Part 4: Managing the application process

The Treasury: Implementing and managing the Crown Retail Deposit Guarantee Scheme.

In this Part, we discuss:

In summary, for the first six months, every institution that met the basic criteria was accepted into the Scheme. No applicant was refused in the first few months of the Scheme for failing to meet any of the "other factors", which included creditworthiness and sound business practice. At this stage, and despite earlier references to limiting the Crown's liability, depositor confidence was the Treasury's priority.

In our view, the application process for NBDTs relied too heavily on the information and perspectives of the trustees. As noted earlier, trustees remain the primary supervisors of NBDTs in the new regulatory framework, and it was appropriate that their knowledge and advice was an important component of the application process. However, the Treasury could have made further inquiries about some applicants. For example, we consider that the Treasury should not have relied so heavily on the trustee's confidence that Mascot Finance would continue to meet its obligations. Mascot Finance failed shortly after it was accepted into the Scheme.

After March 2009, the "other factors" of creditworthiness and sound business practices were more carefully considered. By then, more than 80% of the NBDTs that were accepted into the Scheme had already been accepted (including the nine finance companies that eventually failed). The Treasury told us that the NBDT applications remaining to be processed after March 2009 were generally the more complex applications that had been identified earlier as "borderline cases".

In our view, the change in emphasis for the acceptance criteria should have been actively discussed within the Treasury and the Reserve Bank, and with the Minister.

Timing and number of applications

The Treasury received the first applications on Monday 13 October 2008 – the day after the Scheme was announced. Four financial institutions applied on 13 October 2008, and another 43 applications arrived by 15 October 2008. These early applications came from all institution types, including banks.

The Treasury gave priority to handling applications from large institutions. The first application was approved on 29 October 2008, with three applications approved that day and three on 30 October 2008. All of these approvals were for banks. Of the 12 banks that applied, 11 were approved by mid-November 2008. The last bank's application was approved on 5 December 2008.

As at the end of 2008, 63 entities were covered by the guarantee after 125 applications (12 banks, 48 NBDTs, and three collective investment schemes). Of the remaining applications, 20 were withdrawn from consideration, six were declined, 17 were pending approval and eventually withdrawn or declined, and 19 were pending approval and eventually approved.

In total, the Treasury received 142 applications (85 from NBDTs, 12 from banks, and 45 from collective investment schemes). Ninety-six were approved (60 NBDTs, 12 banks, and 24 collective investment schemes), 15 were declined, and 31 applications were withdrawn. The 96 approvals were for 73 participating entities. Some entities had several investment schemes guaranteed, while some financial groups had multiple financial institutions accepted under the guarantee.

Different types of guarantee deeds

Different guarantee deeds were needed for the different types of institutions. The Scheme had different eligibility criteria for registered banks and other types of institutions. NBDTs, for example, needed to meet additional ongoing requirements that did not apply to banks. Unrated NBDTs also needed to pay a different fee. A different guarantee deed to that for finance companies was drafted for building societies and credit unions (because of the need to include industry-specific references to Acts and Registrars and for coverage to include member shares).

The Scheme had five different guarantee deeds (for registered banks, building societies and credit unions, and three separate NBDT guarantee deeds covering finance companies, cash collective investment schemes, and unit trust collective investment schemes).

Although the guarantee deeds were different for each entity type, they were not individually negotiated with financial institutions. The guarantee deed for each finance company was the same.

A new draft specimen guarantee deed was made available on the Treasury's website each time the policy changed during the first days of the Scheme (for example, there were changes on 12, 15, and 22 October 2008). The urgency of the situation and the need to quickly restore depositor confidence meant that announcements were needed as soon as possible, so new specimen guarantee deeds were posted to the website quickly. This high level of transparency let financial institutions see the requirements they were working to.

Application form

Along with the specimen guarantee deeds, the Treasury's website listed an application form setting out the information required in the guarantee application. For NBDTs, the information required included:

  • the names of directors, management, and trustee;
  • a description of the corporate structure and a profile of the applicant's business and financial services provided;
  • the value of debt securities on issue and number of depositors; and
  • copies of the latest annual report, prospectus, investment statement, and trust deed.

