Other Issues

SSPs perform specialised and important functions for societies, whether they are owners of the SSP or not. The quality of their performance affects the fortunes of the societies with which they deal and may well influence the state of the industry at large.

Certain criteria must be met before an entity can be registered as a SSP. These will vary according to the range of services that the SSP proposes to offer. SSPs will also be subject to requirements governing size, quality of standby facilities, subsidiaries, ownership and control, service contracts and managed funds products. Special conditions also surround the participation by SSPs in the emergency liquidity support mechanism.

A. Size

Objective

To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that special services providers are of a sufficient size to ensure efficient operations and risk pooling.

General Background

While the AFIC Code allows a SSP to be established to serve a minimum of two societies, it is desirable that the constituency of each SSP be considerably larger. Larger SSPs enjoy economies of scale, some of which are internal to the constituent societies, others of which confer benefits upon the industry at large.

In particular, where a SSP offers intermediation services, the larger it is, either absolutely or relative to the industry of which its constituent societies are members:

· the more likely it is that liquidity crises will be managed within the resources of the SSP, without the need to activate the liquidity support provisions of the AFIC Code or even to breach the PLA requirements of distressed societies;

· the more capable is the SSP of establishing substantial and reliable standby credit facilities; and

· the more cost efficient are the internal operations of the SSP likely to be.

While it is desirable that a SSP be large, the range of sizes of its constituent societies is of no particular consequence. A SSP may comprise a large number of small societies or a small number of large societies or some of each type, and still be viable. There is also no special significance in the geographic representation of the constituents of a SSP. It is more important that a SSP be large than that it comprise any particular mix of constituent societies or that it represent a wide regional dispersion.

A distinguishing feature of larger SSPs is their likely ability to secure external means of liquidity support through standby lines of credit negotiated domestically or offshore. This countermands any additional risk which might be incurred through an unbalanced mix of sizes of constituent societies or a narrow geographic representation.

Prudential Standards

5.4.1.a While there can be no objective test of minimum size applicable to all situations, AFIC will, in considering applications for registration of an entity as a SSP, pay close attention to the likely size of its balance sheet in relation to the size of the societies it proposes to serve. This will be viewed as an important factor in determining the likely financial viability of the proposed SSP and its capacity to carry out its stated objectives.

To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that special services providers which offer intermediation services have access to adequate standby credit facilities.

General Background

Considerable importance is placed on the role of SSPs in supporting the general liquidity needs of societies. This function is greatly enhanced where a SSP has access to high quality standby credit facilities. Before commencement of operations as a SSP providing intermediation services, an entity must satisfy AFIC that it has a firm contract for standby credit with appropriate consideration in place and that this standby is of sufficient size and credibility to service its constituent societies in time of need.

Prudential Standards

5.4.4.a To be registered as a SSP offering intermediation services, an entity must satisfy AFIC that:

· a firm contract for standby credit with appropriate consideration is either in place or will be in place before commencement of operations;

· the contract provides for maximum irrevocability;

· no pledge or lien over PLA has been granted in securing this standby line;

· the standby line is secured as far as possible against non-liquid assets, leaving as large a proportion of a SSPs non-PLA liquid assets unencumbered as possible;

· the lender is of sufficient standing and size to make a credible commitment to provide standby credit facilities even in circumstances of general credit restriction; and

· the standby line of credit is no less in total size than the SSPs own required holding of PLA.

E. Subsidiaries

General Background

The formation of Special Services Providers and their incorporation under the FI Scheme is unique and recognises the importance of these institutions to the industries served. Since commencement of the FI Scheme, AFIC has had the opportunity to review the operation of SSPs and particularly their operation compared with competitors both within the FI Scheme and those institutions incorporated outside the Scheme that provide similar services.

The approach to supervision of SSPs remains firmly focussed on prudential management. Originally, the Prudential Standards restricted the ownership of subsidiaries by an SSP. However, the imposition of particular corporate structures or prohibition of other structures is not considered appropriate on two grounds. First, the board and management of institutions are responsible for the commercial and prudent management of their organisations. Second, supervisory imposts should not put SSPs at a competitive disadvantage unless such imposts are warranted on prudential grounds. It is recognised that some activities may be more appropriately conducted by an SSP through a subsidiary, for example, funds management.

AFIC has reviewed its approach to SSP subsidiaries and considers that certain guiding principles for the operation of subsidiaries (adopted from the central bank approach), are more appropriate than the restrictions imposed at the commencement of the Scheme.

Activities conducted through a subsidiary will normally be financial activities other than activities described in Section 36(2)(b)(i)-(v) of the AFIC Code. Other activities should normally have substantial relevance to the SSPs or industrys core business. Subsidiaries should not be overly large when compared with the parent SSP; more particularly, the aggregate assets in subsidiaries should be well below 50 per cent of the parent SSP assets (that is less than 30 per cent of the groups consolidated assets). An SSP must fund equity and financing associated with subsidiary operations from shareholders funds, having close regard to the concern that, over time, such investments should not contribute to a deterioration of the SSPs capital position. More specifically, capital investments in, and other funding including off-balance sheet facilities provided to, subsidiaries are subject to large exposure and intergroup reporting and must not exceed, in aggregate, the value of the SSPs capital base.

