders, note holders and shareholders) in the event of failure.
Debt securities that are issued by building societies or credit unions are either deposits or variants on preference shares. This recognises the ownership stake that investors or members have in mutual organisations.
What difference will the new prudential regulations really make to investors?
The new prudential regulation of deposit takers will not make an immediate difference to investors. Over time however, the introduction of the new rules will raise standards across the industry, that will be better enforced, and mandatory credit ratings will enable investors to make a more informed choice about where they place their funds. Ultimately, a better regulated sector will promote greater public confidence and participation in the non-bank sector, and a sounder and more efficient financial system.
Why is this taking so long?
Although the new legislation has been passed it is true that the majority of the prudential regulations will not be in force until 2010. This reflects the practical changes that deposit takers may need to make as they pre-position themselves for the new regime. This may require restructuring balance sheets, appointing new directors, and getting a credit rating from an approved rating agency.
Why is the Reserve Bank doing this?
The Reserve Bank is tasked with promoting a sound and efficient financial system for New Zealand and New Zealanders. The NBDT sector is an important component of the broader financial system because it provides funding to sectors of the economy that the mainstream banks often avoid and alternative investment options for individuals and organisations. Prudentially regulating this sector will raise standards to the benefit of investors and improve the sector’s overall resilience to adverse market conditions in the future.
Will these new rules prevent future failures?
No. It is neither possible nor desirable to try to prevent institutional failure. The new rules are intended to improve overall standards and to make the risks and rewards of investing more transparent to investors. Deposit takers will continue to be able to pursue a range of business strategies according to the risk appetite of their shareholders and investors. Ultimately, the risk of particular investments will still lie with investors.
Do the risk management programme guidelines impose requirements?
No, the requirements in relation to risk management programmes are set out in sections 157M to 157O of the Reserve Bank of New Zealand Act. The risk management programme guidelines (PDF 129KB) are intended to provide guidance on the key components of any risk management programme, and are cast in manner intended to accommodate the diversity of operations in the non-bank deposit taking sector. Non-bank deposit takers must have and comply with a risk management programme from the 1st of September 2009.
What should happen when a non-bank deposit taker gives its risk management programme to its trustee?
When a trustee receives a risk management programme from a non-bank deposit taker the trustee must satisfy itself that the programme meets the requirements set out in the legislation (in section 157M(2)). However, if the trustee is not then satisfied the trustee can ask the non-bank deposit taker to amend the programme and resubmit it.
Will I need to have my risk management programme audited?
Section 157O gives the trustee the power to require a non-bank deposit taker to have its programme audited at the non-bank deposit taker’s expense. However, the Reserve Bank expects that this power would be exercised only on rare occasions, and generally only in relation to the particular aspects of the programme that the trustee is not satisfied with (after giving the non-bank deposit taker the opportunity to amend and resubmit its programme).
What is capital? And what do different levels of capital mean?
Capital represents the financial commitment of the owners to a business. It consists primarily of shareholders’ equity and retained earnings. Capital is required to absorb unexpected and unplanned losses that an entity may be exposed to. As a consequence, institutions that hold higher amounts of capital tend to be more robust than those with lesser amounts.
Why are restrictions on connected party lending important?
Related party lending (sometimes referred to as connected exposures) occurs when a financial institution advances funds to an associated organisation. This can have the effect of transferring capital from one entity to another to the detriment of depositors. Restricting related party lending is a prudent way of mitigating this risk.
Why are independent board directors important?
Independent directors are a cornerstone of best practice corporate governance as they are better able to provide impartial advice and direction to the company. Having directors who are not directly employed by, or related to the underlying company (or its shareholders) provides a layer of objective scrutiny for shareholders and depositors. This is particularly the case in respect of a deposit taker’s dealings with its controlling shareholders and other related parties, where independent directors are better placed to ensure that any such dealings are not contrary to the interests of the overall organisation.
What does liquidity mean, and why does it matter?
Liquidity is the ability to meet financial obligations when they come due. For a financial institution this means ensuring it has sufficient cash, or access to cash, to meet financial demands, e.g. the withdrawal of deposit funds. Managing liquidity is a daily process that requires deposit takers to monitor and project cash flows to ensure adequate liquidity is maintained. Insufficient liquidity is a critical issue for any financial institution that can quickly result in failure.
What are credit ratings and how much faith should I place in them?
A credit rating is an independent assessment of an institution’s creditworthiness, i.e. an assessment of its ability and willingness to meet financial obligations (e.g. repay debentures) as they fall due. For investors, credit ratings provide a useful indicator of the level of risk they are taking when making an investment, and can be easily used to compare risk across institutions.
Will deposit takers be licensed by the Reserve Bank, and will management, directors and shareholders be subject to ‘fit and proper’ assessment?
Yes, in due course. These requirements are not included in the Reserve Bank Amendment Bill (No 3) that was passed in September 2008. The Reserve Bank intends to introduce separate legislation in 2009 that will address these issues in coordination with legislation that will require all financials service providers to be registered. It is expected that these requirements will come into force in 2010 to align with the other aspects of the prudential regulation of deposit takers.
