Category Archives: Banking and Finance

UK Leverage Ratio Requirement: A Cornucopia Of Capital Complexity?

November 17, 2014Articles, Banking and Finance, Latest NewsBanking, leverage ratio, UKSimon Brennan

The Bank of England Financial Policy Committee’s (FPC) recently published review on the role of the leverage ratio in the UK proposes moving ahead of international standards to introduce new requirements for the biggest UK banks and building societies from next year. It recommends those banks eventually meet a ‘static’ requirement of up to around 4% on an ongoing basis (comprising a minimum of 3% and a supplementary buffer capturing systemic risk). There would also be a time-varying component that varies with the credit cycle and could add around 90 basis points more for some banks at the top of the cycle (on the FPC’s current assumptions).

Calibration, complexity and risk-sensitivity were important topics of debate in advance of the report. The fixed part of the requirement came out close to most industry expectations, although considerably lower than some. The overall package is simpler than in the previous consultation, although it remains more complex than some would have liked. The FPC highlighted that 3% leverage is consistent with the minimum Tier 1 risk-weighted capital required against mortgage lending under the Basel Standardised Approach, so as not to disincentivise banks and building societies from (new) mortgage lending.

The government will now lay legislation before Parliament to effect the recommendations (giving the FPC the power to direct the Prudential Regulation Authority (PRA)). Once approved, the minimum requirement of 3% will be applied straightaway for the largest banks and building societies (superseding the current supervisory expectation that these firms meet a 3% minimum). Buffers within the ratio will be implemented subsequently. Other PRA-regulated firms will be required to meet the 3% minimum from 2018.

UK leverage ratio: simples

The complexity of the proposed leverage ratio framework is borne out of symmetry with the risk-weighted framework, which the FPC argues is required to maintain the relationship with the risk-weighted ratio (and therefore its effectiveness). The ratio will comprise:

A minimum requirement of 3%, for all PRA-regulated firms.
A supplementary leverage ratio buffer (SLRB) for UK G-SIBs, ring-fenced banks and large building societies. The G-SIBs buffer will be set at 35% of the risk-weighted systemic risk buffer and will be phased in from 2016. The appropriate calibration of the buffer for the other firms will be reviewed next year and will apply from 2019.
A countercyclical leverage ratio buffer (CCLB) that varies with the (macro prudential) countercyclical capital buffer (CCB). The FPC expects to set the CCLB at 35% of the CCB. The CCLB will apply to all PRA-regulated firms, as the CCB does, and will be introduced at the same time as the minimum requirement.

The requirements will initially apply at a consolidated level. The FPC will review in 2017 whether the requirements should be extended to apply at the solo level.

Banks will need to meet the requirements using a minimum amount of Core Equity Tier 1 (CET1) capital (at least 75 per cent) for the baseline requirement. All leverage ratio buffers should be met using CET1 exclusively. The Chancellor has asked for this to be aligned with international standards, when they are reviewed – in particular the eligibility of AT1 instruments.

The FPC says that in future it expects the PRA to consider the leverage ratio when determining the regulatory response to stress testing. It does not though give an indication of a minimum requirement for the leverage ratio under stress scenarios.

What it all means

While the new framework provides an important missing piece of the capital jigsaw, the picture is by no means complete. The Financial Stability Board‘s (FSB) proposals for Total Loss Absorbing Capacity are due early this month, and the Bank of England will consult on the “PRA buffer” in January 2015. In addition, both the Basel Committee and the EU Commission are due to review aspects of the leverage ratio in coming years, and further changes may follow. So it will still be some time before the overall capital requirements for the major UK banks are fully specified and an assessment can be made of their aggregate impact.

Looking to implementation, an increasingly important challenge for banks will be managing capital planning and business model decisions within a capital framework that considers simultaneously a risk-weighted capital ratio, leverage ratio, stress testing and loss absorbing capacity requirement. The leverage ratio also interacts with other prudential measures, such as the liquidity coverage requirements

Eurozone Banks Wake Up To A New Supervisor. What’s Next?

November 17, 2014Articles, Banking and Finance, Latest NewsEurozoneSimon Brennan

The Single Supervisory Mechanism (SSM) formally opens for business today. For months, supervisors and banks have been preparing for the transfer of supervisory responsibilities to the European Central Bank (ECB). Yet the 4 November milestone is just the start of a much longer, possibly testing journey for all involved.

