IMF reports on Guernsey - a depositor's reaction

IMF reports on Guernsey - a depositor's reaction

You wouldn't know it from the upbeat press releases issed by GuernseyFinance and the Policy Council but the long shadow cast by the fallout from the collapse of a Guernsey-registered GFSC-regulated bank in 2008 dominates the majority of the reports on Guernsey released in January 2011 by the IMF. The reported entitled 'Financial Sector Assessment Program Update - Detailed Assessment of Observance of Basel Core Principles', which is worthy of particular note in this connection, states the following:

“16. ...In late 2008, the Guernsey subsidiary of the Icelandic group, Landsbanki was placed in administration when the bank was unable to draw down funds placed elsewhere in the group to meet escalating deposit withdrawals. An official enquiry has reported to the Guernsey government on the supervision of Landsbanki. Some 1,600 depositors had £120m on deposit and there was at the time no compensation scheme. To date, recoveries have amounted to around 70 percent.”

A copy of this “official enquiry” was no doubt supplied to the Guernsey government, but the report was commissioned and paid for by the GFSC and conducted under its own terms of reference with no witnesses summoned and only a carefully redacted version released. What depositors have been calling for is a fully-independent Select Committee-type inquiry such as those conducted in the UK, the Isle of Man and even Iceland. Why has the Guernsey government steadfastly refused to do so?

“17. The authorities have responded to the crisis events with regulatory change and a new deposit insurance scheme. The GFSC has strengthened its approach to banks’ exposure to parents - disclosure requirements (to inform depositors on the exposure to parents, exposure limits (set individually by bank) and contingency planning (for problems at the parent). Depositor compensation, which had long been provided for in law but not implemented, was introduced from November 2008.”

Now that the GFSC has strengthened its approach to banks’ exposure to parents it needs to do likewise with banks’ exposure to sister entities which share the same parent e.g. Heritable Bank. A depositor compensation scheme was rushed in after Landsbanki Guernsey Ltd (LGL) collapsed despite having been a strong recommendation of the Edwards report ten years earlier. Curiously there was no mention of LGL in the billet d'etat, the States of Guernsey bill proposing the new legislation.

“21. The deposit insurance scheme covers deposits, mainly those from retail depositors, wherever located, up to £50,000 per person. It is not funded, although it has government guaranteed liquidity back-up... The maximum total amount of compensation is capped at £100 million in any five year period. It will be paid for by the banks through annual charges and special charges in the event of a bank failure. The precise modalities of the funding mechanism remain under discussion.”

Let’s hope they can complete these discussions and finalise the precise modalities of the funding mechanism before another Guernsey bank goes under.

“22. The GFSC now conducts a program of on-site supervision, supported by off-site analysis.”

Now? Does this mean that the GFSC did not conduct any on-site supervision at all at the time of the Landsbanki Guernsey Ltd collapse?

“28. The GFSC cooperates with the home supervisors of institutions active on the island. Numerous memorandums of understanding (MOU) with supervisors abroad have been signed to address both on-going supervision and information exchange. Information is in fact exchanged, and regular visits to and from the home supervisors are undertaken, including for the purpose of on-site supervision. However, as experience in the recent past has shown, the asymmetry in the relationship between the GFSC and certain “home” regulators severely limits the benefit that the GFSC can draw from cooperation with them.”

The GFSC relied on third-party unsubstantiated assurance from the FSA that Heritable Bank in the UK was ring-fenced from Icelandic risk instead of carrying out its own due diligence, which would have clearly shown that it wasn’t. How could Heritable have been ring-fenced from Icelandic risk when it shared the same parent, Landsbanki hf?

“29. Several broad areas for further action have been identified. Primarily, these require primary or secondary legislative changes and the latter’s consequent practical application. In these regards:

(i) CP 4 “Transfer of significant ownership” requires that the GFSC be given power to review and, if necessary, rescind, transfers of controlling interests in licensed banks.

(ii) A similar power for the GFSC is required by CP 5 ‘Major acquisitions’. ”

A clear reference to Cheshire Guernsey Ltd. Adherence to Core Principle 5 would have prevented the sale of safe Cheshire savings to an Icelandic bank that no Cheshire Guernsey depositor is likely to have heard of at the time and which we now know was doomed at the time of the sale in August 2006.

“(iii) For CP 9, the GFSC should have the explicit power to require that a bank increase its level of provisioning and, if necessary, its overall financial strength.

(iv) Given the related party lending which characterizes the business model favored by several major participants in the Guernsey banking industry, large exposure limits (CP 10) should be applied on a consolidated basis and all transactions with banks’ related parties should receive prior board approval and be on market terms (CP 11).”

