(2010) JFRC 18(3), 272–292
1 July 2010
Journal of Financial Regulation & Compliance > 2010 > Volume 18 > Issue 3, 1 July > Articles
Journal of Financial Regulation & Compliance
P.E. Morris
Independent Researcher, UK
is an Independent Researcher specialising
in offshore finance centre regulation. He can be
contacted at: philipmorris74@yahoo.co.uk
© Emerald Insight 2010
Abstract
Purpose — The global financial turmoil of 2008 spilled over into the British Isles offshore jurisdictions of Guernsey and the Isle of Man resulting in the collapse of two local subsidiaries of major Icelandic banking groups and consequent depositors' losses. The purpose of this paper is to contrast the sharply differing reactions of the insular authorities and critically evaluate Guernsey's recently enacted deposit protection scheme.
Design/methodology/approach — The paper outlines the nature of the Guernsey jurisdiction, its offshore development and policy issues in deposit protection. Legislation establishing Guernsey's deposit protection scheme is described and critically evaluated.
Findings — Guernsey's scheme is a rushed legislative reaction dominated by finance centre reputational concerns. The legislation is clear and comprehensive but the long-term robustness of its funding model is unclear.
Originality/value — The analysis contained in this paper highlights the ramifications of international bank instability in small offshore jurisdictions and the regulatory problems this poses. Discussion of the legislative basis of the deposit protection scheme clarifies its nature and limitations as an investor protection technique, which is timely given the status of deposit protection as a key theme in the UK Government's initiated Foot Review of nine offshore jurisdictions.
Keywords Banks, Legislation, Regulation, Offshore investments, Consumer protection
Paper type Research paper
Banking & Finance Law and Regulation
Background: the nature of the Guernsey jurisdiction and its offshore development
Constitutional status and legal
system
The Bailiwick of Guernsey is a British Crown Dependency located off the northwest coast of France in the English Channel with a total population of approximately 65,000. It is comprised of the island of Guernsey itself as the principal geographical unit and the neighbouring islands of Herm, Alderney and Sark[1]. It enjoys sweeping powers of internal self-government buttressed by a firm constitutional convention to the effect that Westminster should not legislate on its domestic affairs without first engaging in consultation with and obtaining the prior consent of the insular authorities (Kilbrandon Report (Report of the Royal Commission on the Constitution 1973), paras 1347–1348, 1362). This is a deeply entrenched political practice which, despite recent tensions
(2010) JFRC 18(3), 272–292 at 273
in Whitehall-insular relationships, is not only
faithfully observed (Kilbrandon Report (Report of the Royal Commission on the
Constitution 1973), para 1469), it has been positively enhanced by recent
concordats struck between the States of Guernsey and the UK Government
conferring on the former constitutional autonomy to develop a separate
international identity by means of negotiations and concluded agreements
entered into with supranational institutions and sovereign states (Department
for Constitutional Affairs/States of Guernsey, 2007). Despite this historic
self-governing status and unfolding international identity, it remains the case
that, in technical constitutional law terms at least, the UK Government is
responsible for the defence and international
relations of the Bailiwick and retains an amorphous power to unilaterally
legislate for it on grounds of good government (Young, 2001; Jowell, 2001).
This residual power of intervention has never been clearly defined but the insular
perspective construes it narrowly as requiring serious civil disorder or
comparable extreme scenarios (Kilbrandon Report (Report of the Royal Commission on the
Constitution 1973), paras 1361, 1363 and 1473). In terms of its
relationship with the European Union, the Bailiwick is not a member but the
terms of Protocol 3 to the UK Act of Accession (European Communities, 1972)
enable it to benefit from rules pertaining to free movement of agricultural and
industrial products while insulating it from Community rules on free movement
of persons and tax co-ordination.
The Bailiwick has a separate legal profession and
court systems embracing civil and criminal jurisdictions at original and
appellate levels (Roberts-Wray, 1966; Robilliard,
1979). Ultimate rights of appeal lie from its Court of Appeal to the Privy
Council in London whose opinions are theoretically persuasive but in practice
close to binding. Sources of law (Dawes, 2003; Ozanne
and Dawes, 2005) are the customary law of Guernsey whose historical and
intellectual foundations are rooted in the now largely defunct customary law of
Normandy; the Guernsey common law which is heavily influenced by but certainly
not dictated to by its English counterpart; and legislation of a primary and
secondary nature enacted by the States of Deliberation (Guernsey's
legislature). The former requires the Royal Assent granted by the Privy Council
acting on behalf of the Crown; normally this is a formality. These sources may
appear a fertile resource for the development of legal doctrine, especially the
Guernsey common law which possesses an independent status and has displayed
great flexibility in adapting to the changing needs of Guernsey society. In
practice, however, the evolution of substantive law tends to be impeded by an
endemic problem in micro-jurisdictions: the lack in sufficient quantity of
case-law on issues of principle which serves as raw material for the crafted
development of Guernsey customary and common law as well as clarification of
legislation (Twining and Uglow, 1981; McGoldrick and
Morris, 1995).
Development of the offshore
finance centre
Turning to its offshore development, it is useful at the outset to reiterate that the Bailiwick is not a tax haven: this is a pejorative label “intensely disliked” by the insular authorities on the ground it suggests offshore business is based solely on zero or low tax rates (Hampton, 1996, p. 15). Rather it is a well developed functional offshore finance centre (OFC) hosting real and substantial financial activity in sharp contrast with compound or notional OFCs located in the Caribbean and Pacific Basin where the bulk of offshore activity takes the form of booking centres and “brass plate” operations designed primarily to avoid onshore taxation and regulation (Hampton and Abbott, 1999a, b).
(2010) JFRC 18(3), 272–292 at 274
This is an approximate distinction based on the
nature of offshore business. It remains the case that the notion of an OFC is
not a juridical concept; it exists by reference to economic cum broad
regulatory criteria including zero-low tax rates, rigid segregation of resident
and non-resident business, a favourable regulatory
environment and an economy dependent to a significant extent on the OFC (Zoromé, 2007). Guernsey's development into a leading
international OFC was facilitated not simply by its constitutional autonomy
permitting the construction of a finance-magnet fiscal structure but also by
rescheduling of the Sterling Area in 1972 and abolition of UK exchange controls
in 1979 which granted finance capital unfettered freedom of movement in search
of low tax, lightly regulated locations (Johns and le Marchant, 1993).
