Proposal for New Regulations on Capital, Related Party, and Credit Rating Requirements for Non-Bank Deposit Takers

IN CONFIDENCE 1 Office of the Minister of Finance PROPOSAL FOR NEW REGULATIONS FOR NON-BANK DEPOSIT TAKERS: CAPITAL, RELATED PARTY AND CREDIT RATING REQUIREMENTS The Chair Economic Growth and Infrastructure Committee PROPOSAL

1. This paper seeks the Committee’s agreement to the making of new regulations under Part 5D of the Reserve Bank of New Zealand Act 1989 (the Act), with respect to capital, related party, and credit rating requirements for non-bank deposit takers (NBDTs). EXECUTIVE SUMMARY
2. I propose that regulations be made for NBDTs on capital, related party, and credit rating requirements. These regulations will play a critical role in the new NBDT regime as they will help to enhance depositor confidence and promote sound risk management in NBDTs. The structure and calibration of the capital measurement framework reflects sound risk measurement principles essential for the prudent management and operations of NBDTs. The proposed related party regulation bears directly on enhancing sound governance as well as effective risk management. The credit rating regulations specify the type of rating that deposit takers must hold and are necessary to give full effect to the credit rating regime already legislated.
3. I am recommending the adoption of a simplified framework based on the banking regime for capital and restriction on related party exposures, taking into account the difference between banks and NBDTs. The capital measurement framework takes the Reserve Bank’s standardised capital adequacy framework for banks as a starting point and modifies it by a principled analytical approach to calibrate the framework. In this connection, I recommend that the minimum capital ratio be 8% of risk weighted exposures for NBDTs with a credit rating from an approved rating agency and 10% of risk weighted exposures for those without a credit rating from an approved rating agency.
4. The regulation on related party exposures provides that a limit on aggregate credit exposure of an NBDT or its borrowing group to all related parties (as defined in the Reserve Bank of New Zealand Act and regulations) must be fixed by agreement between the NBDT and the trustee and be specified in the trust deed, provided it does not exceed a maximum limit of 15% of capital. A transitional period of one year to comply with the regulatory requirements is recommended. BACKGROUND AND OVERVIEW
5. The proposed regulations are being introduced in line with the Reserve Bank’s role as the regulatory authority of NBDTs. The Reserve Bank is empowered to promote a sound and

IN CONFIDENCE 2 efficient financial system by ensuring that all NBDTs meet a transparent set of prudential standards. Aside from the proposed regulations on minimum capital ratio, related party restrictions, and credit rating requirements, the Reserve Bank has regulation making powers to require NBDTs to meet liquidity requirements. Governance and risk management requirements are direct impositions under the Reserve Bank of New Zealand Act. 6. In September 2007, when the Cabinet paper on the regulatory framework for NBDTs was prepared, the intention was that they would have to hold a minimum dollar amount of capital of $2 million but the capital ratio would be set by trustees, while the Reserve Bank’s role would be to put in place a capital measurement framework for trustees to follow. In the light of greater experience with industry (including trustees), and with Crown guarantee in place, a refinement is now recommended – that a minimum capital ratio requirement be required instead of a minimum dollar amount of capital. 7. Under existing arrangements, NBDTs are required to operate in accordance with the terms set out in a trust deed. NBDTs compliance with the conditions of the deed is supervised by a trustee. Most NBDT trust deeds already have some form of minimum capital adequacy ratio requirement to provide a constraint on an NBDT’s capacity to take risks which are excessive in relation to its capital. However, there are a number of problems with the trustee-based regime: • the trustee measurement frameworks are often unconventional, at times complex and difficult to understand, and vary from trustee to trustee; • some frameworks do not adequately capture NBDTs’ risks or take too permissive a view of what should count as capital; • even when the flaws in a given capital adequacy measure are apparent it is often difficult for trustees to renegotiate trust deeds to effect improvements; and, • a competitive market for trustee services can place downward pressure on standards. 8. As a consequence, it is difficult for the market to assess the risk of NBDTs, and to compare one NBDT with another, and many NBDTs adopted risky strategies that were not apparent to depositors and which resulted in wide spread failures with large economic losses. 9. At present, there is no requirement for trust deeds to meet a minimum capital adequacy standard. This has tended to generate capital ratios that are below socially optimal levels. The capital ratio for NBDTs will be set at a level that takes account of the private costs and benefits to the NBDT. It will ignore the costs of a default of an NBDT on the rest of the sector (through contagion1