Communicating the approved applications

Although the Treasury did not release the names of applicants during the assessment process, the approvals were made public. In the interest of public confidence, the Treasury was aware of the need to assess applications and disclose approvals quickly. Once each application was approved, the name of the applicant was listed on the Treasury's website along with a copy of the signed guarantee deed. Also, consistent with the requirements of section 65ZD of the Public Finance Act about issuing a guarantee, a statement announcing the approval was published in the Gazette and presented to Parliament.16

The Treasury published on its website a list of all institutions participating in the Scheme and updated that list as institutions were approved under the Scheme. In our view, these disclosures were very clear. There was no public notice of financial institutions that had their application declined.

How non-bank deposit takers were processed

Approvals for NBDTs started on 7 November 2008. By the end of 2008, 48 NBDTs had been granted the guarantee.

Despite acknowledging that the risk to the Crown would be higher, policymakers in the Treasury and the Reserve Bank had recommended to the Minister in the Options Report of 10 October 2008 that the Scheme be offered to NBDTs. The rationale then was less about public and depositor confidence and more about avoiding a government initiative that could cause the NBDT sector to fail. This recommendation was largely adopted by the Minister.

The Options Report recommended a risk-based fee structure for NBDTs and a lower guarantee cap to reduce the fiscal risk to the Crown. The Options Report also indicated that officials would consider other measures to mitigate the additional fiscal risk, such as improved reporting requirements.

When the Scheme was implemented, not all of these measures were in place. Our interpretation of later Treasury reports was that the Minister preferred a flatter fee structure. The recommendation for a lower guarantee cap for NBDTs was considered in a Treasury report dated 21 October 2008. There was a cap of $1 million for each depositor within each institution.

Assessing applications under the Scheme

The role of the Policy Guidelines

Each individual financial institution's application was considered in its own right. This was required by the Policy Guidelines and by the execution of the guarantee under the Public Finance Act using contracts.

The Policy Guidelines contained "relevant criteria" to be considered in assessing applications (see paragraph 3.31-3.32). The Policy Guidelines also provided a list of "other factors" to be considered in exercising the discretion to offer the guarantee (see paragraphs 3.33). These included size, creditworthiness, related-party exposures, business practices, and track record.

In contrast to the "relevant criteria" that needed to be met, the "other factors" were for guidance only. We understand they were introduced to provide a mechanism through which the Treasury could decline financial institutions that were attempting to misuse the Scheme or were clearly in serious financial trouble. The Treasury was mindful that it needed to exercise the discretion under the Public Finance Act rather than rigidly apply mandatory criteria.

The relative roles of the Treasury and the Reserve Bank

As noted in paragraph 3.15, the Minister delegated the power to give guarantees under the Scheme to the Secretary to the Treasury. As part of the contract between the Treasury and the Reserve Bank, the Reserve Bank considered the applications provided to the Treasury and advised the Treasury about whether an applicant was eligible to apply for the guarantee. The Reserve Bank's advice was based on the relevant criteria outlined above and whether the Reserve Bank considered that it was in the public interest to grant the guarantee.

The application process for NBDTs included these steps:

  • Information was received from the financial institution (see paragraph 4.14).
  • The Reserve Bank requested a letter of attestation from the trustee, which confirmed that the NBDT was a deposit-taker, was eligible for acceptance into the Scheme, did not have solvency issues, and was complying with the terms of its trust deed.
  • The Reserve Bank considered the application against the criteria and provided a letter of advice to the Treasury.

The Reserve Bank's role was advisory and it was the Treasury's decision (under delegation) to either grant the guarantee or decline the application.

The Treasury and the Reserve Bank agreed that the Reserve Bank would apply a negative assurance approach. That is, the Reserve Bank would recommend that the guarantee be given unless, after considering the relevant criteria and the "other factors", there was a reason not to. The "other factors" did not need to be individually confirmed. Moreover, because the content of prospectuses varied considerably across financial institutions, it is unlikely that the Reserve Bank would have been able to assess fully the "other factors" for all institutions.