The nature and size of the Guernsey OFC now
establishes it as a major international player in the world of offshore
business (Home Office, 1998; Morris and Campbell, 2000). It has carved out
specialist areas of activity in captive insurance, international banking,
investment funds and offshore trusts (Home Office, 1998; Johns and le Marchant,
1993). Indeed in captive insurance it can justifiably claim to be amongst the
world's leading centres. This has resulted in overall
bank deposits of £119 billion, over 600 special purpose insurance under-writing
vehicles and in excess of 2,500 open and closed ended investment funds with
total assets of £140 billion (Guernsey Financial Services Commission, 2007).
The net effect of this rapid growth is an insular economy heavily and arguably
dangerously reliant on the OFC: it accounts for in excess of 20 per cent of
overall employment; close to 40 per cent of national income as measured by
gross profits in all sectors of the economy; and it offers by far the most
lucrative employment in terms of calculated remuneration per employee.
Guernsey's banking sector provides retail services but the bulk of deposits are
held in international private and corporate banks servicing the needs of
interbank deposits and high net worth individuals (States of Guernsey Policy
Council, 2008a, b; Foot, 2009). It provides almost 3,000 well-paid skilled jobs
and contributes £40 million in tax revenues annually to the insular economy
(States of Guernsey, Commerce and Employment Department, 2008).
The position has now been reached that, despite
official policies of economic diversification, the Bailiwick's long-term
prosperity is indissolubly linked to the future security of its OFC. Yet this
is increasingly under scrutiny from not merely supranational organisations such as the EU and OECD but also the G20
world leading economies concerned by the role of OFCs in fuelling
onshore revenue losses via international banking practices resulting in tax
evasion (Barker et al., 2009; Webster
et al., 2009;Organisation for
Economic Co-operation and Development, 2009b, Annex C). Guernsey and its
British Isles OFC counterparts of Jersey and the Isle of Man are well placed to
meet this challenge in the form of their rolling programme
of bilateral tax information exchange and co-operation mechanisms which have
been adjudged in conformity with the agreed global standard (Organisation for Economic Co-operation and Development,
2009a, b). If however the UK Government ever took this pressure a stage further
and sought to interfere with Guernsey's attractive fiscal structure (income tax
set at a fixed rate of 20 per cent; corporation tax is confined to the specific
spheres of regulated financial services (10 per cent), income from Guernsey
property (20 per cent) and regulated utilities (20 per cent) and there are no
capital gains taxes, inheritance taxes or value-added tax: Dawes, 2003; Foot,
2009, Annex C), independence as a last resort option to preserve the OFC has
apparently not been ruled out (Kettle, 2009).
(2010) JFRC 18(3), 272–292 at 275
The purpose of this paper set against this background
is a case study of the collapse of Landsbanki Guernsey (LG), a subsidiary of a
major Icelandic banking group, and the reaction of the insular authorities in
the form of a hurriedly enacted deposit protection scheme. It is structured
into three parts. In the first part, the collapse of LG is outlined and
contrasts highlighted with the reaction of the Isle of Man Government to the
contemporaneous collapse of Icelandic subsidiary Kaupthing,
Singer & Friedlander (Isle of Man) (KSF IoM). The second part explores
policy issues in deposit protection with particular reference to the offshore
dimension. The centrepiece of this case study is a
critical evaluation of the recently enacted Guernsey deposit protection scheme.
Although much of this discussion may seem of specific concern to Guernsey, the
legal and policy issues identified are likely to prove of more broad-ranging
relevance in view of the imminent introduction in Jersey, Guernsey's Channel
Islands neighbour and OFC competitor, of a deposit
protection structure and the fact the whole issue of deposit protection forms a
central feature of the UK's Treasury initiated Foot Review of financial
regulation in the British Crown Dependencies and Overseas' Territories. The
review embraces a total of nine offshore jurisdictions only two of which,
Guernsey and the Isle of Man, currently operate deposit protection schemes (Foot,
2009).
The collapse of LG, its implications and an Isle of Man comparison
The Icelandic banking crisis
and collapse of LG
In October 2008, LG was placed in administration by its Guernsey directors in the aftermath of a systemic crisis engulfing the Icelandic banking sector culminating in effective nationalisation of its parent, Landsbanki Islands hf, by the Icelandic Government. The broader context (House of Commons Treasury Committee, 2009) is one of an extreme national economic crisis, triggered and fuelled by the collapses of three major Icelandic banking groups, involving large increases in unemployment, currency devaluation and provision of emergency International Monetary Fund (IMF) financial support to the Icelandic Government. These three groups held a combined debt six times that of Iceland's GDP of 14 billion Euros and around 85 per cent of total bank assets immediately prior to the collapses.
Placing LG into administration was supported by the
Bailiwick's Government, the States of Guernsey, and host regulator the Guernsey
Financial Services Commission (GFSC) as a means of preserving the asset base of
LG in order to maximise possible returns to investors
(States of Guernsey Policy Council, 2008a, b). Precise details of depositors' prima facie losses have not been made
public but it is clear there are around 2,000 of them comprising 800 Guernsey
residents, 200 residents in Jersey and 1,000 non-residents. A substantial
proportion of the latter appear to have been attracted to use of the LG facility
by the prospect of lengthy tax liability deferral and high interest rate
incentives (de Woolfson, 2008c; House of Commons
Treasury Committee, 2009). Over half of LG depositors are expatriate employees
falling into this category and over 60 per cent of them held deposits of
between £10,000 and £100,000 (House of Commons Treasury Committee, 2009). On
the other hand, some island residents have lost their life savings and with it
a vital income source (de Woolfson and Ogier, 2009)
and on the evidence collated it is unfair to depict the clear majority of
depositors as sophisticated investors able to absorb these losses (House of
Commons Treasury Committee, 2009). The Joint Administrators (international
accountancy firm Deloitte) have guaranteed depositors minimum recovery of 30
pence in the pound with the prospects of further repayments in excess of this
(de Woolfson, 2008a, b). Unlike most
(2010) JFRC 18(3), 272–292 at 276
deposit protection schemes, this is not subject to an
overall ceiling. The insular authorities have adopted a firm and consistent
line to the effect their role is the restricted one of acting as a conduit, via
the UK Treasury, for urging the Icelandic government to place pressure on the
LG parent group to honour its (non-legally binding)
letter of comfort assuring LG depositors, issued upon its acquisition from
previous owners, that all its outstanding liabilities would be honoured (States of Guernsey Policy Council, 2008a, b; de Woolfson, 2008a; Ogier, 2008; Bounds and Willman, 2008a).