1 Contagion is the transmission of a financial shock in one entity to other independent entities. ) and on the broader economy if there is widespread failure in the sector. The effect of the deposit guarantee scheme will also generate socially sub-optimal capital decisions. Even if it is fully withdrawn it will increase expectations of a future bailout of depositors should the sector get into trouble. If some

IN CONFIDENCE 3 of the future costs of failure are expected to fall on the Crown, NBDTs will run riskier strategies. 10. Currently, the investing public has lost confidence in parts of the sector (particularly finance companies) and there is a risk of further losses of confidence if ostensibly well capitalised NBDTs run into trouble. In the absence of a prudential framework that the public can have confidence in, some depositors may refuse to invest in apparently well capitalised NBDTs because traditional risk measures have proved so misleading and they do not have a reliable benchmark that signals prudent capital management. 11. The underlying, high-level case for introducing a prudential regulatory regime for NBDTs was established prior to the implementation of the legislation. The primary concerns surrounded the absence of minimum entry requirements, inconsistency in governance and prudential requirements across NBDTs, inadequate official oversight of trustee supervision, inadequacies in public disclosures, and insufficient means for investors to assess and compare NBDT risk profiles. 12. The capital adequacy framework is intended to address these problems. It will help ensure that risk is more clearly and consistently reported and will help reduce the likelihood of failure by ensuring that all NBDTs have to meet a minimum capital ratio requirement. 13. Along with relatively weak capitalisation, excessive related party exposures were (and are still) a feature of the NBDT sector. Related counterparties are entities linked via collective or common ownership, financial linkages or interdependency, or generally whereby one party significantly influences the other such that one of the parties is less able to pursue its own independent interest. However, there may be good reasons to pursue related party transactions particularly for conglomerates or large banking groups. An example would be in order to optimise expertise or opportunities (such as access to liquidity or the capital market) present in certain parts of the group, thereby lowering overall cost. Thus, in principle, related party transactions can be beneficial. 14. As observed in practice however, a related party relationship could be abused to take advantage of the connected relationship. This often does not serve the NBDT’s best interest. Some of these activities are undertaken for sound commercial reasons, but some appear not to have been arranged on a totally arms-length basis, despite pronouncements to the contrary. Unlike banks which are prudentially regulated, NBDTs have not been subject to any minimum standards, governance requirements nor any form of regulatory constraints, prior to the introduction of the regime.2 15. The proposed capital ratio and capital measurement framework has three main components. They are:

• definition and measurement of capital; • definition and measurement of risk exposures; and,

2 The RIS for the recommended related party regulations (appended) provides a stylised overview of possible methods or approaches to connected practices, as well as some illustrated examples of related party activities undertaken in recent times.

IN CONFIDENCE 4 • setting a minimum capital adequacy ratio. 16. The scope of related party regulation includes: • refinements to the definition of a related party; and • setting a maximum limit on aggregate exposure to related parties. 17. The Act provides for regulations to specify the type of rating that a deposit taker must have of its creditworthiness. In this paper I recommend that regulations be made to specify the type of rating be a local currency, long term, issuer rating. PROPOSALS FOR CAPITAL, RELATED PARTY, AND CREDIT RATING REGULATION Principles and considerations in drafting regulation 18. In recommending regulations for the NBDT sector, the Bank is required to do so in a manner that is consistent with the broader objectives in the Act. In addition, section 157F of the Act requires the Reserve Bank to take account of the following principles when carrying out its functions under Part 5D: a) the desirability of consistency in the treatment of similar institutions, regardless of matters such as their corporate form; b) the importance of recognising: i. that it is not the purpose of this part to eliminate all risk in relation to the performance of NBDTs or to limit diversity among NBDTs; and ii. that depositors are responsible for assessing risk in relation to potential investments and for their own investment choices; c) the desirability of providing to depositors adequate information to enable them to assess risk in relation to potential investments and to distinguish between high￾risk and low-risk NBDTs; d) the desirability of sound governance of NBDTs; e) the need to avoid unnecessary compliance costs; and, f) the need to maintain competition within the deposit taking sector. 19. These principles sometimes push in different directions and the design of the framework has been a matter of balancing these principles. The Reserve Bank has had regard to the statutory principles, and sought to design a framework that is consistent with the following high-level considerations: • the need for the framework to apply to a diverse set of institutions ranging from finance companies with balance sheets of around $2 billion to credit unions with assets of less than $1 million; • the desirability of leveraging off the existing bank standardised regime where appropriate. This is based on well tested capital adequacy design principles