Low marks for CP 10 observance.

“Recommended Action Plan to Improve Compliance with the Basel Core Principles

“CP 4 Amend law so GFSC has power to review, object to and reject any proposal to transfer a “significant ownership” interest.

CP 9 Commission should get authorisation to require banks to increase their levels of provisions.

CP 10 The Commission should continue to restrict large limits of banks to their parents in relation to their own capital approaching the 25 % limits to all banking exposures.”

Again, the Guernsey bank failed because of its exposure to a sister bank in London and not directly as a result of exposure to the parent. Although the deposit with the parent is regrettably likely to have been lost in its entirety, the amount was much lower than that with Heritable.

“CP 11 Establish regulations that require transactions with related parties to be subject to prior approval by the bank's board; legislation should be introduced that exposures to related parties explicitly may not be granted on more favourable terms.”

Yes, “related parties” such as sister banks.

“Table 3. Detailed Assessment of Compliance with the Basel Core Principles

“In November 2009 the GFSC published an implementation paper requiring Guernsey incorporated banks to make clear to their depositor clients that “upstreaming” takes place and to advise clients to satisfy themselves of the parent’s ability to enable repayment of deposits. The paper’s provisions came into force in January 2010.”

Oh, I see: It’s the depositors’ job to “satisfy themselves of the parent’s ability to enable repayment of deposits”, not the paid regulator. The GFSC has been referring savers that lost money deposited in Cheshire Guernsey, taken over by Landsbanki, to this esoteric paper that none of them are highly unlikely to have seen and which was first published in the form of a consultation paper on the GFSC website in August 2008. In essence, the GFSC has been telling depositors - after the event - that they should have been aware that Parental Guarantees were, in fact, not legally binding and therefore not ”guarantees” at all, despite the fact that the regulator had authorised the publication of these “guarantees” in bank promotional literature and websites and that depositors had not been informed otherwise.

“…the GFSC considers that, due to an asymmetry of information, contact and information flow between a home and host authority are not as good as they should be. The Commission has committed resources in both the OGBS and in the Basel Cross-Border Banking Resolution Group to address this problem through international consensus. Current thinking on this issue is set out in the recent paper from the Cross-border Banking Resolution group. The Commission has written to the FSA CEO with suggestions as to how Commission-FSA communications might be developed.”

I would suggest that “not as good as they should be” is an accurate description, if somewhat of an understatement.

“In practice, the GFSC has periodically required banks to provide additional information and this can be pertaining to the parent where counterparty risk is significant. For example, during the 2007-9 crisis, several banks were required to report liquidity daily or weekly. In two cases this was made a licence condition.”

One of these must have been Landsbanki Guernsey Ltd. That being the case why didn’t the GFSC direct LGL to immediately repatriate the large interbank deposit placed with Heritable in the UK? That action might have saved LGL and in particular, savers’ deposits.

“In pursuit of its mandate, the GFSC (Banking Supervision (Bailiwick of Guernsey) Law: s25, 26) has unfettered and routine access to all banks’ files and carries out file reviews during on-site visits to banks. This includes verification that banks meet internal rules and limits as well as external laws and regulations.”

Pity they didn’t start doing this before Landsbanki Guernsey Ltd failed.

“…the GFSC does not have power to object to (and reject) a proposal for acquisition of “significant shareholder” status, but does have power to object to (and reject) a proposal to obtain “shareholder-controller” status.”

It was well known and informally confirmed by the GFSC in early 2006 that Cheshire Guernsey Ltd was closing down. Customers were surprised to suddenly discover in August 2006 that it had been acquired by a hitherto largely-unknown Icelandic bank. It is now know with hindsight that Landsbanki hf was doomed at the time of the acquisition. Why was the sale not blocked by the GFSC which has vastly superior knowledge, contacts and resources at its disposal than depositors?

“In that latter regard, the Banking Supervision (Bailiwick of Guernsey) Law (ss14(3)) states:

“The Commission may serve notice of objection under this section if it is not satisfied-

(a) that the person concerned is a fit and proper person to become a controller of the description (i.e. shareholder controller or indirect

controller) in question of the licensed institution;

(b) that the interests of depositors and potential depositors of the licensed institution would not in any other manner be threatened by that person becoming a controller of that description.”

The Guernsey authorities were no doubt intent on preventing the closure of a Guernsey bank with the contiguous loss of jobs on the island. But were not the interests of depositors and potential depositors threatened by the sale of their safe Cheshire savings to an Icelandic bank that we now know was already doomed?