Over time, the SSM will change the terms of engagement between supervisors and banks. It will introduce higher supervisory standards than some banks have been used to in the past; greater standardisation of approach, and a change in perspective (so that different issues might come to the fore of the supervisory relationship).

Banks need to seize the initiative, recognise the raised expectations and take the opportunity to make a fresh start in the supervisory sphere. The first 12 months of the SSM will be key for establishing the priorities and approach of the SSM. Through a careful analysis of the SSM supervisory objectives, the experience of banks during the comprehensive assessment, and of other supervisory regimes, banks can cut through uncertainty around what these priorities and approach will be.

Four characteristics stand out as drivers for change in day-to-day supervision. Each of these could affect the supervisory expectations placed on banks substantially, although the effect will be felt more and more rapidly by directly supervised ‘significant’ banks:

The SSM will harmonise how risk-based, forward looking supervision is conducted in the Eurozone.
The SSM will integrate qualitative and quantitative analysis, but may have a stronger quantitative approach to supervision than most NCAs currently have, at least initially.
Seeking supervisory consistency will be a key driver for how banks are supervised.
Peer group analysis will be a key new supervisory tool, in part to deliver consistency between countries.

Under the risk-based approach, supervisory interactions will increasingly move towards focusing on areas of concern. The intensity of supervision will be affected by the efficiency of banks’ risk and risk appetite management, and how effective is the link between risk management and strategy when calibrating the intensity of its supervision. While this is not a novel approach, the ECB will have an opportunity to apply it more rigorously and consistently. The ability of banks to coordinate internally, between Eurozone entities as well as between regulatory projects such as their capital, liquidity, and recovery and resolution projects.

The supervisory emphasis on quantitative analysis and data (evident through the comprehensive assessment) will result in heightened expectations of data availability, quality and governance. Data governance, risk data aggregation and automisation of processes such as stress testing and AQR will be a key investment. At the same time, quantitative analysis will highlight disparities between banks quickly. Banks need to ensure that disparities are not driven by poor data quality, and be prepared to explain such disparities where they are driven by bank interpretation and policy or local market idiosyncrasies.

The ECB will have discretion over a number of important decisions which previously sat with NCAs, for example the application of exemptions or waivers. As the ECB looks to improve supervisory consistency, banks will find some of these key decisions reversed or amended.

Peer-group analysis will be a key tool in the delivery of consistent supervision, and it may be the case that some of the peer groups created are less than obvious and could end up resulting in some novel and challenging comparisons. One possible outcome is to encourage a wider spread of ‘best’ practice across banks.

Making a success of the SSM

The impact of supervision on banks – both in terms of the financial cost and the call on senior management time – can be affected by how actively banks manage the regulatory relationship. Thus, it is important for banks establish trust and understanding of their business with supervisors. In the past this has been an interactive process over many years; in contrast the new relationship with the SSM needs to be established immediately. In our experience, the impact of supervision on banks – both the financial cost and the call on senior management time – depends on how actively banks manage the regulatory relationship.

To be successful under the new regime, banks should be proactive – in addressing the outcomes of the CA, and beyond, in assessing which aspects of their business could cause supervisory concern, and in managing the supervisory dialogue around such issues. Any resultant changes should not be implemented in a vacuum – instead, banks should take a strategic view of how the adaptation to the new supervisory regime links to on-going and forthcoming regulatory change projects, and what synergies can be drawn. All in all, this is a new start not just for the supervisor, but for many aspects of a bank’s work.

Impact Of FATCA On Cayman Islands Entities

November 17, 2014Articles, Banking and Finance, Latest NewsCayman IslandsCraig T. Fulton

This publication provides a brief overview of the expected impact on entities incorporated in the Cayman Islands of (a) the foreign account tax compliance provisions (“FATCA“) of the Hiring Incentives to Restore Employment Act, 2010 of the United States of America (the “US“); and (b) equivalent rules implemented in relation to United Kingdom (UK) taxpayers.

1. BACKGROUND

FATCA is a US federal law that aims to reduce tax evasion by US persons. FATCA has significant extra-territorial implications and, most notably, requires foreign financial institutions (“FFIs“, discussed further below) to report information on accounts of US taxpayers to the US Internal Revenue Service (“IRS“). If an FFI fails to enter into the necessary reporting arrangements with the IRS, a 30% withholding tax is imposed on US source income and other US related payments of the FFI.