IN CONFIDENCE 5 and would allow risk to be compared across the financial sector and help maintain competitive neutrality across the banking and NBDT sectors; • the need for simplicity. The regime must be able to be understood and implemented at low cost by the smallest NBDT; • the need to have regard to lessons from the New Zealand NBDT sector experience of the last two years and relevant lessons from the international financial crisis; • the desirability of the structure and calibration of the framework reflecting sound risk measurement analytical principles; and, • the reality that the government deposit guarantee scheme will impact on the efficiency of the NBDT sector. 20. I also understand from the Reserve Bank that while the regime has calibrated to suit the wider sector, they expect that in certain cases applying the regime may be unduly onerous for a given NBDT – possibly because of specific circumstances that the regime was not designed for (the section on “Industry consultation and impact” discusses this in more detail). Accordingly, the Reserve Bank expects that it will grant exemptions that are consistent with the principles it is expected to operate to under the Act, on a class or case-by-case basis (a particular example is discussed in the second-to-last bullet point of paragraph 43). Minimum Capital Ratio Requirement and Capital Measurement Framework 21. The calibration of the minimum capital ratio is a key element of the regulation. It is my view that the ratio has been set at a level that is credible but is not so high as to unreasonably reduce the array of risk models that might be presented to investors. Henceforth, I believe markets will demand better capitalised NBDTs and that the effect of the minimum ratio will be to crystallise preferences around a new benchmark rather than constrain them. Another point to note is that a capital ratio is only one factor that impacts on a financial institution’s risk (other factors may include the strength of the franchise, risk management systems and controls), and in particular, how this risk is conveyed to investors through a credit rating. 22. A robust capital regime will help restore confidence in the sector, allowing a well managed and well capitalised NBDT to compete for funds from those who are comfortable with their risk profile. On the other hand, the main issue with a Reserve Bank imposed minimum ratio is that it generates tension between two competing concerns. If the minimum is set too low then there is a risk that this will be interpreted as the Reserve Bank’s view of an adequate capital ratio and encourage those with a higher ratio to reduce the amount of capital they hold. If, on the other hand, the ratio is set too high, it reduces or constrains the available range of business models in the market. These concerns point to the appropriateness of the calibration of the minimum ratio. 23. The Reserve Bank is also the prudential regulator and supervisor of registered banks in New Zealand, and I understand that the calibration of the exposure risk weighing structure of the capital adequacy regime for NBDTs is based on the following: a. Reserve Bank-estimated models with well defined analytical structures;

IN CONFIDENCE 6 b. experience with regulating credit risk in the broader deposit-taking sector (including an understanding of the nature of risk in loan and asset portfolios); c. knowledge of the relative performance of banks and NBDTs over the recent economic downturn; and, d. industry practice, as expressed in the capital requirements in current NBDT trust deeds. 24. The capital ratio is calculated by dividing the NBDT’s capital by its risk weighted exposures. I recommend a minimum capital ratio be set in regulation at a level of 8% of capital for the following reasons: a. This is around the average of actual bank tier one capital ratios; b. Relatively weak capitalisation has contributed to an unacceptably high failure rate among NBDTs over the last two years; and, c. The government deposit guarantee scheme means that it is now more important to have a robust minimum capital ratio requirement to offset some of the distortions generated by the scheme, such as weaker incentives upon depositors to monitor NBDTs’ performance. 25. Every NBDT and trustee must ensure that the trust deed includes the minimum capital ratio requirement that the NBDT must maintain. This ratio must be calculated in accordance with the framework set out by the Reserve Bank. The specified minimum capital ratio requirement of 8% will apply to NBDTs with a credit rating from an approved rating agency. For those without a credit rating from an approved rating agency, the minimum capital ratio requirement is set at 10%. Related Party Requirement 26. Capital adequacy and restrictions on connected lending are directly linked, as capital represents owners’ funds at risk. Having a cap on lending to related parties limits the scope and ability of owners, and their related interests, to extract benefits from the NBDT. Capital requirements are intended to ensure that owners have strong incentives to manage risks prudently. Connected exposures can undermine this objective if owners and other related parties can in turn secure loans from the NBDT they own or control, thereby effectively reducing the net invested funds at risk. 27. Part 5D of the Act sets out the definition of a related party in relation to a NBDT and further provides for regulation to extend the definition and restrict related party exposures. The Act defines related parties to include parent entities or owners and persons who control or have significant influence; subsidiaries; directors; senior office holders, and their relatives. 28. The proposed expanded definition of related parties includes the following: • entities where owners have control (sister subsidiaries), and persons with substantial interest in owners (ultimate shareholders), and,