“The financial crisis showed that large exposures including those to parent banks can cause immense insolvency risks. This is recognised by the Commission, which has already limited exposures of banks to their parents in certain cases. The Commission should continue to restrict large limits of banks to their parents in relation to their own capital approaching the 25 % limits to all banking exposures.”

Yes, but LGL’s large exposure, which in the end brought down the Bank, was not to its parent bank, Landsbanki hf, but to a sister bank, Heritable in the UK. The GFSC should have carried out its own due diligence instead of relying on unsubstantiated third-party assurances.

“In order to prevent abuses arising from exposures (both on balance sheet and off balance sheet) to related parties and to address conflict of interest, supervisors must have in place requirements that banks extend exposures to related companies and individuals on an arm’s length basis; these exposures are effectively monitored; appropriate steps are taken to control or mitigate the risks; and write-offs of such exposures are made according to standard policies and processes.”

Why was the large interbank deposit in Heritable not done on an arm’s length basis?

“According to section 8 of Principle 1/1994/24, exposures to companies or person connected with the lending bank, its managers, directors or controllers require special care to ensure a proper objective credit assessment is undertaken. Such exposures may be justified only when undertaken for the clear commercial advantage of the lending bank, and when they are negotiated and agreed on an arm’s length basis.”

The large exposure to Heritable was undertaken for the clear commercial advantage of the sister bank and not the lending bank, Landsbanki Guernsey, and was not negotiated and agreed on an arm’s length basis. There is also the matter of the large UK loan book which was inextricably linked in complex contracts with Heritable.

“There is no guidance on the policies and processes to assess, manage and monitor outsourced activities as well as on the content of outsourcing agreements in place. The Commission does accept the establishment of "Administered Banks". Under the administered bank concept existing banks are permitted to administer other banks, seconding staff and leasing areas of office space. Many of the administered banks do not have any staff in Guernsey at all. In addition is to be pointed out, that one service provider bank in Guernsey manages 8 administered banks. This concept of outsourcing even essential parts of banking business is not compatible with international standards regarding outsourcing.”

Customers had no idea that Landsbanki Guernsey Ltd had no staff in Guernsey. Shouldn’t they have been informed and might that knowledge not have set alarm bells ringing?

“The extent of outsourcing regarding the administered banks should be reduced and not cover essential functions as risk management. A minimum number of persons should be required to be locally employed by the administered banks providing the essential functions.”

Demonstrates the widespread impact of the demise of Landsbanki Guernsey Ltd, extending also to outsourcing.

“The Commission is issuing an Outsourcing Guidance. This will require banks to ensure that banks conduct due diligence checks on outsourcing service providers, structure outsourcing to ensure that the arrangements do not impair the bank’s conduct of business, senior management control, conduct oversight and control by internal governance bodies such as the Board of Directors, or committees of the boards and not compromise the Commission’s ability to supervise the bank. Outsourcing contingency arrangements and exit strategies must be established. The Outsourcing Guidance will explicitly require banks to consider the effects of and conduct risk assessment before outsourcing.”

Better late than never, I suppose.

“The GFSC assesses its effectiveness by empirical evidence. The GFSC has also been subjected to many reviews (e.g. FATF/OGBS, FSF, UK Home Office (Edwards Report)…”

The Edwards Report strongly recommended the establishment of a deposit compensation scheme in 1998 but the Guernsey authorities delayed doing so for a decade - until Landsbanki Guernsey Ltd collapsed in 2008 - arguing that Guernsey was too well regulated for one of its banks to fail.

“…FATF (NCCT), IRS (QI) and IMF), to an external and internal audit function and in addition to the specially commissioned Promontory Report.”

The less said about the Promontory Report, the better. The UK, the Isle of Man and even Iceland have conducted independent parliamentary inquiries into the banking crisis in their respective countries. What is Guernsey waiting for?

“…widely held market concerns over both the Iceland’s economy and Icelandic banks - together with events in financial markets - led to the GFSC imposing four conditions on the licence of Landsbanki Guernsey Limited in order to support the bank at a time of stress...”

One of the four conditions was the redistribution of assets that had hitherto been mostly upstreamed to Iceland. That much we know. We also now know (thanks to the IMF, above) that several Guernsey banks were required to report liquidity daily or weekly. In two cases this was made a licence condition, so one of them must have been LGL. But what were the other two conditions? This must be part of the information that the GFSC has declined to release to the Depositors Action Group and, I believe, also to the former administrators, now liquidators. The GFSC must have left it very late, though, because the conditions clearly didn’t prevent the bank from failing. Depositors and liquidators alike would be very interested to learn what the other two conditions were. In any event, all will at long last become clear during the inevitable independent inquiry.