On the face of it, little in the Non-Bank Deposit Takers Bill (NBDT Bill) would excite the non-specialist. But the prudential regime it envisages goes well beyond the finance companies it was designed to regulate.
We hope that the Finance and Expenditure Select Committee addresses this before the Bill becomes law.
This Brief Counsel outlines the problems and suggests some practical solutions.
The Bill, which was introduced into the last Parliament and released for submissions late last year, will replace Part 5D of the Reserve Bank of New Zealand Act 1989 (RBNZ Act) and so provides an important opportunity to deal with Part 5D’s defects.
Instead, it carries them over into the new legislation.
Unless remedial action is taken the NBDT regime’s reach will continue to extend well beyond the finance companies which were the intended target and will continue to discourage highly rated and high quality issuers from going into the retail bond market. This will reduce choice to investors, the exact opposite of what this reform was meant to achieve.
A glimpse at the exemptions page on the Reserve Bank (RB) website shows how far the NBDT regime has veered from its objective of cleaning up the finance company sector. Not only are several retail brokers’ cash management schemes exempted, although a purer example of compliance cost without benefit is hard to envisage, but there is even an exemption for a supermarket.
Key problems are:
- the definition of NBDT is far too wide (indeed, wider than that in any regime that we have checked)
- there is not enough guidance on purpose, so the RB has adopted a literal interpretation which gives no regard to whether an entity is in substance a finance company, and
- the exemption regime is too narrow and is heavily stacked in favour of regulation.
The deterrence to high quality issuers results from the capital adequacy requirements being designed with an homogeneous set of issuers in mind (businesses which are finance companies within the ordinary meaning). For the much wider range of businesses to which the regime might apply, these requirements more often than not will be unduly restrictive, too costly, or require substantial changes to the issuer’s business plan. For finance companies who have no other realistic funding options, it’s just a matter of ‘take it or leave it’. But high quality issuers have a full range of funding choices, domestically and internationally, and are simply not going to adopt an issuing format that will have these sorts of adverse consequences for them.
The definition debate
The definition of “deposit taker” (now “NBDT”) exercised the minds of lawmakers when Part 5D of the RBNZ Act was enacted and Parliament basically kicked for touch by leaving it to the RB to decide which entities should be covered and which exempted.
The weaknesses of this approach are that:
- the RBNZ Act talks of “borrowing and lending” without being clear that this borrowing and lending must be ‘of the nature carried out by a credit institution’ as opposed to, say, lending money within one’s one group of companies, and
- the RB is naturally reluctant to get into a situation where, by excluding a particular entity, it creates a precedent or even a loophole that others, who should be covered, can exploit.
The RB’s policy positions have arguably exacerbated these effects; in particular the RB’s presumption that:
“all entities that clearly fall within the definition of a deposit taker will be subject to prudential requirements, and that exemptions – especially class exemptions – should be the exception, not the rule.”
The exemptions regime
There are in theory two ways one can be exempted from the NBDT regime if the “deposit taker” definition applies:
- total exemption - exclusion from being a "deposit taker" under a section 157C(5) regulatory declaration, and
- partial exemption - exclusion of a deposit taker from particular aspects of the regime pursuant to section 157G.
In practice, the RB does not use section 157C and instead relies exclusively on section 157G. But the tests under section 157G are weighted strongly in favour of regulation. Deposit takers must be able to demonstrate that each and every particular requirement of the regime is “unduly onerous and burdensome” and that any exemption granted is no broader than what is “reasonably necessary”.
There are no rights of appeal against RB decisions or any other practical recourse for the putative deposit taker.
This is discouraging high quality companies from issuing debt securities to the New Zealand public. The RB does not identify it as a cost in the Regulatory Impact Statement to the Bill, but the damage to New Zealand’s capital markets will be no less real for being invisible.
The RB should have the power to assign non-NBDT status where a person is technically a deposit taker but is not in substance a finance company or similar credit institution. Note that this would apply only to individual entities - not to classes of organisations, which would invoke wider policy considerations.
Clearer guidance to the RB in respect of its gate-keeping function and the intended boundaries of the regime would also be helpful.
Defining ‘financial institutions’
In a leading case in the United Kingdom Court of Appeal, Harman LJ observed:1
it is notoriously difficult to define the business of banking and no statute has attempted it.