In order to facilitate reporting under and reduce the burden of compliance with FATCA, the Cayman Islands has signed a Model 1B intergovernmental agreement with the US (the “US IGA“).The US IGA allows Cayman Islands entities that are FFIs to comply with the reporting obligations imposed by FATCA without having to enter into an agreement directly with the IRS. Instead, a Cayman Islands FFI may report directly to the Cayman Islands Tax Information Authority (the “TIA“) and, provided it complies with the relevant procedures and reporting obligations, will be treated as a deemed compliant FFI that is not subject to automatic withholding on US source income and other US related payments.

While this publication is principally focused on FATCA and the US IGA, it is important to note that the UK has implemented an equivalent reporting regime in relation to UK citizens (“UK FATCA“).The UK regime, which is similar to FATCA, however does not impose withholding on UK source income, has been implemented by means of an intergovernmental agreement between the Cayman Islands and the UK (the “UK IGA“). A brief summary of UK FATCA and its impact on Cayman Islands entities is included in section 7 below.

2. WHAT DOES FATCA MEAN FOR YOUR CAYMAN ISLANDS ENTITY?

The impact FATCA will have on a Cayman Islands entity fundamentally depends on one key question: is the Cayman Islands entity an FFI?

While FATCA has significant implications for Cayman Islands entities that are FFIs – such as banks, custodians, hedge funds, private equity funds, trust companies, trusts and other regulated entities – a typical Cayman Islands holding company or joint venture vehicle will not generally be an FFI and should not be materially affected by FATCA.

Accordingly, the first step a Cayman Islands entity needs to take is to determine its FATCA classification and in particular whether or not it is an FFI. A broad summary of how to determine whether your Cayman Islands entity is an FFI, and a description of the steps that must be taken if the Cayman Islands entity is an FFI, are addressed in sections 3 and 5 below.

Any Cayman Islands entity that is not an FFI – such as a typical Cayman Islands holding company – will be a non-financial foreign entity (a “NFFE“) for the purposes of FATCA. Cayman Islands NFFEs are not generally subject to registration or reporting requirements under FATCA, but they will be required to self-certify their status to financial institutions and other withholding agents with whom they maintain accounts to avoid FATCA withholding. This is discussed further in section 4 below.

3. WHEN WILL A CAYMAN ISLANDS ENTITY BE CLASSIFIED AS A “FOREIGN FINANCIAL INSTITUTION” OR (“FFI”)?

FATCA is very complex and a detailed analysis is required in each case to determine if a Cayman Islands entity is in fact a FFI. However, generally, the following four categories of Cayman Islands entities will be FFIs and be directly affected by FATCA’s registration and reporting requirements:

Investment Entities: Broadly, an entity that conducts (or is managed by an entity that conducts) trading or portfolio and investment management activities as a business on behalf of a customer or otherwise invests, administers or manages funds or money on behalf of other persons.
Custodial Institutions: An entity that holds, as a substantial portion of its business (broadly, more than 20% of gross revenues), financial assets for the account of others.
Depository Institutions: An entity that accepts deposits in the ordinary course of a banking or similar business and regularly engages in one or more of the following activities (a) provision of credit; (b) trading in receivables, notes or similar instruments; (c) issues letters of credit; (d) provides trust or fiduciary services; (e) finances foreign exchange transactions; or (f) deals in finance leases or leased assets.
Specified Insurance Companies: An insurance company (or its holding company) that issues, or is liable under, certain cash value or annuity contracts.

Set out below are categories of Cayman Islands entities that Conyers frequently deal with alongside some basic guidance on whether such Cayman Islands entities will be FFIs. In cases where such entities may be FFIs, we also consider whether any exemption to registration and reporting may be available.

Hedge funds and private equity funds

Almost all hedge funds and private equity funds will be Investment Entities and therefore qualify as FFIs under FATCA. The one exception is that funds where more than 50% of the gross revenues are from real estate (or other non-financial assets) will generally fall outside the definition of Investment Entity (and therefore FFI) for the purposes of FATCA.¹ There are some other limited exemptions available to hedge funds and private equity funds, but these are expected to be of limited practical use for the vast majority of such funds.

