Introduction

This Note sets out AFIC's approach to a number of related issues, including its treatment of subsidiaries, guarantees given by societies and ownership of building societies.

A. Subsidiaries

Objective

To protect and promote the financial integrity and efficiency of the State-based financial institutions scheme and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that societies are not exposed to undue risk as a result of the activities of subsidiaries or associates.

General Background

A society may choose to establish and operate a subsidiary for a variety of reasons including as a means of diversifying activities and to provide products and services that meet the demands of members and other markets. While all financial intermediation should be conducted through the holding society, there are some non-intermediation financial activities that may be better conducted through subsidiaries. An example is the provision of managed fund products1.

The prudential concern is that the operations of subsidiaries are a potential source of risk to financial institutions and, where managed improperly, have contributed to their failure both in Australia and overseas.

Section 118 of the FI Code requires a society to obtain approval from its SSA before acquiring a subsidiary. This is consistent with the requirement for a society to consult with its SSA before engaging in new activities. It is not the intention of either AFIC or the SSAs to prohibit the establishment or acquisition of subsidiaries. However, each society must give careful consideration to the potential risks that may arise from the operations of subsidiaries and be able to satisfy its SSA that policies and systems for reporting and control are adequate. Further, subsidiaries should not be overly large in comparison to the parent society, nor should there be a proliferation of subsidiaries. SSAs will be concerned with transactions between a society and its subsidiaries including, loans and extension of credit, purchase of assets, and the provision of guarantees and letters of credits. At the least, all transactions are subject to associated standards including large exposures and capital adequacy requirements.

Prudential supervisors have similar concerns where a society invests in an associate. An investment by a society that would create an interest of more than 10% of an entity involved in the field of finance should be referred to the SSA before the society enters a firm commitment. A society should also refer equity investments in non-financial businesses where the amounts invested exceed in aggregate 5% of Tier 1 capital, or an individual investment basis in excess of 0.25% of Tier 1 capital.

The SSA will review each society, its subsidiaries and associates on a case-by-case basis to make an overall risk assessment of the society. The SSA may require additional internal controls, reporting or possibly capital, if there is undue risk arising from a lack of legal, economic or moral separation of the society from subsidiary or associate operations.

Prudential Standards

3.4.1 Subsidiaries

3.4.1.a In accordance with section 118 of the FI Code, a society must obtain the approval of its SSA before establishing or acquiring a subsidiary.

3.4.1.b A society should also consult with its SSA before entering into a firm commitment in an associate as follows:

• in the case of institutions in the field of finance, where the investment would create an interest in excess of 10%; or

• in the case of non-financial businesses, where the investments in aggregate will exceed 5% of Tier 1 capital or an individual investment exceeds 0.25% of Tier 1 capital.

3.4.1.c A society must satisfy its SSA that there are in place adequate systems, policies and procedures to manage, monitor and control residual risk to the society arising from subsidiarys or associates activities. The SSA may also seek evidence that the subsidiary or associate has sound and prudent management aimed at achieving viability within the capital resources of the subsidiary or associate.

3.4.1.d A society must ensure that the operations of a subsidiary or associate are separated sufficiently, so that the society will not be obliged, morally or commercially, to support a subidiarys/associates on-going operations. In particular, a society should not give a general guarantee of the obligations of a subsidiary or associate. Other dealings with associates should be on the normal terms and conditions that would apply to unrelated entities. The society must also ensure that a subsidiary or associate does not give any impression that the societys resources stand behind, or could be called to stand behind, its operations.

3.4.1.e While a general guarantee is not appropriate, a society may choose to provide a specific guarantee. A society must consult with its SSA before providing a guarantee of, or on behalf of, a subsidiary or associate. Where provided, guarantees are subject to Prudential Standard 3.4 C Guarantees. As part of the review process, the society should be prepared to estimate the maximum loss should the guarantee be called and also satisfy its SSA that the provision of a guarantee will not have a detrimental effect on the interests of its depositors.

3.4.1.f A society must ensure that subsidiaries comply with any directions made by its SSA.

3.4.1.g Accounts of the society and subsidiaries must be consolidated for the purpose of prudential supervision, including the application of all prudential standards.

C. Guarantees

Objective

To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that building societies are not exposed to undue risk as a result of guarantees made by or on behalf of the building society.

General Background

The provision of guarantees, sureties, indemnities and similar off-balance sheet facilities by a building society can generate additional income from a given asset base without the introduction of direct liabilities. A building society may also be obliged to provide guarantees or indemnities to access financial services such as cheque and card facilities for use by members. This off-balance sheet activity introduces contingent rather than direct liabilities that can nevertheless create risks for a financial institution. The dangers are particularly acute if guarantees are extended without full analysis of the potential risks.