In particular, the States is implacably opposed to the provision of ad hoc financial support, any form of
guarantee or retrospective extension of its recently enacted deposit
compensation scheme (DCS) to LG depositors (Ogier, 2009; Bounds and Willman,
2008b; de Woolfson, 2009).
This stance is shared by the UK Government which
applies the “overarching principle” that deposits are not protected if lodged
in jurisdictions outside its regulatory control; a position endorsed in recent
political scrutiny of the Icelandic bank collapses (House of Commons Treasury
Committee, 2009) notwithstanding the acknowledged “severe distress” experienced
by savers in the aftermath of the LG and KSF IoM collapses (House of Commons
Treasury Committee, 2009, para 106). Given this unflinching political position,
lack of recourse to a Guernsey scheme and the fact the Icelandic deposit
protection scheme is confined to the European Economic Area (which Guernsey is
outside of) the effect is to confine investor redress to a private, opaque and
asset-weakened liquidation process.
Apart from Icelandic banking sector meltdown caused
by over-indebtedness, the immediate root cause of LG's collapse lies in the
international banking practice of “upstreaming”. This involves the wholesale
transfer of local subsidiaries' funds to the parent group in order to bolster
its liquidity and maximise commercial returns which
are limited in Guernsey given the absence of a Treasury function and restricted
commercial lending opportunities relative to the size of the banking sector
(Guernsey Financial Services Commission, 2008). The practice is endemic in
Guernsey with 13 out of 24 major banking institutions placing more than 50 per
cent of their deposits intra group (GFSC, 2008). Although the independent
inquiry into the LG collapse exonerates the GFSC from blame in the face of this
entrenched business model (Promontory Group (UK) Ltd, 2009), it seems probable
it will be compelled to adopt a series of new regulatory standards in order to
reduce the risks of a repetition including a cap of 85 per cent of
subsidiaries' assets which may be “upstreamed” to its
parent, an obligation to place funds outwith the
group in liquid, high quality assets or high-grade loans or in the form of
interbank lending and stricter controls on the establishment of branches in the
Bailiwick since compared with a subsidiaries they pose a greater risk to
deposit protection (Promontory Group (UK) Ltd, 2009). The inquiry is flawed by
its conspicuous failure to investigate clear evidence of poor regulatory
co-operation between the United Kingdom Financial Services Authority and the
GFSC which may well have averted the transfer of £36 million from LG to
Landsbanki Group's UK subsidiary, Heritable (UK), shortly preceding the
administration decision; these funds are clearly the precise economic reason
for depositors' losses which are unlikely to be fully or even substantially
recouped.
An Isle of Man comparison
The reactions of the insular authorities in Guernsey to the administration of LG stand in stark contrast to those of the Isle of Man Government faced with the placing into
(2010) JFRC 18(3), 272–292 at 277
provisional liquidation of KSF IoM at around the same
time. These are vigorous, imaginative and have been focussed
on securing much fuller returns for depositors. That said the Manx authorities
position is more favourable than the States of
Guernsey since the asset base of KSF IoM is considerably stronger than that of
LG and they have consistently striven to avoid formal triggering of its deposit
protection scheme in order to secure enhanced compensation for depositors and
prevent damage to confidence in the Isle of Man as a sound offshore banking centre. The Island's deposit protection scheme has been
viewed throughout this affair by the insular government as very much a last
resort option.
In its reaction to the placing of KSF IoM into
provisional liquidation the Isle of Man government pursued an interventionist approach
designed to safeguard the reputation of the banking sector and secure the
fullest possible returns for depositors. This has included Manx Treasury funded
and administered early repayment schemes covering for an initial time phase
claims of up to £1,000 (Isle of Man Government, 2008a) and subsequently £10,000
(Isle of Man Treasury, 2009) in order to alleviate distress experienced by
depositors in the face of freezing of the bank's assets. These schemes
represented essentially advance payments pending projected sale, restructuring
of the bank, distribution of its assets in liquidation or formal invocation of
the Island's deposit protection scheme. Payments made under them will
subsequently be recovered via a “set off” once the deposit protection scheme is
triggered as now appears certain. Nonetheless, they provided investors with
speedy, streamlined compensation and created valuable space for the Provisional
Liquidator to explore bank resale or corporate restructuring alternatives.
Throughout most of the KSF IoM affair the likely
outcome seemed to be a Manx High Court supervised scheme of arrangement (Isle
of Man Government, 2009a, b, c) involving staged repayments to depositors. This
bespoke provisional solution underwritten to the tune of £180 million by the
Isle of Man Government guaranteed full repayment for 50 per cent of depositors
within three months and over 70 per cent within two years. Estimates from the
administrators suggested a possible minimum recovery rate from KSF IoM of 75
per cent counterbalanced by a £50,000 cap (Isle of Man Government, 2009d).
Despite being the favoured solution of the Isle of
Man Government, it failed to garner the necessary support in a vote of
depositors. Larger depositors and unsecured creditors effectively vetoed it
(despite overwhelming support amongst smaller depositors) causing KSF IoM to be
formally placed into liquidation and triggering imminent operation of the
Island's deposit protection scheme (Isle of Man Government, 2009f). This will
involve Manx Government funding of £193million recoverable via bank levies
under the scheme and dividends paid out by the Liquidator. Payments are
expected to provide full recovery for 75 per cent of depositors within three
months but will be subject to the scheme cap of £50,000 per depositor. (Isle of
Man Government, 2009e). At first glance this outcome appears broadly similar to
the proposed scheme of arrangement but the insular authorities regard it as
inferior on the grounds it requires imposition of significant levies on banks
and precludes any prospect of fuller returns in excess of £50,000. The decisive
factor appears to be, in crude terms, the sheer rapidity of complete payouts
compared with the more protracted and contingent scheme of arrangement.