It is important to note that, where a master-feeder structure is used, both the master fund and the feeder fund will be FFIs. Furthermore, a subsidiary Cayman Islands trading entity of a hedge fund is also likely to be an Investment Entity and therefore an FFI.² In section 6 below, we discuss the possibility of using a “Sponsoring Entity” to facilitate FATCA compliance for structures with multiple FFIs.

Cayman Islands managers and advisers of hedge funds and private equity funds

Cayman Islands entities that act solely as managers and advisers of hedge funds and private equity funds will typically not need to register and report as FFIs.

Although Cayman Islands managers and advisers fall within the definition of Investment Entity (and therefore FFI), the US IGA contains an exemption for a Cayman Islands FFI that qualifies as an Investment Entity solely because it (a) renders investment advice to, and acts on behalf of, or (b) manages portfolios for, and acts on behalf of, a customer for the purposes of investing, managing, or administering funds deposited in the name of the customer with a participating FFI. Accordingly, Cayman Islands managers and advisers will generally not be required to register with the IRS and report on their own account. They may, however, be required to self-certify as NFFEs.

Cayman Islands holding companies and joint ventures

As noted above, a typical Cayman Islands holding company or joint venture vehicle that owns assets on its own account and does not operate as an investment fund would not generally be expected to be an FFI for the purposes of FATCA. Rather, this type of Cayman Islands holding company will generally be a NFFE (discussed in section 4 below).

However, the directors of a Cayman Islands holding company that has or wishes to open a bank or securities account will still need to consider their FATCA classification carefully. Such a Cayman Islands holding company will likely be required to certify their status to the relevant financial institution to avoid withholding, as discussed in section 4 below.

Cayman Islands securitization vehicles

A typical Cayman Islands securitization vehicle will normally be an Investment Entity and therefore an FFI for the purposes of FATCA, subject to limited transitional relief for pre-existing vehicles.

Financing SPVs

Cayman Islands entities that are established solely for the purpose of borrowing or granting security in relation to the provision of debt finance to an underlying business typically will not be FFIs. Similarly, Cayman Islands entities which are established to own and finance aircraft, ships or other form of moveable asset of a similar nature would not typically fall within the definition of an FFI.

Trusts with a Cayman Islands trustee

The treatment of trusts under FATCA is complex. The Cayman Islands FATCA rules only apply to a trust if the trustee is a Cayman Islands entity or is an individual resident in the Cayman Islands. Subject to some complex optionality for trustees, the majority of trusts that have a Cayman Islands trust company acting as trustee will likely be FFIs for FATCA purposes.

Private trust companies (“PTCs“) are also likely to be FFIs for the purposes of FATCA, although this needs to be considered in each case. In particular, if the PTC and its directors are not remunerated for acting as trustee, the PTC and the underlying trust may conclude that it does not meet the definition of an FFI on the basis that the PTC is not conducting business. This is a topic that should be discussed with your adviser.

Clients with trusts that have Cayman Islands trustees or a Cayman PTC are advised to liaise with their advisers to determine the most appropriate course of action for their trust.

Insurance companies

Only insurance companies that issue or are required to make payments with respect to a cash value insurance contract or an annuity contract will be FFIs pursuant to FATCA. Captive insurers and insurance companies that do not write annuities or whole life insurance products will generally be NFFEs.

Branches and foreign subsidiaries

Branches of entities are treated separately for FATCA purposes – an overseas branch of a Cayman Islands FFI will not be covered by the Cayman Islands IGA and must consider the rules applicable in that branch’s jurisdiction, whether under an IGA or the US regulations. A foreign subsidiary of a Cayman Islands FFI must also comply with the FATCA rules in its home jurisdiction.

4. CAYMAN ISLANDS ENTITIES THAT ARE NOT FFIS

As noted above, any Cayman Islands entity that is not an FFI – such as a typical Cayman Islands holding company – will be a NFFE. Although NFFEs are not generally subject to registration or reporting requirements, they will still be required to self-certify their status to financial institutions with whom they maintain financial accounts to avoid FATCA withholding.

In this regard, the US W8-BEN-E form has recently been amended to require entities to confirm their FATCA classification to US withholding agents and provide related information with respect thereto. Cayman Islands entities that hold accounts with financial institutions can certainly expect to complete these W8-BEN-E forms and provide other FATCA related certifications.