The Treasury would then apply a positive assurance approach. To do this, the Treasury would consider the Reserve Bank's advice and any other information at hand (such as the institution's size and its importance to the financial system). This information would then be considered in the context of depositor confidence, to decide whether it was in the public interest to grant the guarantee.

Despite this agreement, there were some early discussions between the Treasury and the Reserve Bank about the extent of due diligence checking of the financial position of individual NBDTs. The level of enquiry needed for "other factors" such as creditworthiness, for example, was unclear. This led to some confusion about how to apply the "other factors" in the Policy Guidelines when assessing applications.

It was agreed that the Reserve Bank would assess the information provided as part of the application, the advice given by the trustees, and any other information the Reserve Bank held, but that the Reserve Bank would not carry out a full due diligence check. The Reserve Bank would not make further inquiries unless it had pre-existing information or was on notice about a particular matter relevant to the Policy Guidelines.

Reviewing applications

The process for bank applications was relatively straightforward. The Reserve Bank had been the supervisor of registered banks for some time, so its advice was mostly about whether a bank was in breach of its prudential requirements.

A number of financial institutions were declined based on their failure to meet the relevant criteria. For example, some applicants were not deposit-takers or had complex structures. Some were in a moratorium (that is, they were suspended from activity as part of a creditor arrangement). No applicant was refused in the first few months of the Scheme based on the "other factors", such as creditworthiness or business practices.

We understand that there was pressure to quickly process applications. This appeared to be driven by the objective of maintaining confidence rather than by any direct pressure from the Minister or senior managers within the Treasury. The pressure to process applications may have also resulted from the fact that an institution was not covered by the Scheme until its application was approved (due to the opt-in approach). Although we did not see any target times for processing applications, a media statement on 22 October 2008 indicated that it may take "several days for any particular application to be processed", given the large number of applications.

Staff of the Treasury said during interviews that they felt under significant pressure to process applications quickly. There was limited opportunity to carry out extensive reviews of individual financial institutions. There was also limited time to request additional information and no time to appoint an inspector, which would have been required to fully investigate the financial position of NBDTs.

As part of the application process, the Reserve Bank, and hence the Treasury, relied on the advice of the trustee (as supervisors of the NBDTs). Although this was consistent with the terms of the supervisory model, it was clear during our audit that many in the industry had concerns about the capability of some of the trustees. The Registrar of Companies also raised a number of issues with the trustee supervisory model as part of a report from the Ministry of Economic Development to the Commerce Committee in 2008.17

In our view, further inquiries could have been made of some financial institutions as part of the application process (either to the financial institution or to the trustee through the Reserve Bank). The Treasury and the Reserve Bank did not seek additional information in the early days of the Scheme. They were focused on the objective of depositor confidence rather than trying to minimise the Crown's liability.

If an institution's application was declined and the institution later failed, public and depositor confidence might have been affected when maintaining this confidence was the Treasury's priority. The Treasury also considered possible legal risk when reviewing the applications from financial institutions.

By the end of 2008, financial markets showed some signs of stabilisation, even though the economy was still in recession. The financial crisis had eased, and market confidence had improved. The Treasury and the Reserve Bank continued to consider applications to join the Scheme, but by late 2008 there were few financial institutions applying.

Mascot Finance Limited's entry into the Scheme

Mascot Finance was one of the institutions considered in late 2008. Although Mascot Finance had applied for the guarantee on 15 October 2008, its application was not approved until early 2009 (mainly because there was a delay before the confirmation letter was received from the trustee – see Figure 8). Shortly after, on 2 March 2009, Mascot Finance was placed into receivership by Perpetual Trust Limited.

Although the Treasury and the Reserve Bank acknowledged that an NBDT failing under the Scheme was inevitable, the first failure so early in the Scheme was a surprise.

Figure 8
Application process for Mascot Finance Limited

Mascot Finance applied to join the Scheme on 15 October 2008 (the application letter was dated 14 October 2008). Mascot Finance was based in Timaru and primarily provided property loans (to developers and investors), and gaming and commercial loans.