Although the commercial positions of failed banks are
unique as is the range of possible regulatory and corporate rescue responses,
there is a spectacular contrast
(2010) JFRC 18(3), 272–292 at 278
between the classic laissez-faire position of the
States of Guernsey and the creative, interventionist position adopted by the
Isle of Man Government. The reasons for this are not solely due to the vastly
superior asset position of KSF IoM, they are traceable to the infamous collapse
of the Savings and Investment Bank in 1982 which inflicted serious damage on
the reputation of the Manx OFC and impeded its development for over a decade
(Johns and le Marchant, 1993; Cobb, 1998; Kermode, 2001). It was this debacle
which prompted the creation of the Isle of Man deposit protection structure in
1991 with its clear purpose of avoiding the damaging spectacle of large numbers
of depositors (over 4,000 in the Savings and Investment Bank affair) placed in
the position of lacking access to guaranteed restitution. So why, somewhat
bizarrely, was there such a marked reluctance to place KSF IoM into liquidation
and thereby trigger formal operation of the scheme with its guaranteed full
recovery of deposits within the statutory £50,000 ceiling? Explanations for
this are difficult to deduce in view of the lack of public discussion amongst
key actors but are almost certainly due to an aversion to imposition of ad hoc levies on banks to fund depositor
compensation on the ground this may damage business confidence in the Island as
a banking centre and that publicity generated by
formal invocation of the scheme could, paradoxically, cast doubts on the
soundness of its banking system and thus deter use of its facilities by
potential investors. In more positive terms, for a minority of investors
alternative options involved possible full(er) recovery in excess of the
scheme's £50,000 ceiling. The end result however has been that political and
regulatory concerns regarding the reputational interests of the offshore
banking sector have been overridden by depositor voting power favouring sheer speed in compensation distribution.
The historic position of the insular authorities in
Guernsey has been that deposit protection is unnecessary since a rigorously
selective licensing regime coupled with a more stringent stance towards capital
adequacy ratios than under Basle rules is sufficient to safeguard the interests
of depositors(le Marchant, 1999). This policy has had to be rapidly reappraised
following the collapse of LG and resulted in a fast-tracked deposit protection
scheme with innovative features. In a jurisdiction with a weak consumer
protection tradition, the driving force behind this, despite official rhetoric
to the contrary, is arguably more about shoring up the reputation of the OFC
than guaranteeing restitution for depositors (Mann, 2008). The Manx experience
of over 20 years of deposit protection and rapid OFC development suggests this
as a sound (albeit instrumental) policy response, but the KSF IoM affair
underlines the point that active government intervention exploring a range of
alternatives including bank resale, corporate restructuring, ex gratia (recoverable) payments and a
court supervised scheme of arrangement may be preferable from both investor
protection and reputational perspectives. Failure to bring one of these
alternative options to fruition does not invalidate the point. In the OFC
environment, therefore deposit protection is arguably a double-edged sword: an
enacted scheme certainly bolsters a jurisdiction's reputation as a
professionally regulated OFC but there is clearly a perception that actual
invocation of it may hinder, if only in a subjective, psychological sense, its
efforts to attract deposits in the fiercely competitive world of offshore
finance.
Policy issues in deposit protection
While deposit protection schemes are still not
required or recommended best practice in international financial regulation
terms, they have proliferated rapidly since the
(2010) JFRC 18(3), 272–292 at 279
1980 s to such an extent that most developed jurisdictions
possess some form of explicit scheme (Hoelscher et al., 2006). The twin principal
justifications typically advanced for deposit protection (Cartwright, 1999,
2004; Campbell and Cartwright, 1998, 1999, 2002; Goodhart et al., 1998) are reduction of systemic risk in the banking sector
and consumer protection. By providing solid guarantees in the event of a bank
default, deposit protection removes the incentive for depositors to withdraw
funds once news breaks a bank is in financial difficulty; this in turn reduces
the risk of bank runs developing; and with it contagion-induced systemic
instability flowing from interbank dependency based on interbank lending and
shared responsibility for the payments system. Consumer protection is advanced
via provision of a safety net which is accessible and alleviates the distress
bank failure causes to small-scale investors. Although conceptually distinct
these dual rationales for deposit protection in practice overlap(Campbell and
Cartwright, 1999; Cartwright, 2004): consumer confidence in savings media
generated by the existence of deposit protection removes the need to withdraw
funds at the first sign of financial problems and thus provides a bulwark
against bank runs.
Moral hazard, systemic risk and
consumer protection
The main and enduring criticism of deposit protection is based on the economic theory of moral hazard. This holds that such schemes are a source of systemic risk since they remove the incentive for savers to perform checks on the financial soundness of banks and likewise senior bank management will inevitably tend to adopt risky business models in view of the fact most savers will be compensated in the event of a bank collapse (Campbell and Cartwright, 2002; Cranston, 2002). The theory is flawed by the social reality that most savers lack the means to properly evaluate the soundness of a bank and even if they could access such information they are in no position to evaluate it (Cartwright, 1999; Campbell and Cartwright, 1999; European Commission, 2008). Despite this, moral hazard continues to exert a powerful influence on policy makers and regulators in the design and implementation of deposit protection schemes. Failure to build moral hazard concerns into the substantive features of a deposit protection scheme is regarded as a serious design flaw in the banking and regulatory communities (Garcia, 2000; Dale, 2000; Hoelscher et al., 2006).
In an offshore jurisdiction, such as Guernsey,
heavily dependent on banking in terms of employment and public revenues,
systemic risk concerns are if anything greatly magnified. Bank runs in Guernsey
would trigger capital flight and damage confidence in the OFC as a whole. Such
action is facilitated by the fact most funds are held in international banking
conglomerates with Island management denied effective independence and key
decision makers at parent level more concerned by the financial exposure of the
group than the reputation of the host OFC or indeed the interests of depositors
in the local subsidiary. The wider consequences of capital flight for the
insular economy would be disastrous and persist for a considerable period of
time. Accordingly deposit protection in Guernsey possesses a powerful,
independent rationale: a means of bolstering investor confidence in the
fundamental pillar of the Bailiwick's economy. This overriding imperative
justifies the moral hazard and business costs inherent in any deposit
protection scheme. Well-designed deposit protection schemes operating in the
context of good quality financial intermediation
(2010) JFRC 18(3), 272–292 at 280
have been empirically verified to be a source of
banking sector stability in offshore jurisdictions (Mayasami
and Sakellariou, 2008; Laeven,
2002).