For the purposes of the Prudential Standards, guarantees, indemnities or other, provided by a building society on its own behalf to access services, will not generally be treated as direct credit substitutes. Guarantees provided to a subsidiary or other venture associated with the building society or on behalf of members must be treated as direct credit substitutes.

Where a building society provides guarantees or other off-balance sheet facilities, it must, as part of its risk management, maintain policies with respect to the provision of guarantees, sureties, indemnities and so on and must be able to demonstrate appropriate systems to identify and manage the individual and aggregate risks. Further, off-balance sheet facilities that are direct credit substitutes must be capitalised and are subject to large exposure limitations.

Prudential Standards

Guarantees

3.4.3 Granting of Guarantees by a Society

3.4.3.a Each building society must have available for review a written description of its policies with respect to providing guarantees, indemnities or other sureties and must satisfy their SSA that it has adequate systems and procedures for managing the risks involved.

3.4.3.b AFIC may deem that certain types or classes of guarantees or other sureties are direct credit substitutes.

3.4.3.c A guarantee or other surety provided on behalf of a member is a direct credit substitute. Indemnities provided by a building society on its own behalf will not normally create direct credit substitutes.

3.4.3.d A guarantee that is a direct credit substitute:

· must be for a limited amount;

· is subject to the same large exposure restrictions as the provision of loans and other credit (see Prudential Standard 3.1.4); and

· must be capitalised (see Prudential Standard 3.2.5). An SSA may also increase a building society's capital adequacy ratio if, in the opinion of the SSA, the guarantee, or guarantees in aggregate, add significantly to the overall risk of the building society.

3.4.3.e The provision of guarantees and indemnities may create contingent liabilities and must be disclosed in the building society's financial statements in accordance with applicable accounting standards.

E. Service Contracts

Objective

To protect and promote the financial integrity and efficiency of the State-based financial institutions system and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that societies are not exposed to undue risk or unfair practices with respect to service contracts.

General Background

Under Section 245 of the FI Code, a society must obtain prior written approval from its SSA before entering into a management contract. Management contracts are defined as arrangements whereby a third party performs the whole or a substantial part of the functions of the society. The key feature of a management contract is the abrogation of total or substantial management control to a person or entity external to the society. Examples include situations where the day-to-day operation of the society is managed through entities controlled by directors or independent third parties.

Service contracts are other arrangements entered by a society to obtain services or products without the abrogation of management control. Each society is likely to enter a variety of such contractual arrangements for valid economic and efficiency reasons, especially where the society neither has, nor seeks, the expertise. While service contracts will cover a range of relationships with external parties, supervisors are concerned with those contracts that create additional risks, create conflicts of interest or require disclosure to members and shareholders.

A conflict of interest may arise where a society enters arrangements with a director or officer (or their associates) for the provision of services. AFIC recognises that some regionally-based societies may face difficulty appointing suitably qualified directors who are not otherwise associated with the provision of services to the society in the normal conduct of business. AFIC does not intend to outlaw such arrangements but seeks to ensure arm's length dealings.

Financial and operating leases entered into in the ordinary course of business on an arm's length basis are not service contracts for the purposes of this section. However, such leases are subject to normal reporting requirements as part of the financial statements.

Prudential Standards

Service Contracts

3.4.5 Review of Service Contracts

3.4.5.a Each society must demonstrate systems for selection, regular review and renewal of service arrangements that ensure arm's length dealings.

3.4.5.b A society must not enter service contracts that:-

· diminish control of the society by the Board;

· diminish the SSA's ability to review and supervise the society; or

· are contrary to the Financial Institutions Legislation.

3.4.5.c Before entering into a service contract a society must consider the risks arising from the proposed arrangement. This includes a documented assessment of the impact of the contract on its operational and control environment as well as the commercial risks that may arise from entering into the contract.

3.4.5.d Where a society enters into a contract (not being a management contract) that permits an external party to make decisions in its name, or on its behalf, then the society must ensure there are adequate systems and controls in place to review the decisions made and ensure they are in accordance with its board approved policies and procedures.

3.4.5.e Where an SSA has concerns with the ability of a society to comply with this standard, it may require it to consult with it, in advance, before entering into some or all future service contracts. In this consultation process the society will need to demonstrate that the proposed contract will not expose it to excessive risk.

3.4.5.f A society must advise its SSA of any service contract under which payments in a current or future year are likely to exceed 5% of non-interest expense. It must consult with its SSA in advance before entering into a service contract where the payments in a current or future year are likely to exceed 10% of non-interest expense. In this consultation process the society will need to demonstrate that the proposed contract will not expose it to excessive risk.

3.4.5.g A society must retain a register of service contracts. At a minimum this should include details of the parties involved, date of commencement, termination date, review date, fee structure, a brief description of the purpose of the contract and a reference to the location of the detailed documentation. The documentation must be made available for review upon request from an SSA.