About 57% of Mascot Finance's loans were to the property sector. Its total assets at 31 March 2008 were $137 million (compared with $183 million on 31 March 2007), with $26 million in impaired loans. At the time of its application, Mascot Finance did not have a current prospectus (it had been withdrawn in September 2008) and was in wind-down mode, although it still had debt securities on issue (with retail deposits of $98 million from about 5000 depositors at the time of application). A $650,000 standby facility from Westpac was withdrawn on 18 June 2008.

As part of each application, a letter was required from the trustee to confirm certain aspects of an NBDT's position. The Reserve Bank requested this letter on 24 October 2008. The letter, dated 16 December 2008, from Perpetual Trust Limited was sent to the Reserve Bank confirming that Mascot Finance had eligible debt securities on issue and that, other than the trust deed breach described below, there was no issue with solvency or Mascot Finance's ability to pay its debts. The letter described a breach of the terms of the trust deed in March 2008, discovered in May 2008, due to a misclassification of certain assets. This breach was rectified by 31 May 2008.

In addition, Perpetual Trustees had appointed an investigating accountant in September 2008 to look at Mascot Finance's financial position, provisioning, and level of bad debts. The accountant reported that, although Mascot Finance was to exit the industry, it was concerned about Mascot Finance's ability to meet cash flow needs. The accountant suggested selling a specific loan, getting additional security, or presenting a capital repayment plan to investors.

The Reserve Bank raised these issues with the trustee on 19 December 2008. The trustee had confidence in Mascot Finance's ability to continue to meet its obligations and noted that there had been no further impairment and no further breaches of the trust deed. Additional security was also obtained for the specific loan. Mascot Finance was considering re-issuing its prospectus and recommencing taking deposits if it was granted the guarantee. There was also anecdotal evidence that South Canterbury Finance would not let Mascot Finance fail (Mascot Finance and South Canterbury Finance shared a common home base of Timaru).

In a letter to the Secretary to the Treasury on 22 December 2008, the Reserve Bank confirmed that Mascot Finance was eligible for a guarantee and met all the criteria set out in the Policy Guidelines. The Reserve Bank also confirmed that:
… based on the material it has considered, and having considered other factors that might be relevant in coming to a decision as to whether or not to offer or refuse a Crown Guarantee, the Bank has no reason to believe that it would not be in the public interest and consistent with the maintenance of public confidence in New Zealand's financial system and the maintenance of confidence of general public depositors in New Zealand financial institutions, as referred to in the purpose of the Public Finance Act, the preamble to the deed and in the overarching principles of the Policy Guidelines, to invite the Entity to enter into a Deed of Guarantee with the Crown.

The Treasury held an internal meeting on 22 December 2008 to discuss the application. Those at the meeting considered the Reserve Bank's advice, the size and status of the institution, the advice from the trustee, the nature of the prior breach of the deed, and Mascot Finance's solvency position. The Treasury was concerned that public confidence would be affected if Mascot Finance was not covered by the guarantee. The conclusion was that it was necessary and expedient to provide a guarantee.

Mascot Finance's application was approved on 12 January 2009.

Mascot Finance experienced problems when a single large borrower failed to repay as expected. The institution was put into receivership on 2 March 2009.

Our assessment of the Treasury's handling of Mascot Finance Limited

The processing of Mascot Finance's application followed the steps that applied to all applications. The application took longer to process than some others (but this was mainly because of the delay in receiving the confirmation letter from the trustee).

When presented with information that could have possibly affected the outcome, the Reserve Bank went back to the trustee for more information. The Reserve Bank relied on the trustee's opinion that it was confident that Mascot Finance could continue to meet its obligations, which was consistent with the role of the trustee as the supervisor of Mascot. The Treasury relied on the advice of the Reserve Bank (which, again, was consistent with the terms of the service agreement and the expertise of the Reserve Bank) but also considered the issues surrounding the application, including the trustee's advice.

Mascot Finance clearly met the technical eligibility criteria as part of the Policy Guidelines (it had debt securities on issue, and provided financial services predominantly in New Zealand and not primarily to related parties).