IN CONFIDENCE 7 • entities with interlocking directorates, referring to entities where 40% or more of the directors are also directors of the NBDT and/or of an entity with a substantial direct or indirect interest in the NBDT, including sister subsidiaries. 29. The aggregate credit exposure of the NBDT or the borrowing group to all related parties must be specified in the trust deed and fixed by agreement between the NBDT and the trustee, provided it does not exceed a maximum limit of 15% of capital. Credit Rating Requirement 30. From 1 March 2010, all NBDTs will have to have a rating of their creditworthiness of the type specified by regulation. NBDTs must obtain their ratings from a rating agency that is approved by the Reserve Bank. In March 2009, the Reserve Bank approved three rating agencies for this purpose: Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s Ratings Services. 31. I note that the Reserve Bank proposes to exempt smaller deposit takers – those with less than $20 million in liabilities – from the requirement to hold a rating. This threshold was set after reconsidering an earlier proposal for the measure to be $10 million in assets in view of the costs of ratings relative to the size of businesses involved. 32. To give effect to the credit rating regime established in the Act, I recommend regulations be made under section 157K to specify that the type of credit rating a deposit taker must have and what the rating relates to be a local currency, long term, issuer rating. The regulations would not restrict deposit takers from obtaining other ratings according to their business needs (for example, a foreign currency rating or a short term rating). I note that these credit rating regulations are of a minor or machinery nature and are necessary to give effect to policy already enacted. INDUSTRY CONSULTATION AND IMPACT 33. Over the past several months, the Reserve Bank had been consulting on its proposed policies on the capital ratio, related party, and credit rating requirements. The formal consultation papers were posted on the Bank’s website to reach a broad audience and allow the general public to make submissions on the proposal. The Bank received forty￾one written submissions for capital and related party policies, and 13 for the draft credit rating requirements. Consultation meetings were held in Auckland, Wellington, and Christchurch in February 2009, and were well attended. 34. Moreover, significant engagement has continued with industry since the close of the consultation period, with a number of further significant changes now being recommended in the light of engagement with industry. 35. I am advised that there was good support from industry and stakeholders for the overall intent of the policy and draft regulations. Overall, they welcomed the introduction of regulations and were broadly supportive of the proposed framework for capital measurement and minimum capital ratio, related party, and credit rating requirements.

IN CONFIDENCE 8 Respondents commented generally on the basis of the provisions of the draft regulations that would materially affect their performance, business model, or structure. (The appended RIS details a number of specific concerns raised in the submissions and the Reserve Bank’s responses.) 36. Broadly speaking, and based on submissions received and direct engagement with industry, I am advised by the Reserve Bank that: • Credit unions are largely comfortable with both capital and related party regulations. The bigger concern for this sector had been the credit rating requirement, although this issue is very likely to disappear for all but one or two credit unions once the NZACU puts in place a cross guarantee. This arrangement will enable participating members to be rated as a part of the group, thereby spreading costs. There are one or two credit unions that sit just above the 20 million dollar liabilities threshold for a credit rating and are not likely to participate in the cross guarantee arrangement. I am advised by the Reserve Bank that they expect to receive an exemption application from such entities, which will (in-principle and without prejudging their decision) be likely to have merit on the basis of the costs of a credit rating being unduly onerous in net revenue terms given their business model. • The building societies are generally supportive of the regime and the capital and related party regulations. Most of the building societies remain conservative in their business practices, are mostly rated already, and are supportive of a capital regime that distinguishes clearly the different risk profiles in the NBDT sector. • While the majority of finance companies supported more regulation in the sector, a small number face challenges meeting the proposals (and would indeed face challenges meeting far less conservative requirements). Most of the concerns raised with the calibration of the capital and related party policies come from a few companies that are currently quite a distance from compliance. 37. The Reserve Bank has assessed where the stress of the recommended regulations will fall in the industry: • Credit unions: compliance with the proposed capital requirements is not an issue for credit unions, with the industry average tier one capital ratio sitting at 14.2 percent as at May 2009, with all credit unions above the 8 percent recommended minimum capital ratio.