It must nonetheless be conceded that there are limits
to the utility of deposit protection in small Island OFCs. International
banking facilities in these are normally conducted on a group basis with local
operations heavily influenced by both group liquidity problems and systemic
instability in international banking generally. There is little contribution
deposit protection can make to alleviate these problems; its role is the narrow
one of provision of consumer redress in the event of a bank failure. Where
these problems are deep seated it is questionable whether it is in practice
capable of fulfilling its much vaunted role of minimising
systemic risk. The LG and KSF IoM collapses in Guernsey and the Isle of Man,
respectively, suggest insular banking operations are quickly overwhelmed by
group and international banking problems relegating deposit protection to a
narrow consumer protection function. These collapses moreover highlight the
point that the fundamental regulatory issue is not deposit protection but
absence of insular influence on group management, lender of last resort
facilities and central bank exhorted corporate rescue operations in
OFC-dominated jurisdictions lacking full constitutional sovereignty, the effect
of which is to confine prima facie corrective
action to placing political pressure on home governments and parent group
management in the hope of securing observance of comfort letter commitments.
These structural limitations on banking regulation in
offshore dependencies have been noted in early stages of the Foot Review and a
clear hint given that their regulatory architecture may require rethinking in
order to broaden the range of policy instruments necessary to deal with
economic volatility including possibly deposit protection, additional powers of
intervention and capacity to provide emergency funding in order to ameliorate
the effects of bank failure. The urgency of these reforms scarcely needs emphasising given the lessons of the LG affair: that letter
of comfort commitments are in practice of little value in the context of a
foreign-owned parent group itself in a dire financial position.
The consumer protection dimension is however not to
be dismissed lightly in view of the losses sustained and numbers of investors
involved. This in turn has two specific ethical justifications which, for
small-scale depositors at least, effectively “trump” moral hazard concerns.
First, distributive justice dictates that bank failure causing substantial loss
of wealth to those least able to bear it ought to be the subject of
commensurate restitution measures (Cartwright, 2004). Second, the principle of
legitimate expectation holds that the investor by choosing low-risk ordinary
savings media has opted for security over returns; protection of the deposit
avoids the disappointment of his legitimate expectation (Page and Ferguson,
1992). These are compelling principles but their application may in the
offshore context be problematic given the increasing prevalence of
non-residents motivated to use banking facilities for tax liability deferral
and financial return reasons.
The Guernsey DCS: key substantive features
Rationales for the Guernsey DCS are clearly
articulated:
● to protect small retail depositors against loss of their deposits; and
● in doing so enhance Guernsey's reputation as a well-regulated OFC (States of Guernsey, Commerce and Employment Department, 2008).
(2010) JFRC 18(3), 272–292 at 281
The DCS was designed and enacted within the space of
a couple of months, the insular authorities frankly admitting that although it
was already under active consideration, the global financial turmoil of Autumn
2008, which generated spill over effects in the Crown
Dependencies, has speeded its progression onto the statute book (States of
Guernsey, Commerce and Employment Department, 2008). Moral hazard concerns are
addressed via the exclusion of corporate investors as well as high net worth
individuals and partial funding in the form of risk-related premiums (which
serve as a disincentive to the adoption of high risk business models: States of
Guernsey, Commerce and Employment Department, 2008) but limited by the
principle that “that small depositors lack the capacity and access to
information to monitor the financial health of banks in any meaningful way”
(States of Guernsey, Commerce and Employment Department, 2008, para 4.13).
Moreover, expectations of the DCS are realistic: it can provide investor
redress in the aftermath of bank failure but cannot and is not designed to deal
with a major bank crisis rooted in systemic risk; this can only be tackled by
stringent corporate governance and regulation (States of Guernsey, Commerce and
Employment Department, 2008).
(i)
Scope and the trigger mechanism
The Ordinance establishing it[2] explicitly extends the reach of the DCS to the entire Bailiwick so it covers not simply Guernsey but also the neighbouring jurisdictions of Alderney and Sark where branch and office banking activity takes place (ss33(1) and 34(2)). The scheme is formally designated the Guernsey Banking Deposit Protection Scheme and is administered by the Guernsey Banking Deposit Protection Board (s1(1) and (2)). Participation is mandatory for banks holding a banking licence in the Bailiwick although there is provision for withdrawal if the licence has been revoked or upon giving six months written notice to the Board (s2(1) and (2)). Deposits covered are those in cash denominated in sterling or any other currency. Protection extends to deposits made by trustees for the purpose of a retirement annuity scheme, by a parent for the benefit of his child and an administrator or executor of an estate of a deceased person where the deposit represents the proceeds of the estate (Schedule 4, para 1). Deposits by corporate bodies are not covered nor are deposits in respect of which there has been a criminal conviction or civil recovery proceedings pursuant to insular anti-money laundering legislation (Sch 4, para 2).
The DCS compensation and alternative powers regime
does not become operative until the GFSC has made a formal declaration of
default (s9(1)). It is required to do so when a participating bank incorporated
in Guernsey has, in accordance with the Guernsey Companies Law 2008[3],
been wound up, put into administration, entered into an arrangement/ compromise
with its creditors or its affairs been declared en desastre (s9(2)(a)(i)–(vii)).
Where the bank is incorporated outside Guernsey an event equivalent to these
must have occurred (s(9)(2)(b)). Once a formal declaration of default is made
the Board is required to appoint a Guernsey Companies Law qualified external
auditor to audit its financial affairs (s9(3)(4)). Thus, it is the GFSC as
banking regulator which formally triggers the DCS and until this has occurred
there is no barrier to the insular authorities pursuing the types of
alternative action witnessed in the KSF IoM affair. Such de facto powers
therefore exist independently of the Board's wide-ranging corporate rescue/
restructuring powers which come into play following a formal
(2010) JFRC 18(3), 272–292 at 282
declaration of default (Schedule 1). In summary,
flexible broad-ranging alternatives to compensation payments under the DCS
exist both pre and post-declaration of default.
(ii) Administration
Stewardship of the DCS is specifically entrusted to the Board which is itself appointed by the States Department of Commerce and Employment subject to the final approval of the States of Deliberation (s3(1)(4);s33(1)). The composition of the Board is that of a Chairman and up to four ordinary members (s3(3)). Board members are appointed for renewable fixed terms of up to five years, their names have to be published and they are removable by the Department on a range of grounds including conviction for an indictable offence and being unfit/unable to continue in office (s3(5)(a)–(d)–(6)). The Board will operate via a system of majority voting specified in operational rules published by the Department (s3(8)(9)) but there is provision for streamlined decision making without holding formal meetings provided Board members are in contact with each other and able to access relevant discussion (s4(1)(a)(b)).