However, based on the information provided by the trustee, in our view, a closer review of Mascot Finance's financial position was warranted. As discussed above, the process agreed between the Treasury and the Reserve Bank was that the Reserve Bank would not conduct a full due diligence check on the individual institution but would consider the information at hand that was relevant to the Policy Guidelines. The Treasury would then apply its positive assurance approach (see paragraph 4.28), relying on the Reserve Bank's advice as well as other information at hand. We consider that the concerns raised by the trustee constituted "information at hand" that warranted further review.

There is no question that both the Treasury and the Reserve Bank closely considered the issues raised by the trustee. The agreed process was followed (that is, making further inquiries when aware of any issues), and the issues raised in the letter from the trustee were pursued by telephone conversations between the trustee and the Reserve Bank. The outcome of that conversation was conveyed to the Treasury. In considering this information, the Treasury and the Reserve Bank relied significantly on the trustee and, in particular, on the trustee's confidence in Mascot Finance's ability to continue to meet its obligations.

In our view, the concerns raised by the trustee's investigating accountant about Mascot Finance's exit plans should have been further explored. We did not see evidence that the Treasury or the Reserve Bank met with the trustee or the investigating accountant to discuss the concerns or to conduct any further inquiries. The application was processed quickly once the trustee's advice was received. We consider that there was time to pursue further lines of inquiry given that some of the initial urgency associated with getting institutions into the Scheme should have been starting to subside. If further investigation had been pursued in early 2009, it is possible that the deterioration in Mascot Finance's financial position would have been more evident.

We realise that our comments are made with the benefit of hindsight. We also note that there were some signs in late 2008 that Mascot Finance's position was improving. Therefore, we are not suggesting that Mascot Finance should have been immediately declined based on the information at hand. This carried some risk, and could have had repercussions for the public confidence that the Scheme was designed to maintain. Rather, we suggest that additional information should have been requested about Mascot Finance's liquidity position to provide further assurance that Mascot Finance was able to meet its upcoming debt obligations. We also appreciate that the supervisory model involved relying on the trustee's advice. Nevertheless, in a borderline case, and in the light of industry concerns about the weaknesses of the trustee model, further inquiries should have been made.

Reviewing applications for the Scheme after the failure of Mascot Finance Limited

At the time of Mascot Finance's failure, media commentators, politicians, and others began questioning the Treasury's acceptance of Mascot Finance into the Scheme. Possibly because of this, or as a result of the easing of the financial crisis, the Treasury and Reserve Bank's emphasis on "other factors" when processing applications changed.

Until early 2009, the objective of depositor confidence was seen to be more important than concerns about credit quality or financial strength. As a consequence, applications were considered largely in the context of the "relevant criteria" in the Policy Guidelines.

Although not formally documented as a change, applications processed after February 2009 were more closely considered in terms of the riskiness of the institution. The "other factors" to be considered, such as creditworthiness and business practices, became more of a focus once eligibility was confirmed. The Treasury has told us that this change in focus reflected the fact that, by this time, the remaining applicants were generally higher risk institutions. A number of financial institutions were declined based on their high probability of failure and the potential for an increase in the cost to the Crown if they were accepted.

The change in emphasis occurred about the time that the Treasury increased its monitoring of individual institutions because the more straightforward applications had already been processed. The Treasury had started to receive risk reporting from the Reserve Bank about NBDTs under the Scheme (see Part 6). New Treasury staff with the skills needed to carry out this monitoring had also just started work.

With the failure of Mascot Finance and the need for the Treasury to pay depositors and wait to recoup funds, possibly at a loss, the financial implications of the Scheme had become clear. Although the objective of the Scheme was still maintaining depositor confidence, the Treasury started to place more emphasis on minimising the potential cost to the Crown.

We did not see evidence that the shift in emphasis was actively discussed in the Treasury or with the Minister. In our view, a change like this should be clearly documented and reported to the Minister.

16: Section 65ZD requires that issuance of a guarantee by the Crown in excess of $10 million must be published in the Gazette and presented to Parliament.

17: Report of the Commerce Committee, 2007/08 Financial Review of the Ministry of Economic Development, Appendix B.

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