IN CONFIDENCE 9 Figure 1: Tier one capital ratios3 • Building societies: Eight out of the nine building societies are already above the minimum required, and the industry average was 10.9 percent as at May 2009. The one building society that is below the proposed 8 percent, is close to 8 percent, and would not be expected to have any particular difficulties in meeting the requirement. • Finance companies: By number most finance companies are already above the 8 percent, but the industry average is skewed by some of the bigger players. Of the larger finance companies – that is, over 100 million dollars of assets – three companies (UDC, Medical Securities, and PGG Wrightsons Finance) would already be compliant or are unlikely to have issues in becoming compliant. On the other hand, three companies (South Canterbury Finance, Marac, and Allied Nationwide Finance) are likely to require substantial capital injections and / or restructuring, or have a longer path to compliance by way of exemption. F&P Finance may also require a small capital injection to become compliant. Of the smaller finance companies, 10 of 13 are over 8 percent and therefore would be expected to be compliant. The remaining three non-compliant companies face significant challenges, but this is related to the poor quality of their books, and the consequent challenges they are likely to face in raising capital (rather than the capital regime per se). 3 Tier one capital instruments are primarily ordinary shares and retained earnings. Non-cumulative preference shares, which meet certain requirements that give them strong equity like characteristics, qualify as tier one capital but are restricted to a limit of 25 percent of that capital.

IN CONFIDENCE 10 38. On balance, the proposed capital requirements are not considered to be unduly conservative. Moreover, I note that while the Reserve Bank recommends the capital and related party regulations come into place by September 2010, the Reserve Bank has the ability to allow longer transition paths for NBDTs on a case-by-case basis. However, should this be required, it can be anticipated that these would amount to a relatively small number given the capital position of most of the NBDT sector. Related party exposures 39. The industry, with one or two exceptions, has not been particularly concerned with the proposed restrictions on related party lending, and has generally welcomed regulations in this area. Figure two, below, illustrates that compliance with the requirement that aggregate credit exposure of the NBDT to all related parties must not exceed 15 percent of capital (the dotted line) is not expected to be problematic. The exception is South Canterbury Finance, which will need a significant restructuring of its connected exposures. Figure 2: Related party lending to capital ratio – average by sub-sector CHANGES TO POLICY FOLLOWING INDUSTRY CONSULTATION 40. The majority of submissions focused on the need to recalibrate the risk weights for asset classes in the capital measurement framework, with refinements being more sensitive to the risk profile of NBDTs in relation to the markets they serve. The main comment received regarding the related party requirement was on the threshold for director interlocks, with submitters suggesting an increase in the threshold from 20% to 40%. The ratio refers to the minimum threshold or proportion of directors or members of the governing body of the NBDT and/or its related parties, and another entity for them to be deemed as related parties. 41. Taking into account the main thrust of the submissions, key changes are now being recommended in the proposed regulations. Risk weights for credit exposures have been

IN CONFIDENCE 11 recalibrated with provision for increased granularity in risk weights for sub-classes within an asset category such as residential mortgage loans, ‘other lending’ and ‘other assets’, differentiated according to loan type, security, and other factors. 42. Before turning to the recommended changes as a result of consultation, it is worth making a general point and that is the plea from industry for a broadly comparable regime across both the bank and NBDT sectors. In particular, some submitters have pointed to perceived differences between the bank and NBDT calibrations. The Regulatory Impact Statement addresses this issue in more detail. However I understand from the Reserve Bank that broadly, and on average, loan portfolios with similar risks are treated similarly in the bank and NBDT sectors. 43. Banks do get some capital concessions because they have spent considerable resources and time more finely differentiating risk than would be possible or necessary for NBDTs. In the Reserve Bank’s view, some concession is appropriate because this work should mean that those banks can better manage their risks. However, there are some specific cases where the banks have materially lower capital because the advanced bank models (under Basel II) still need to improve. The advanced model regime is relatively new and the Reserve Bank has not, as yet, had the opportunity to address all of the teething problems that have come to its attention. I understand that by the time the NBDT regime comes into effect, however, these issues should have been addressed and the two regimes will be broadly competitively neutral. The main features of, and changes (as the result of consultation) to, the recommended capital, related party, and credit rating requirements follow: Capital measurement framework --risk weights • More finely calibrated and differentiated set of residential mortgage risk weights – the risk weights have been generated using a regionally-calibrated version of the Reserve Bank’s capital model and differentiated according to the type of security and the loan-to-valuation ratio (LVR), which is the ratio of the loan relative to the property value estimated using independent valuation. There are now seven sub￾categories within the residential mortgage loan category. • The ‘other lending’ category has been further divided into personal lending, operating leases, and property development lending. Risk weights are now differentiated by lending type and by security. Property development lending has a higher array of risk weights, differentiated by security type. • The delinquency or past due loans risk weight category for housing and other loans has been dropped as the point is to have sufficient capital well ahead of a stress event, rather than a requirement that increases capital in the midst of a stress event. • The initial proposal for ‘other assets’ risk weight was 500%. This category applies mostly to assets such as furniture and office equipment that support the finance business, as well as nonfinancial assets such as buildings or other assets (often designed to boost reported equity). The high risk weight was aimed at discouraging NBDTs from placing risky non-financial assets on their balance sheet. Respondents, on the other hand have argued that the weight was overly punitive, considering that some NBDTs own their office buildings. The risk