Subsidiaries should be capitalised adequately. In addition, an SSP must meet capital adequacy requirements on a consolidated basis. The exception is where a subsidiary is subject to a separate regime of supervision that expressly requires capital in support of activities. Then equity investments must be deducted from the SSPs capital base before calculating the capital adequacy requirement. Consolidation of assets relating to trust-like or other off-balance sheet assets that are beneficially owned outside the group, such as funds management operations, will be required, if the SSP cannot satisfy AFIC that an appropriate separation policy is applied that makes clear that an entity dealing with the subsidiary has no claim on the parent SSP.

5.4.5 Subsidiaries

5.4.5.a Each SSP must have comprehensive written policies and systems to measure, monitor and manage risks associated with the operation of subsidiaries. The board of directors must provide initial endorsement of significant policies (and changes, as applicable) and senior management is responsible for implementation of policies and systems and their regular review. The SSP must ensure that the subsidiary has sound and prudent management aimed at achieving undoubted viability within the capital resources of the subsidiary itself. Policies and systems of the SSP must be audited annually by the SSPs external auditors. Their operation and implementation may be subject to review during on-site inspections by AFIC.

5.4.5.b Only services other than those identified in Section 36(2)(b)(i)-(v) may be conducted through non-SSP subsidiaries.

5.4.5.c Total assets of subsidiaries should not be overly large compared with the parent SSP. More particularly, assets of subsidiaries should be well below 50 per cent of the assets of the parent SSP (that is, less than 30 per cent of the group assets).

5.4.5.d Capital investments in, and other exposures, including loans, guarantees, off-balance sheet facilities and similar are to be funded from the SSPs shareholders funds and subject to large exposure limits. An SSP seeking to capitalise or otherwise fund a subsidiary to a value in excess of 10 per cent of the SSPs capital base must first consult with AFIC.

5.4.5.e Each SSP must meet capital adequacy requirements on a consolidated basis. Subject to an adequate separation policy, the exception is where the subsidiary of the SSP is subject to a separate regime of supervision that expressly requires capital in support of activities. Such equity investments must be deducted from the SSPs assets and capital base before calculating compliance with capital adequacy. In terms of a separation policy, an SSP must satisfy AFIC that an adequate separation policy applies that makes clear that an entity dealing with a subsidiary, such as a funds management operation, has no claim on the parent SSP.

5.4.5.f An SSP may own a subsidiary, incorporated as an SSP, company under Corporations Law or otherwise. An SSP cannot be a subsidiary of a non-SSP entity.

F. Guarantees

To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that special services providers are not exposed to undue risk as a result of guarantees made by or on behalf of the special services provider.

General Background

As recognised by banking supervisors, guarantees and other off-balance sheet activities introduce contingent rather than direct liabilities, which can threaten the viability of a financial institution. The dangers are particularly acute where guarantees are extended without full analysis of the potential risks. Banking supervisors now require guarantees to be treated as direct credit substitutes.

In their role as providers of liquidity services SSPs are likely to become involved with the extension of guarantees. To ensure that the provision of guarantees does not threaten the on-going viability of a SSP, guarantees and other off-balance sheet financing will be treated as direct credit substitutes for the purposes of prudential supervision. SSPs must keep AFIC advised of their policies with respect to guarantees and off-balance sheet financing and will need to demonstrate appropriate management systems and an understanding of the risks involved.

Prudential Standards

5.4.6.a Where SSPs want to provide guarantees, they are to provide AFIC with written descriptions of their policies with respect to guarantees and must satisfy AFIC, prior to issuing the guarantee, that they have adequate systems and procedures for managing the risks involved.

5.4.6.b Where guarantees are provided, they must be for a fixed maximum amount.

5.4.6.c Such guarantees will be treated as direct credit substitutes and assigned risk weights appropriate to the counterparties involved (see Prudential Standard 5.2.5). AFIC may also increase the SSP's required capital adequacy ratio if, in AFIC's opinion, the guarantee adds significantly to the overall risk of the SSP.

5.4.6.d Guarantees are subject to the same large exposure restrictions as lending (see Prudential Standard 5.1.4).

G. Deleted

To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that special services providers are not exposed to undue risk with respect to service contracts.

General Background

Under application of Section 245 of the FI Code, an SSP must obtain prior written approval from AFIC before entering into a management contract. Management contracts are defined as arrangements where a third party performs the whole or a substantial part of the functions of the SSP. The key feature of a management contract is the abrogation of total or substantial management control to a person or entity external to the SSP.

Examples include situations where the day-to-day operation of the SSP is managed through entities controlled by directors or by independent third parties.

Service contracts are other arrangements entered by an SSP to obtain services or products but without the abrogation of management control. Each SSP is likely to enter a variety of such contractual arrangements for valid economic and efficiency reasons, especially where the SSP neither has, nor seeks, the expertise. While service contracts will cover a range of relationships with external parties, AFIC is 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 an SSP enters arrangements with a director or officer (or related entity) for the provision of services. 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

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

5.4.8.b An SSP must not enter service contracts that:-

· diminish control of the SSP by the board;

· diminish AFIC's ability to review and supervise the SSP; or

· are contrary to the Financial Institutions Legislation.

5.4.8.c To avoid the establishment of unreasonable contingent liabilities, contract periods should not exceed two years unless approved by AFIC.

5.4.8.d Details of all material service contracts must be fully and clearly disclosed to members and shareholders. AFIC may deem a contract to be material.