There are two categories of NFFE:

Active NFFE: The criteria which would qualify a NFFE as being an Active NFFE are numerous, and include where less than 50% of its gross income for the preceding calendar year is passive income (such as dividends, interest, royalties, annuities and rent) and less than 50% of the assets held during the preceding calendar year or other appropriate reporting period are assets that produce or are held for the production of passive income. For Active NFFEs, completion of the W8-BEN-E form essentially only requires completing the information on the first page, ticking “Active NFFE” on question 5 and then certifying that the entity is an Active NFFE in question 39.
Passive NFFE: Broadly, a Passive NFFE is a NFFE that is not an Active NFFE. For Passive NFFEs, the W8-BEN-E form also requires the NFFE to certify (having done appropriate due diligence) whether or not it has any substantial US owners (broadly, a US person with a 10% or more interest). To the extent it has substantial US owners, the name, address and US taxpayer identification number of each substantial US owner must be provided.

It is important that each Cayman Islands NFFE establishes which category it falls into so it can provide the necessary certification to financial institutions with which it maintains accounts. The W8-BEN-E form is signed under penalty of perjury.

5. WHAT DOES A CAYMAN ISLANDS FFI NEED TO DO TO COMPLY WITH FATCA?

If your Cayman Islands entity is an FFI for which an exemption is not available, you will need to take the following steps:

Obtain a Global Intermediary Identification Number (“GIIN”) by 31 December 2014: Cayman Islands FFIs that are not exempt (“Reporting FFIs“) and certain “registered deemed compliant ” FFIs are required to register on the IRS FATCA registration portal (https://sa2.www4.irs.gov/fatca-rup/) for the purpose of obtaining a GIIN. This registration must occur no later than 31 December 2014, although it is recommended you register as soon as possible to avoid registration congestion at the end of the year.³ If a non-exempt Cayman Islands FFI does not register for a GIIN by this date, the entity will not continue to benefit from the IGA after 1 January 2015 and it will be subject to withholding from US paying agents and other FFIs.
Identify Reportable Accounts: FATCA and the US IGA impose an obligation on Cayman Islands Reporting FFIs to identify and report details of “reportable accounts” to the TIA. “Reportable accounts” are financial accounts where the account holder is either a “Specified US Person” (broadly, any US person or person liable to pay US tax with some exceptions) or is a non-US entity the controlling persons of which include one or more Specified US Persons. Financial accounts include any depositary or custodial accounts and also, in the case of certain Investment Entities, any debt or equity holdings in the FFI. In the case of Cayman Islands funds, the relevant account is the shares/interests each investor holds in the fund.
Identifying reportable accounts involves two separate processes, one for existing accounts and one for new accounts:
1. Existing accounts: FFIs will also need to perform due diligence on “financial accounts” that they maintained as at 30 June, 2014 (subject to certain de minimis thresholds for small accounts). Specifically, accounts that are reviewed must be searched for prescribed US indicia, including US place of birth and US address. If the account holder is a Specified US Person, details of their account must be reported (as described below). If the account holder is not a Specified US Person but there are US indicia in relation to its account, the Cayman Islands FFI must take steps to “cure” the US indicia. In particular, self-certification by the account holder and further documentation evidencing the person is not a Specified US Person, is likely required. If the account holder does not respond or it is not otherwise possible to cure the US indicia, the account should be treated as reportable. The deadline for completing due diligence on existing accounts depends on a number of factors, including the balance of the account. Most critically, remediation of US indicia needs to be completed on all accounts over US $1 million by 30 June 2015.
2. New account procedures and due diligence: For new accounts opened with the FFI after 1 July 2014,⁴ it is necessary to carry out due diligence and obtain self-certification regarding whether the account holder is a Specified US Person. If US Indicia are found that suggest the person may be a US taxpayer, prescribed steps will need to be taken to confirm this. For accounts opened by another participating FFI, the FFI’s GIIN should be obtained and verified against the publicly available IRS FFI list. In general terms, all Cayman Islands FFIs should be revising their account opening forms and/or subscription agreements to ensure they comply with FATCA rules in relation to new accounts. For funds, it is also important to update offering and constitutional documents to ensure FATCA is appropriately addressed.
Reporting: On or before 31 May 2015, Cayman Islands FFIs must make their first report to the TIA in relation to accounts held by Specified US Persons or a non-US entity with one or more controlling persons that are Specified US Persons. The US IGA prescribes the information that needs to be reported. Most significantly, it requires the balance of value of the relevant account held by the Specified US Person to be reported. Expanded information is required for the subsequent reporting period ending 31 May 2016. Upon receipt of a report, the TIA will pass the reported information to the IRS.