The Board enjoys all the powers of a Guernsey
registered company with unlimited objects including the capacity to enter into
contracts, acquire, hold or dispose of property, operate bank accounts, employ
staff, guarantee the obligations of other persons and participate in joint
ventures with other persons (s4(3); Sch 1, para 1(a)–(i)).
Perhaps its most vital power is that it “may insure all, or any parts of, the
payment of compensation pursuant to the Scheme in such manner as it considers
appropriate” (s4(3)). This is arguably in commercial terms the key provision in the legislation since projected exercise of
the power in the form of the States created captive insurance entity is the
vehicle for ensuring effective long-term functioning of the DCS as a source of
compensation and means of reducing systemic risk. It is worth noting, however,
that the power is a subjective, discretionary one: there is no requirement for
the DCS to be funded by any form of insurance mechanism. This means if the
captive insurance entity becomes excessively expensive or inadequate it can
simply by wound up and alternative arrangements pursued.
Board powers are not confined to making compensation
payments. It enjoys sweeping alternative powers to pursue a variety of
corporate rescue procedures including restructuring the bank's business,
facilitating its sale, take-over or merger, provision of financial assistance
to a bank in order to prevent its failure, powers to acquire, sell or dispose
of the bank's assets, business or property at a price it considers reasonable
or delegate these functions to third parties (Sch 1, paras 2(i)–(iv)). These flexible corporate rescue powers are only
exercisable if four conditions are met: a declaration of default has been made;
the reputation of the Bailiwick as a finance centre
is at risk; that the total cost to the DCS of exercising these powers “is
likely to be lower than paying compensation”; and the GFSC has been consulted
(Sch 1, paras 2(a)–(d)). Recourse to the DCS is accordingly not mandatory; the
Board is invested with discretionary power to explore a range of corporate
rescue and administration procedures which may secure fuller returns for
depositors or ensure the continuation of accounts under different bank
ownership. There is thus clear power to act along similar lines to those of the
Isle of Man authorities in the aftermath of the KSF IoM collapse and this may
also, particularly if it preserves the bank as a business operation, better
safeguard the reputational interests of the OFC than the publicly damaging
spectacle of formal invocation of the DCS. Such alternative powers also exist
de facto
(2010) JFRC 18(3), 272–292 at 283
in the absence of a formal declaration of default.
The operational reality is that the Board will be a skeletal body performing
essentially a fees collection function; but in the event of a bank default or
looming crisis it will spring into action recruiting extra staff, expanding
into additional premises and actively pursue the complete range of options
until such time as its corrective action or co-ordinating
efforts justifies reversion to its normal passive mode (States of Guernsey,
Commerce and Employment Department, 2008).
(iii) Funding
The Board is under a duty to establish compensation and administration funds following a formal declaration of default. Essentially, the administration fund is used for the purpose of meeting the running costs and management of the DCS. It is funded by a system of annual fees levied in accordance with s16 and insurance levies paid by participating banks in accordance with s17 ((s7(1)(a)–(f)). Payments out of the administration fund cover the costs of running the DCS and any insurance premium/arrangement entered into pursuant to s4(3) ((s7(2)(a)–(e)). Compensation funds in contrast take the form of levies imposed on banks following a declaration of default, the so-called compensation levy imposed by s18, monies received from a liquidator, administrator or receiver or an insurance policy/arrangement (s8(a)–(e)). Payments out of the compensation fund may take the form of compensation in regard to qualifying deposits and repayments to claimants following the Board's exercise of a right of subrogation by virtue of s23(4) (s18(1)(a)(b)(2)(3)).
Detailed rules on sources of DCS funding are laid
down in the Ordinance: annual fees levied by the Board (s16); insurance levies
imposed in order to finance the States-owned captive insurance vehicle (s17);
and compensation levies imposed by the Board when a participating bank is
declared in default (s18). The latter is intended to be a form of “top up” in
the sense that in calculating them monies paid out of the captive insurance
vehicle have to be taken into account (s18(3)). In general terms a compensation
levy as per individual bank may not exceed £1 million per financial year or 50
per cent of its average profits over the previous three years whichever is the
lesser. (s18(4)(a)(b)). Where this levy is insufficient to meet the claims of
qualifying creditors, additional levies may be imposed, and the overall limit
is only per annum with the result levies may be imposed in subsequent years
without limit until the claims of qualifying creditors are met in full
(s18(5)(a)(b)). Precise rules are articulated on calculation of banks'
individual contributions to a compensation levy. Essentially all banks are
equally liable for the first £10 million of the Board's estimate under s18(Sch2).
Over and above this limit each bank is liable in accordance with a co-efficient
prescribed by the Department: calculate the total qualifying deposits as if a
declaration of default was made and multiply the figure by 0.66 per cent[4].
In broad terms this places a cap on banks potentially open-ended compensation
liability so that the failure of a large or multiple banks does not itself fuel
systemic risk by imposing a crushing burden on individual participants. Rights
of appeal against annual insurance or compensation levies may be made to the
Royal Court of Guernsey in accordance with Sch 3 which broadly mirrors the
grounds for substantive judicial review of administrative action.
There are three specific comments worth making
regarding these funding arrangements. First, the model adopted is an innovative
mixed pre- and post-funded one in sharp contrast with the Isle of Man scheme
(Tynwald, Isle of Man, 2008; Isle of
(2010) JFRC 18(3), 272–292 at 284
Man Government, n.d.) which has no standing fund and
is entirely ad hoc post-funded. This
of itself, notwithstanding wide-ranging alternative powers conferred on the
Board, may in situations where the compensation liability is manageable, reduce
the need to pursue corporate rescue/restructuring options. Indeed recourse to
alternative options post-declaration of default appear to be ultra vires where they are more costly
than invocation of the DCS. Second, the long-term credibility of the DCS turns
on the perceived robustness of the States-owned captive insurance vehicle. Yet
there remains a distinct lack of detail on its functioning other than the fact
(States of Guernsey, Commerce and Employment Department, 2008) the States will
guarantee the initial £20million with banks eventually replacing this by
building up the fund via insurance levies of up to £2million per annum in
aggregate. Once the £20 million liquid figure is reached banks would contribute
an additional tranche of £10 million equally and a further £70 million
calculated according to each bank's deposit base, risk profile and a
co-efficient. The net effect of these arrangements is a total liability
exposure cap on the DCS of £100 million over a five year period (s14(1)(2)). It
is envisaged as purely a cash holding vehicle with no capacity to jeopardise the fund by engaging in investment activities.