Despite this difficulty, we recommend the following changes to the way “NBDT” is defined in the Bill:
- clarify that the test is an in substance one, relating to persons who are or should be regarded as finance companies or credit institutions
- permit the RB to exempt particular persons from the NBDT regime in its entirety on the basis that they are not in substance a finance company or credit institution
- include a non-exhaustive list of factors relevant to the substance test, including:
(a) if the entity (or, where the entity is guaranteed, the credit group) should be regarded as a corporate issuer rather than a finance company on the basis that its financing activities are ancillary to its primary business
(b) an assessment of the financial statements of the entity or credit group. A feature of true finance companies is that their balance sheets are dominated by loan receivables and their income statement is dominated by interest income and other finance charges – usually about 90%+ in each case. Where this is not the situation, that would be a strong indication that it is not in substance a finance company or credit institution
(c) an assessment of the nature and terms of the debt securities being issued. Relevant factors here would include:
(i) a history of continuous issuance (corporate issuers tend to offer debt securities only through discrete offer periods, rather than keeping their offers continuously open)
(ii) whether the debt securities are in the nature of a deposit or a bond. The former will usually have a maturity of two years or less and may be rolled over. The latter will usually have a maturity of three or more years and a fixed maturity date
(We note that there are currently criteria in the existing (unused) section 157C(6) of the RBNZ Act, which, while a step in the right direction, we submit do not go far enough.)
- delete from the definition of NBDT the words “or providing financial services, or both”, since they are not necessary in order to capture true finance companies but generate a lot of false positives, including brokers’ cash management accounts
- provide an explicit exclusion for “licensed insurers” within the meaning of the Insurance (Prudential Supervision) Act 2010, on the basis that they are subject to their own distinct prudential regime
- tidy up grey areas such as lending within a group. The regime should only apply if the proceeds are ultimately lent to external borrowers, not lent within a group whose activities do not substantially involve being a finance company.
Conclusion about the threshold issue
We consider that the current approach of having the broadest possible definition and leaving it to the regulator to police the boundaries of its own regime is demonstrably not working (a fact alluded to in the Cabinet Paper leading to this reform but not addressed in the Bill).
Much better, in our view, would be to have greater prescription around who is and, just as importantly, who is not an NBDT. Issues around avoidance can be dealt with by bestowing on the Minister a “call-in” power.
The regime in context
The prudential regime now encapsulated in Part 5D of the RBNZ Act and to become part of an NBDT Act is simpler, but not necessarily less exacting, than the regime applying to registered banks.
In its original conception, it was to be a targeted regime, recognising the second-tier nature of finance companies.2 Specifically, there were to be two levels: the first involving Authorised Deposit Takers (or ADTs), which would be larger finance companies subject to a bank-like prudential regime, “but pitched at a somewhat lower level”.3 Then there would be Tier 2 NBDTs, subject to enhanced trustee-based supervision but with only limited capital adequacy requirements.
The Ministry’s rationale for this treatment was:4
“Requiring all NBDTs to be licensed and supervised to a uniform level would impose substantial efficiency costs on the financial system.”
The efficiency costs, according to the Ministry, would come both in the constraint on investor choice and in the reduction of the NBDT sector to meet the needs of the economy in niche markets not readily serviced by banks.
This policy consideration seems to have disappeared from view, which is perhaps unfortunate in a climate of tightening lending standards in the banking sector and reducing growth forecasts in the economy. Notably, lending from finance companies has been in freefall since late September 2007, with credit growth in the sector hovering for each of the past two years at around minus 20%.5
Much of this no doubt reflects an unwind of the credit-fuelled property development bubble, but equally the question should be asked about the productive and dynamic efficiency effects of this trend.
It goes without saying with respect to the aims of this reform that the horse has already bolted. The majority of significant finance companies are and will continue to be exempt from prudential requirements because they are already bust.6
Among those finance companies that remain, some have chosen to abandon the retail deposit model because compliance costs are too high. Others have chosen to become fully fledged registered banks, sometimes after merging with others for critical mass.
In practice, then, there is not much left to be regulated under this regime.
The law of unintended consequences
Leaving aside specific questions about the sustainability of the NBDT sector and any potential economic impacts of its downscaling, the consequences of the NBDT Bill for capital markets participation and choice must not be ignored.
It is time to acknowledge that the failed finance companies and their captive financial advisers were a sector unto their own. The outsized growth of this sector exactly coincided with a global credit binge and asset bubble and, ultimately, the sector was brought down by the same forces that created it.
To some degree, the law of unintended consequences will attend any attempted reform. But a reform designed to improve the retail capital market which acts as a deterrent to the participation in that market of high quality issuers is not a step in the right direction.