6. SIMPLIFIED REPORTING FOR GROUPS OF FFIS

If a group has one or more eligible Investment Entities, the group may elect to register one “Sponsoring Entity” for FATCA reporting purposes. The appointment of a Sponsoring Entity effectively allows all FATCA compliance and reporting to be delegated to one entity in the group. To appoint a Sponsoring Entity:

The Sponsoring Entity must be authorized to act on behalf of the sponsored Investment Entities and agree to carry out all due diligence and reporting obligations on behalf of the sponsored Investment Entities.
The Sponsoring Entity has to register and obtain a sponsoring GIIN.
If the sponsored Investment Entities hold reportable accounts, the Sponsoring Entity will ultimately be required to register each Sponsored Investment Entity that it manages.

A Sponsoring Entity must report to the TIA all reportable accounts of its sponsored Cayman Islands Investment Entities.

7. UK FATCA AND FUTURE REPORTING

UK FATCA follows the FATCA model very closely, although there are some important differences in the detail. In particular, it requires Cayman Islands FFIs to undertake due diligence to identify and then report on financial accounts of Specified UK Persons. As UK citizens are not subject to universal taxation, the definition of Specified UK Persons is not as extensive as under FATCA and generally includes a UK resident and a UK incorporated entity. A non-UK entity controlled by Specified UK Persons is also subject to the reporting obligation.

UK FATCA requires Cayman Islands FFIs to start carrying out due diligence on its accounts and identify Specified UK Persons now, although the first reporting date for UK FATCA is not until 31 May 2016.⁵ On the first reporting date, specified information on the accounts of Specified UK Persons and non-UK entities controlled by Specified UK Persons must be reported to the TIA.

No withholding tax will be imposed for non-compliant FFIs under UK FATCA. However, under the Cayman Islands implementing legislation there are specific offences for Cayman Islands entities that fail to comply with the reporting obligations of UK FATCA.

A number of banks in the UK have already begun requiring Cayman Islands entities that hold accounts to certify their status under UK FATCA. Accordingly, just as with FATCA, it is important that all Cayman Islands entities determine their UK FATCA classification as soon as possible (which will almost always be the same as under FATCA).

8. CONCLUSION

FATCA is a controversial piece of legislation, not least because it imposes a significant compliance burden on FFIs. However, the automatic exchange of information and increased transparency introduced by FATCA looks to become the global standard. In addition to UK FATCA, forty-seven countries (including the Cayman Islands and all other OECD countries) have committed to implement the OECD’s Common Reporting Standard (the “CRS”). The CRS, which is based on FATCA and requires the automatic exchange of information on assets and income of citizens of all signatory countries, will likely be brought into force around 2017. Accordingly, the implementation of robust systems by Cayman Islands FFIs to comply with FATCA can be viewed as important preparation for what is likely to be a new global standard on information exchange.

For the majority of Cayman Islands entities which are not FFIs, it is very much a case of “business as usual”. Other than having to determine their FATCA classification and certify/evidence their status to financial institutions with which they hold accounts, FATCA and UK FATCA should hopefully have a limited impact on day-to-day operations.

Footnotes

1. In the private equity context, this “gross revenues” test may also exempt Cayman Islands portfolio companies from being Investment Entities.

2. The position is more complex for Cayman Islands subsidiaries of private equity funds and advice should be sought.

3. In order to be included on the IRS GIIN Registration List for 1 January 2015, registration is required by 22 December 2014.

4. Although it should be noted that IRS Notice 2014-33 generally allows FFIs to treat new accounts opened before 1 January 2015 as “pre-existing”, subject to certain modifications of the compliance rules for such accounts.

5. The first reporting period is for 2014 and covers the period from 30 June 2014 to 5 April 2015. This information must be reported to the TIA by 31 May 2016 for onward submission to UK authorities by 30 September 2016.

Regulators’ Increased Focus On Systems And Controls Environment

November 17, 2014Articles, Banking and Finance, Latest NewsIrelandDavid Nolan

Introduction

As expected, there has been a marked increase in the level of regulation, regulatory supervision and regulatory sanctions in the wake of the 2008 financial crisis. Between 2008 and 2012 €1.5 trillion in state aid was introduced throughout Europe to prevent another financial crisis occurring. Regulatory enhancement is cyclical and, following a financial crisis, history dictates a call for a strengthening of regulatory supervision and intervention. To address these calls and to enhance financial stability, the European Union (“EU“) coordinated with its international counterparts in the G20 and developed a regulatory reform agenda which included over forty proposals to be introduced over a five year period.