The fund is therefore institutionally ring-fenced and held external to the
banking sector. Third, while these arrangements incorporate clear recognition of
moral hazard in the form of risk-related premiums (it is envisaged these will
result in some banks obtaining discounts of up to 30 per cent with others
paying up to double their initial contribution depending on their assessed risk
profiles: States of Guernsey, Commerce and Employment Department, 2008), it is
at the technical level extremely difficult to precisely quantify such premiums
with confidence and they possess an innate tendency to become excessively
expensive. In the long run, this could impose significant continuing business
costs on certain types of bank with higher risk profiles. These may feed
through into group management decision making regarding business distribution
offshore. Although possible relocations may, from a regulatory perspective, be
judged as generating beneficial reduction in systemic risk this has to be
weighed against employment and tax losses in a small Island economy heavily
dependent on its OFC.
(iv) Compensation payments
The DCS includes a series of clear rules following a formal declaration of bank default which both govern the procedure in making an application for compensation and substantive conditions attaching to the issuance of compensation awards.
Turning to administration first, within 21 days of a
formal declaration of default the Board is required to make available to
claimants a standard application form containing evidence supporting the claim
(s10). Compensation claims are assessed on their merits by the Board and are
required to be lodged within six months of the depositor first becoming aware
of the default and in all circumstances no later than twelve months from the
declaration of default (s11). Once a declaration of default has been made and
the claim verified the Board is required to make a compensation payment in
sterling (s12(1)(2)).
In terms of substantive conditions, the total amount
of compensation payable is the aggregate amount of qualifying deposits or
£50,000 whichever is lower (s12(2)(a)(b)). This replicates the compensation
ceiling in the UK and Isle of Man schemes, both of which have recently been
significantly raised in response to banking
(2010) JFRC 18(3), 272–292 at 285
instability concerns. Moreover, there is no use of
co-insurance, which is ostensibly designed to address moral hazard, but which
in practice causes hardship to small-scale investors. In regard to joint
accounts, for the purposes of calculating the £50,000 ceiling the account is to
be divided into equal shares if there is no indication of division or if there
is according to the division stated in the account documentation(s12(3)). An
inroad is driven into the £50,000 cap by s12(3) which provides that in the
three specific scenarios of monies deposited by a trustee of a retirement or
annuity scheme or a parent for the benefit of a child or administrator/executor
of an estate these should be treated separately for the purpose of calculating
the £50,000 ceiling. In other words, ordinary cash deposits held by the
claimant in these scenarios is to be disregarded thus avoiding arbitrary
outcomes and possible hardship where the claimant makes use of his/her existing
bank for these transactions.
Perhaps the most important clarification of the
£50,000 ceiling is in s12(6) which makes crystal clear that a qualifying
claimant “may not receive compensation in respect of more than one account with
a single participant in default”. Essentially, this is an anti-avoidance
provision: it is not possible to circumvent the ceiling by opening several
accounts with the same bank. There is however no barrier in the DCS to an
investor both spreading his risk and increasing the prospects of full(er)
compensation by opening multiple accounts with different banks. In this
situation the s12(6) limitation is inapplicable and depositors enjoy extensive protection
in the event of a number of bank failures. Compensation payments can be reduced
on account of payments received from other sources including compensation
schemes outwith the Bailiwick equivalent to the DCS
or those made by a receiver or liquidator whether inside or outside the
Bailiwick or arising from any set off between the claimant and the
bank(s12(7)(a)–(d)). As a general rule, payments are required to be made within
three months of the declaration of default or receipt of the application whichever
is the later (s15(1)). In view of the strains which may be placed on the DCS by
large-scale multiple claims, provision is made for staggered payments where
full immediate payment “would not be prudent”; this is at the absolute,
subjective discretion of the Board (s15(2)(a)(b)). This is subject to a duty to
pay portions of the compensation in subsequent calendar years following the
declaration of default although this is simply delaying rather than denying
full payment; the Board remains under a continuing obligation to make full
repayment in accordance with the rules of the DCS (s15(3)). These provisions
for delayed payments arguably reflect concerns as to proper financing of the
scheme in practice. Finally, the DCS compensation liability is subject to an
overall £100 million limit over any five year time frame; where compensation
payable to eligible claimants exceeds £100 million “it shall be apportioned pari passu”(s14(1)(2)).
Due process and a measure of legal accountability are
grafted onto the DCS by s12(11) which creates a right of appeal against Board
decisions to the Royal Court. Basic provisions on this are laid down in
Schedule 3: the right has to be exercised within twenty-eight days of the
Board's determination; it may be made on grounds which reflects conventional
judicial review of administrative action such as that it is ultra vires, unreasonable, lacks
proportionality or contains an error of law; the Royal Court can vary, set
aside or refer it back to the Board with directions; and there is a right of
appeal on questions of law to the Guernsey Court of Appeal. Once the essential
nature of the claim and clarity of DCS rules is grasped, it is clear this is
(2010) JFRC 18(3), 272–292 at 286
a “back stop” provision designed to assuage broad
rule of law concerns by guaranteeing correction of egregious mistakes rather
than importing judicial involvement into the quantification of deposit
compensation.
(v) Additional regulatory
powers
The DCS contains a raft of procedural matters designed to boost its operational effectiveness. Banks are subject to an overriding duty of co-operation with the Board as are their successors in title including liquidators, receivers and administrators (s20). The Board is invested with the rights, powers and privileges of a creditor including the right to sit on a creditor's committee (s22). It enjoys rights of subrogation in respect of any qualifying deposit (s23). Where a bank fails to comply with the terms of the DCS the GFSC may withdraw its licence (s24). Full and clear information regarding the DCS should be made available to depositors by participating banks, and they are required to provide account holders on request with complete information regarding the substantive conditions attaching to the payment of compensation and procedure for making a claim (s27). This deals with a common criticism levelled at deposit protection arrangements: low levels of consumer awareness of their very existence although there is no overarching obligation on the Board, Department or GFSC to engage in high profile, publicity campaigns. The Board, Department and their employees enjoy legal immunity in connection with the discharge of any of their functions under the Ordinance (s30). In explicit terms the DCS is denied retrospective effect (s31) with the result that aggrieved LG depositors are unlikely to recover their deposits in full.