IN CONFIDENCE 12 weight is recommended to be scaled down to 350% which is the appropriate weight for property exposures that dominate this category. As well, it is still high enough to draw attention to the capital cost of non-property ‘other assets’. Capital measurement framework- eligible capital instruments • I am recommending only one tier of capital for the following reasons: a. Tier one capital is the only form of capital that is permanently and freely available to absorb unanticipated losses without the institution being obliged to cease trading. Tier two instruments primarily have value in reducing the extent of losses in the event of failure. b. The international regulatory community is moving towards a greater emphasis on tier one capital. c. A single tier regime is simpler than a multi-tier regime. d. Tier two instruments and other subordinated debt have, in recent years, often been marketed to relatively unsophisticated investors who have not understood the nature of the risks of these instruments. e. Very few NBDTs have tier two capital. • I note that credit unions have requested a more permissive regime because of their inability to raise capital by the issue of ordinary shares. I agree that it is appropriate to take a more permissive approach to ‘mutuals’ because they cannot issue ordinary shares. The initial proposal sets a limit of 25% on qualifying hybrids within total capital, in line with the bank framework. Therefore, I recommend this limit be raised to 50% for ‘mutuals’. • I also recommend that there be no change in the boundary between qualifying and non-qualifying capital instruments. One or two NBDTs have raised tier two capital, and I understand from the Reserve Bank that they intend ‘grandfathering’ such capital – by way of an exemption – for up to five years, provided: i. It counts as equity for solvency purposes; ii. It is no more than 50% of total qualifying capital; and, iii. It was issued before 1 January 2009. • This is to acknowledge the fact that capital recognition has been altered and that there is an economic cost in replacing existing capital. A grandfathering period of five years for qualifying tier two instruments is intended to materially reduce the cost of sourcing capital and takes into account the state of the New Zealand and international capital markets. Related party requirements • In the draft regulation on restriction of related party exposures, the threshold for director interlocks is recommended to be raised from 20% to 40%. This means

IN CONFIDENCE 13 that if 40% or more of the directors of an entity are also directors of the NBDT, its sister subsidiary, or an entity with a substantial direct or indirect interest in the NBDT, they will be considered related parties under the interlocking directorate provision of the proposed regulation. This particular provision was designed to minimise or avoid possible conflicts of interest, particularly when a loan granted to a company where an NBDT’s director also sits as director, goes bad. Most of the submissions received in this area noted that the threshold was set too low in the light of the small size of the market and limited pool of qualified directors in NZ. Credit rating requirements • Submissions were broadly supportive of the type of credit rating proposed by the Reserve Bank in its consultation paper. No changes were required to the proposed policy for local currency, long term, issuer ratings. • The main area of concern in relation to ratings was not with the proposal for the type of rating that would be required but rather was with the size threshold for exempting smaller deposit takers. This was responded to separately by the Reserve Bank, which proposes to exempt deposit takers with less than $20 million in liabilities instead of an earlier proposal to exempt those with less than $10 million in assets. 44. Finally, as regulations for capital requirements will be complex by nature, I am advised by the Reserve Bank that it would be prudent to consult on an exposure draft of the regulations. The Reserve Bank intends doing this over the next two months. Reserve Bank / Trustee relationship 45. Concerns about the performance of trustees have been raised over the last year or so in a number of quarters. The Reserve Bank believes that the model of trustee as ‘frontline supervisor’ can be made to work, especially as the proposed regulations now remove much of the discretion to set minimum capital. That is, without any clear minimum requirements, the trustee model historically resulted in a lack of consistency, transparency and capital adequacy. That will no longer be the case under the recommended regulations. Indeed, the capital and related party proposals would be the same if the Reserve Bank was the supervisor of the NBDT sector, rather than just the regulator. Moreover, as well as being the regulator, the Reserve Bank will also exert influence over the trustees’ supervisory behaviour. 46. In this sense, the public should have more confidence in the new model, and relying on trustees to monitor and continue to run the trust deed regime appears workable. Of course, the Reserve Bank is required to assess how well this model is working with the