The objectives of this reform agenda included: the enhancement of financial stability and resilience of the financial system; the restoration of the EU single market; protection of investors and consumers; and improved efficiency and minimisation of transaction and financial services costs.

In Ireland, the Taoiseach (Irish Prime Minister) launched the ‘Strategy for the International Financial Services Industry in Ireland 2011-2016’ which included the high level goal of the ‘Proper and Effective Regulation of Financial Institutions and Markets’. To achieve this goal, the report set out a number of strategies for the Central Bank of Ireland (“Central Bank“) to undertake which mostly reflected the G20 reform agenda. Financial institutions must also be conscious of upstream regulatory risk and impending legislative developments awaiting transposition or entry into force.

Such an enhanced focus on regulation and supervision inevitably leads to an increase in regulatory sanctions, both in terms of frequency and amount. In 2010, the Central Bank imposed eight fines on financial institutions totalling €2,248,700 whereas in 2013, sixteen fines were imposed totalling €6,350,000. A leading contributory factor to these sanctions being ineffective and deficient systems and controls environments. The table below sets out a summary of sanctions since 2010 and highlights the percentage of these imposed due to ineffective and deficient systems and controls.

A recurring theme in this regard is the substantial proportion of fines for or with reference to ineffective and deficient systems and controls. In five of the six sanctions issued by the Central Bank in 2014, the Director of Enforcement in the Central Bank, Derville Rowland, has highlighted the importance of effective systems and controls frameworks, most notably stating in one sanction:

“The Central Bank views the existence and proper functioning of a firm’s policies, procedures, systems and controls as being fundamental to ensuring its compliance with its regulatory requirements. The existence of inadequate policies, procedures, systems and controls is an unacceptable risk to the Central Bank as it can be the basis for, and potentially leads to, large scale non-compliance with regulatory requirements.”

PRISM, Themed Reviews, Enforcement Priorities and Financial Enquiry Panel

There continues to be a sustained increase in PRISM (Probability Risk and Impact SysteM) engagements by the Central Bank across all sectors rising from 2,198 engagements in 2012 (including pre-PRISM engagements) to 3,925 in 2013, highlighting a clear indication that the Central Bank is interacting with and scrutinising regulated financial institutions more frequently.

Regulated financial institutions should also be aware of the Central Bank’s ‘Programme of Themed Reviews’ (“Reviews“). The Central Bank annually publish a list of Reviews that it intends to carry out separate to its reactive reviews and regular engagements, covering multiple financial sectors and focusing on specific areas of regulation. The principle behind the Reviews is that they “allow the Central Bank to monitor compliance with the relevant rules and requirements” set by the Central Bank. In anticipation of these Reviews, regulated financial institutions must have procedures in place documenting compliance and ensuring that the entity’s obligations are documented to mitigate the risk of a Central Bank sanction, particularly in areas highlighted under the Reviews.

The Central Bank also publishes annually its “Enforcement Priorities” (“Priorities“) which document its targeted areas for enforcement action. In 2014, the Central Bank set out fifteen Priorities specific to certain sectors including two applicable to all sectors – prudential requirements and systems and controls.

In October 2014, the Central Bank announced details of its new Financial Enquiry Panel (“FEP“), which comprises a panel of thirteen domestic and international legal and banking experts with the task of investigating potential breaches of banking rules by credit institutions and personnel. Included in the FEP is Fiona Muldoon, former Central Bank Director of Credit Institutions and Insurance Supervision. In line with the Central Bank (Supervision and Enforcement) Act 2013, the FEP has the power to fine up to €10 million or 10% of an entity’s turnover. It can also ban and fine individuals up to €1 million, provided it does not bankrupt them.

The key observation to be made from this increased supervisory and regulatory activity is that regulated financial institutions need to be aware of the legal regulatory obligations applicable to their business and the need to have effective and robust systems and controls in place to monitor, record and stress test these obligations. Preparation and evidencing testing results is fundamental to documenting systems and controls. Where deficiencies are found, these need to be remedied and, in some instances, legal advice will need to be sought.