Concluding thoughts
The DCS is embodied in fast tracked legislation which
is commendably clear and contains funding features considerably more sophisticated
than its UK and Isle of Man equivalents. In this narrow sense it is an early
illustration of the benefits of the Bailiwick's shift to a semi-executive form
of government in 2004 which facilitates rapid decision making and legislative
action, in contradistinction to the previous bloated and cumbersome
committee-based system, particularly in regard to external threats to the OFC
(Massey, 2004; Ogier, 2005; Morris, 2008a, b). Its administering agency is
invested with a battery of powers to fulfil not only its deposit protection
mandate but also explore and constructively interact with alternative (or
concurrent) corporate rescue and insolvency procedures. Although its detailed
rules relate to depositor compensation in the aftermath of a bank failure, the
LG affair and wider international concerns regarding banking stability suggest
its real driving force is that of underpinning the reputation of the OFC as a
safe depository for liquid funds rather than consumer protection. The reactions
of the insular authorities have undoubtedly been informed by the Manx
experience post the collapse of the Savings and Investment Bank in 1982.
Subsidiary influential factors are the current Foot Review, the remit of which
embraces deposit protection issues in British Crown Dependencies and Overseas'
Territories and the scheduled IMF evaluation of its financial regulation regime
in Autumn 2009. There is clearly a political element of rapidly establishing
the DCS on a firm statutory basis in the hope of obtaining favourable
judgments in these increasingly important external reviews, which themselves
impact on the international regulatory reputations of OFCs.
Rapid legislative action, even if motivated by
legitimate reputational concerns, may result in defects which a more reflective
response would have addressed. This is
(2010) JFRC 18(3), 272–292 at 287
arguably the case with the DCS funding model. Its
entire long-term viability turns on the formation and governance of the
States-owned and eventually fully bank-funded captive insurance vehicle. While
the initial States guarantee of £20 million sends out a powerful message of
political support for the DCS and it is not required to deliver any financial
performance, there is scant detail on its formation and governance and no
proper cost-benefit analysis of its deployment. Guernsey is an offshore
jurisdiction with high levels of expertise in use of captive insurance
structures but this has not been brought to bear during the pre-legislative
consultation nor in detailed rules governing its operation. These will
doubtless emerge in due course but the rushed nature of the legislative
framework, in particular the apparent failure to consider the full range of
funding options, means its credibility turns on the effective functioning of an
unformed, untested special purpose vehicle designed for commercial insurance rather
than what remains in substance a quasi-governmental function.
The insular authorities may feel their speedy
response is warranted in the best economic interests of the Bailiwick but it is
flawed in terms of good quality policy/ law-making by the failure to engage in
any convincing cost-benefit analysis of regulatory versus economic cost trade offs and comparative legal analysis of deposit
protection schemes in micro-jurisdiction hosted OFCs. Evidence-based policy
development along these lines coupled with the findings of the on-going Foot
Review would probably have resulted in a better informed scheme with a funding
regime less reliant on technically problematic risk-related premiums and
clearer recognition of potentially excessive business costs in the future. This
flaw constitutes a failure to make proper use of new executive-oriented
government arrangements designed to stimulate higher quality policy making via
external expert advice and constructive scrutiny (Massey, 2004; Morris, 2008a,
b).
The policy adopted by their Jersey counterparts
represents an instructive comparison. This involves, initially at least,
provision of an interim implicit deposit protection scheme in the form of a
States of Jersey political guarantee that all Island residents' retail deposits
in Jersey licensed banks are protected, apparently without a financial ceiling
(States of Jersey, 2008; Walker, 2008a, b), in the event of a bank failure. The
guarantee is designed to reduce the risk of contagion caused by banking collapses
and was touted by Jersey's political leaders as a measured “wait and see”
approach, based on IMF advice (Walker, 2008a), involving proper evaluation of
the financial crisis and its implications for offshore jurisdictions. Refusing
to wait for this to become clear or the outcome of the Foot Review towards the
end of 2009, the insular authorities, acting on external economic consultants
advice including cost-benefit analysis and comparative legal perspectives (Oxera, 2009), have secured the approval in principle of the
States Assembly for a deposit protection scheme (States of Jersey, 2009a) which
combines a system of levies imposed post-bank default with shortfalls provided
by the States Strategic Fund up to a total of £100 million over a five year
period. Payments to depositors of up to £50,000 per banking group may be made
with £5,000 paid within seven days of a claim and the balance within three
months (States of Jersey, 2009b).
How robust this structure will prove in practice in
the event of a large bank failure or systemic crisis must be open to doubt
given the by no means theoretical risk of government reserves being dissipated.
The rapidity of the legislative response, apparent determination to operationalise the scheme by Autumn 2009 and admission
(2010) JFRC 18(3), 272–292 at 288
that risks of contagion appear to have receded
(States of Jersey, 2009b), suggest that, as in Guernsey, the political
imperative of responding to the Foot Review agenda rather than identifiable
bank soundness concerns is the catalyst for the Jersey blueprint. In addition
deposit protection can be regarded as sharpening an OFCs competitive edge if
one conceptualises stringent financial regulation as
a factor in attracting quality business (Home Office, 1998; Oxera,
2009, pp. 5–6). The Channel Islands' OFCs have therefore committed to the
principle of deposit protection but as exercises in financial regulation policy
making their actions are flawed by the failure (in Guernsey's case) to
commission external expert advice, absence of critical scrutiny and
questionable motives. Viewed through this lens both schemes should be regarded
as provisional and likely to undergo a process of review and revision in the
medium term.
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Further reading
States of Guernsey (2008), “The banking deposit
compensation scheme (Bailiwick of Guernsey) Ordinance 2008”, Billet d'Etat
XLVIII, States of Guernsey, St Peter Port.
States of Guernsey (2009), The Banking Deposit
Compensation Scheme (Liability of Participants to Compensation Levy) (Bailiwick
of Guernsey) Regulations 2008 (Guernsey Statutory Instrument 2009 No 1,
operative as from 10 December 2008), States of Guernsey, St Peter Port.
End of Document