IN CONFIDENCE 14 ‘five year review’ it is required to complete by 2013 – with the performance of trustees being a central component of the review. FINANCIAL IMPLICATIONS 47. Any expense arising from the proposal will be met within the Reserve Bank’s funding agreement. HUMAN RIGHTS IMPLICATIONS 48. The proposal is not inconsistent with the New Zealand Bill of Rights Act and the Human Rights Act 1993. LEGISLATIVE IMPLICATIONS 49. The proposal in this paper will require the drafting of regulations under the Reserve Bank of New Zealand Act. CONSULTATION 50. The following government agencies were consulted in the preparation of this paper: Treasury, Ministry of Economic Development, Securities Commission, and the Department of Prime Minister and Cabinet. In addition, selected stakeholders have been consulted on the substance of the changes from the original consultation paper, as noted in the section “Industry Consultation”. REGULATIORY IMPACT ANALYSIS Capital adequacy requirements 51. A Regulatory Impact Statement (RIS) has been prepared, and the regulatory impact analysis (RIA) and RIS have been independently reviewed by the Treasury’s Regulatory Impact Analysis Team (RIAT). RIAT considers the analysis to be adequate according to the adequacy criteria, and the RIS contains the required information and accurately reflects the analysis undertaken. 52. The Reserve Bank confirms that the Regulatory Impact Statement was circulated with the Cabinet paper for departmental consultation, and that it has complied with the principles of the Code of Good Regulatory Practice and the regulatory impact analysis (RIA) requirements, including the consultation RIA requirements.

IN CONFIDENCE 15 Related party requirements 53. The proposal will not have significant impact on economic growth, nor will it affect competition or availability of finance for businesses and is not contentious. The Reserve Bank confirms: • That the principles of the Code of Good Regulatory Practice and the regulatory impact analysis requirements, including the Regulatory Impact Statement requirements, have been complied with. • The Reserve Bank considers the Regulatory Impact Statement to be adequate. Credit rating requirements 54. Regulations for the type of rating are required to give effect to the credit rating regime already enacted. These regulations are of a minor or machinery nature and do not require a Regulatory Impact Statement. PUBLICITY 55. The Reserve Bank will notify NBDTs and trustees when the regulation is made and will put a statement on the Reserve Bank’s website (accompanied by a press release). The Reserve Bank also intends to undertake extensive engagement with industry and trustees to assist both groups of stakeholders to fully understand the regulations. No other publicity is planned. RECOMMENDATIONS The Minister of Finance recommends that the Committee:

1. note that in making regulations under part 5D of the Reserve Bank of New Zealand Act, the Bank must take into account a set of principles set out in section157F(2);
2. note that section 157S(1) provides that the Governor-General may, by Order in Council, on the advice of the Minister given in accordance with a recommendation of the Bank, make regulations for the purpose of imposing a requirement that NBDTs and trustees ensure that trust deeds include a capital ratio, calculated in accordance with a prescribed framework, that the NBDT must maintain;
3. note that section 157V(1) provides that the Governor-General may, by Order in Council, on the advice of the Minister given in accordance with a recommendation of the Bank, make regulations for the purpose of imposing a requirement that NBDTs and trustees ensure that trust deeds include a maximum limit on exposures to related parties;

IN CONFIDENCE 16 4. note that in relation to rating of creditworthiness required to be held by NBDTs, section 157K provides that the Governor-General may, by Order in Council, on the advice of the Minister given in accordance with a recommendation of the Reserve Bank, make regulations for the purpose of providing for the type of rating and what the rating relates to; Summary of main features 5. agree that the Minister of Finance advise the Governor General to make by the regulations by Order in Council in accordance with the Reserve Bank’s recommendations for a minimum capital ratio and capital ratio measurement framework, related party exposure, and credit rating requirements, as listed below: Minimum capital ratio requirement and capital measurement framework 5.1 Regulation to specify every NBDT and trustee to ensure that the trust deed includes the minimum capital ratio requirement that the NBDT must maintain and which is calculated in accordance with the framework set out by the Reserve Bank; 5.2 Regulation to specify the minimum capital ratio requirement to apply in respect of the NBDT or the borrowing group of which the NBDT is part, if applicable; 5.3 Regulation to specify the minimum capital ratio requirement for NBDTs with a credit rating from an approved rating agency be set at 8% of risk weighted exposures and for NBDTs without a credit rating from an approved credit rating agency, it be set at 10% of risk weighted exposures; 5.4 Regulation to specify the methodology for the calculation of the capital ratio; Definition and form of capital 5.5 Regulation to specify the type or form of eligible capital instruments and the deductions from capital; 5.6 Regulation to specify the methodology for the calculation of capital; 5.7 Regulation to specify the limit on qualifying hybrid capital for mutuals and for other NBDTs; Risk exposures definition and measurement 5.8 Regulation to specify the risk weights for on-balance sheet assets as listed in table one below;