Fitness and Probity

In addition to the regulatory focus on financial institutions, the Central Bank’s Fitness and Probity (“F&P“) standards, enforceable under the Central Bank Reform Act 2010, highlight that the legal regulatory obligations extend further than just the regulated financial institution as a legal person, but to those persons in particular positions. Under the F&P standards, a person elected to a ‘pre-approval controlled function’ (“PCF“) or a ‘controlled function’ (“CF“) is required to be ‘competent and capable’ which compels the person to demonstrate that he or she:

“has a sound knowledge of the business of the regulated financial service provider as a whole, and the specific responsibilities that are to be undertaken in the relevant function;” and

“has a clear and comprehensive understanding of the regulatory and legal environment appropriate to the relevant function”.

The message from the Central Bank is clear; those who hold a PCF or CF position must understand and be aware of their regulatory obligations and must be able to demonstrate their compliance with their obligations, much like regulated financial institutions. Failure to do so may lead to the Central Bank determining the individual to be unfit for their respective control function.

The Need to Show Awareness

Recent sanctions imposed by both the Central Bank and the FCA have highlighted that regulated financial institutions are required not only to be aware of their obligations, but also actively to test and demonstrate compliance with these obligations. A number of regulated financial institutions have received warnings and sanctions for not applying regulatory measures set out in legislation after identifying the need to apply them. These institutions should regularly test their compliance framework to ensure that the controls in place are effective, operational and accurate. Stringent risk based tests should be carried out on a continuous basis evidencing compliance with legal regulatory obligations.

Responsibility for compliance with legal regulatory obligations rests with senior management and a disconnect between management and the compliance function will be detrimental: this will reject badly on the firm’s ability to demonstrate a proper compliance system. Information presented to senior management must be useful, accurate and of sufficient quality in terms of how the regulated financial institution is discharging its responsibilities. Senior management should establish and assess a positive compliance culture and evidence that culture in action.

Conclusion

The Central Bank is conducting an increased number of inspections and PRISM engagements. The cost set aside by regulated financial institutions to manage compliance risk is increasing in line with the rise in regulatory sanctions and the associated fines imposed. The Central Bank is concentrating on preventing regulatory breaches before they occur by scrutinising regulated financial institutions’ systems and controls environments. The most important step a regulated financial institution can take in mitigating risk is to ensure the implementation of an effective and robust compliance environment and framework. This framework must be tested regularly and the results evidenced. Senior management are becoming more vulnerable than ever and must also take steps to demonstrate their compliance with applicable legal regulatory obligations. Clear reporting and escalation procedures in the event of any regulatory breaches or concerns must be established, and these breaches and concerns can only be identified by sufficient testing of a regulated financial institution’s systems and controls.

Why Are So Many London Listed Investment Funds Incorporated In Guernsey?

November 17, 2014Articles, Banking and Finance, Latest NewsInvestment FundsJoe Truelove

Guernsey has been home to listed investment funds since 1953 when the fund now known as Threadneedle UK Select Trust Limited was admitted to trading on the London Stock Exchange.

Today Guernsey is the domicile of 70 investment funds which are listed on the London Stock Exchange which is more listed funds than all other jurisdictions excluding the UK added together. So far in 2014 five funds have been formed in Guernsey and listed on the London Stock Exchange.

Does tax avoidance push funds to Guernsey? No, it’s true that Guernsey investment funds are exempt from taxation in Guernsey but then most investment funds in all jurisdictions are rightly tax exempt. This is morally defensible; collective investment schemes should not be taxed because the investors in these funds suffer tax on their income or gains.

So is a desire to avoid regulation pushing funds to Guernsey? No, Guernsey has adopted regulation equivalent to the Alternative Investment Fund Managers Directive and of course funds listed on the LSE have to comply with the Stock Exchange Rules wherever they are formed.

So why is Guernsey so popular for these structures? Well we speak English, use sterling and are in the same time zone as London with regular connections to UK airports.

Our sixty year track record with listed investment funds means that lawyers, auditors, company secretaries, regulators and fund administrators in Guernsey have unmatched expertise.

Furthermore Guernsey’s innovative structures and processes like protected cell companies and the registered fund application process allow fund managers to launch investment funds efficiently and in Guernsey we do not penalise funds which invest in alternative assets like social infrastructure and clean technology.

In this niche area Guernsey contributes to the continuing dominance of the London Stock Exchange.