IN CONFIDENCE 17 Table 1: Risk weight for on-balance sheet assets On-balance sheet assets Risk weight Cash (notes, coins and gold bullion held on site) 0% Crown and the Reserve Bank (claims) 0% Public sector entities (claims) 20% Banks (claims) 20% Corporate short-term Corporate (short-term claim with rating grade 1) 20% Corporate (short-term claim with rating grade 2) 50% Corporate (short-term claim with rating grade 3) 100% Corporate (short-term claim with rating grade 4) 150% Corporate (short-term unrated claim) 150% Corporate long-term Corporate (long-term claim with rating grade 1) 20% Corporate (long-term claim with rating grade 2) 50% Corporate (long-term claim with rating grade 3) 100% Corporate (long-term claim with rating grade 4) 100% Corporate (long-term claim with rating grade 5) 150% Corporate (long-term claim with rating grade 6) 150% Corporate (long-term unrated claim) 150% Residential mortgage loans Residential mortgage loans (first ranking with loan-to￾valuation ratio not exceeding 70%) 35% Residential mortgage loans (first ranking with loan-to￾valuation ratio greater than 70% but not exceeding 80%) 50% Residential mortgage loans (first ranking with loan-to￾valuation ratio greater than 80% but not exceeding 90%) 100% Residential mortgage loans (first ranking with loan-to￾valuation ratio greater than 90% but not exceeding 100%) 125% First ranking with loan-to-valuation ratio greater than 100% 150% Second mortgage residential loans 150% Insured housing loans 20% Property development loans Property development loans (first ranking with loan-to￾valuation ratio not greater than 60%) 150% Property development loans (first ranking with loan-to￾valuation ratio greater than 60% but not greater than 100%) 200%

IN CONFIDENCE 18 Property development loans (where there is second or subsequent ranking security, no security and others) 300% Personal loans Personal loan registered as a security interest -PPSR 100% Unsecured personal loans 150% Other loans secured by first mortgage over land and/or buildings First ranking, with loan-to-valuation ratio not greater than 70% 100% First ranking, with loan-to-valuation ratio greater than 70% but not greater than 100% 150% Other loans not secured by first mortgage over land and/or building Registered as a security interest -PPSR 150% Unsecured or other security 200% Moveable machinery Loans registered as a security interest (on the PPSR), with a loan-to-valuation ratio not greater than 70% 100% Operating leases 175% Equity holdings (not deducted from capital) 600% Other assets 350% 5.9 Regulation to specify the methodology for the calculation of the total value of risk-weighted on-balance sheet assets; 5.10 Regulation to specify the methodology for the calculation of the total value of risk-weighted off-balance sheet credit exposures; 5.11 Regulation to specify the methodology for calculation of credit-equivalent amounts for an off-balance sheet exposure to include the credit conversion factor and the risk weights for off-balance sheet credit exposures; 5.12 Regulation to specify the methodology for the calculation of credit risks, operational and market risk exposures; 5.13 Regulation to specify calculation of risk-weighted exposures as the sum of credit risk exposures, operational risk exposures and market risk exposures; 5.14 Regulation to specify the treatment of certain assets when calculating risk￾weighted exposures; 5.15 Regulation to specify that credit assessments from approved rating agencies may be used to determine rating grades for calculating risk-weighted exposures; 5.16 Regulation to specify the calculation of loan-to-valuation ratio for residential and commercial properties;

IN CONFIDENCE 19 5.17 Regulation to specify treatment of funds management, securitisation and loan transfers in the capital measurement framework; Related party requirements 5.18 Regulation to declare a person or class of persons as related parties of a NBDT and the borrowing group to which the NBDT belongs; 5.19 Regulation to require a limit on exposures to related parties which must be fixed by agreement between the NBDT and the trustee and included in the trust deed; 5.20 Regulation to specify that the maximum limit on exposures to related parties be calculated in respect of the NBDT or the borrowing group of which the NBDT is part, if applicable; 5.21 Regulation to specify a maximum limit on exposures to related parties to be set at 15% of capital, calculated in accordance with the capital measurement framework; 5.22 Regulation to specify the methodology for the calculation of the percentage of exposures to related parties; 5.23 Regulation to define what constitutes an exposure to a related party; and, Credit ratings 5.24 Regulations to specify the type of rating a deposit taker must have and what the rating relates to as a local currency, long term, issuer rating. 6. agree for the Minister of Finance to direct officials to provide drafting instructions to the Parliamentary Counsel Office to give effect to the decisions above. Hon. Bill English Minister of Finance Date signed: