The Building Societies Association (BSA) welcomes the opportunity to respond to the FSA’s proposals for reforming the FSCS funding model, as set out in Consultation Paper 12/16.
The BSA represents mutual lenders and deposit takers in the UK including all 47 UK building societies. Building societies have total assets of almost £330 billion and, together with their subsidiaries, hold residential mortgages of £210 billion, 17% of the total outstanding in the UK. They hold just over £215 billion of retail deposits, accounting for 19% of all such deposits in the UK. Building societies account for about 31% of all cash ISA balances. They employ approximately 39,000 full and part-time staff and operate through approximately 1,700 branches.
We called for the current funding review back in 2008-09 and were pleased when the FSA confirmed in Policy Statement 09/11 in July 2009 that, in response to BSA lobbying, it would be embarking on a review of the FSCS funding model. However, three years down the line, the funding review has so far failed to address our essential concerns about the unfairness of the funding model for the Deposit Class. This is very frustrating for our members, even if the reasons for the further delay are perhaps understandable, being principally the stuttering progress through EU legislative process of the recast deposit guarantee schemes directive.
Q2: Do you have any comment on our analysis of the alternative bases of allocation and class structures or any suggestions for further consideration?
Q3: Do you have any comment on our analysis or proposal to retain the current approach?
While the consultation paper is calling for responses to relatively minor changes to the FSCS funding model, it has failed to address the wider issues of inequity of the funding structure within the Deposit Class. This is disappointing especially given that - as noted above - it was BSA members’ concerns about the unfairness of the current Deposit Class levy structure that prompted FSA’s review in the first place. We acknowledge that certain key factors, such as the risk-based levy provisions of the DGSD have yet to be finalised. However, it would have been helpful if the FSA had at least explored in the CP the options for risk-based levies.
The current funding model imposes an unfair burden on building societies and other mutual lenders and fails to take account of the lower risks of the building society model. Contributions to the depositor class are currently determined by market share of FSCS-protected deposits. As building societies and other mutual lenders are funded predominantly through retail deposits - and are non-profit maximising - their share of FSCS contributions is proportionately higher, both in relation to their total balance sheet and as a percentage of pre-tax profit, than those of banks of equivalent size.
This currently equates to 19% of pre-tax profit for BSA members, compared to only 5% for the plc banks. A risk-based method for calculating FSCS funding would help to rebalance - and more fairly share - the burden.
One proxy for a risk-based approach that we have aired with the FSA is that levies for firms in the Deposit Class be based on all of a deposit taker’s liabilities, rather than just retail deposits. The rationale for this being that the narrower basis does not reflect the full risk profile of a banks’ balance sheet - in the case of Northern Rock, for example, it was the inability to refinance wholesale liabilities which led to the failure of the bank rather than any problem with retail funding. It is disappointing that there is no recognition in the consultation paper of this alternative approach. Indeed, there is no consideration of any risk-adapted approach that would take account of the lower risk appetite of institutions such as building societies.
Q5: Do you agree that it is reasonable to remove the home finance provision class from the funding model?
Q6: Do you agree with our recommendation to end cross-subsidy from, to and between the PRA classes?
We agree that the possibility of cross subsidy between the deposit class and FCA classes should be removed as it represents an exposure of deposit takers to liabilities within sectors with which they may have only tenuous connections, if any.
Now that the FSCS has the ability to borrow, principally from the National Loans Fund (NLF), the need for cross-subsidy between PRA classes has arguably been diminished, as FSA suggests. Experience of the banking failures in 2008-09, was that although cross-subsidy of the Deposit Class was available to the authorities, they chose not to make use of it. The resolutions of the banks that failed in 2008-09 were funded principally by borrowing, suggesting that the cross subsidy of the deposit class may have been theoretical anyway.
However, if cross-subsidy is no longer to be an option, there needs to be much more transparency and certainty around the FSCS’s borrowings, particularly its borrowing from the NLF. Currently this is anything but transparent and certain.
This is a major concern for the BSA and our members - the costs of FSCS’s borrowings being passed directly on to levy payers. Having experienced a protracted period of uncertainty prior to the FSCS’s refinancing in April 2012 of its £18billion loans with the NLF, we consider the lack of transparency and constraints surrounding the interest rate setting to be unacceptable. It is unjust to the levy payers which are required to service the interest payments, as well as to repay any capital shortfall, to be kept in the dark about the calculation of the interest on FSCS’s borrowings from the NLF - and for them to be excluded entirely from the negotiations between HMT and FSCS about FSCS loan refinancing.
Moreover, in the case of Dunfermline Building Society, which was resolved under the Special Resolution Regime, the resolution was funded initially directly by the Government. The costs of resolution are ultimately to be borne by the FSCS and interest is accruing on the principal amount it is liable to repay at a rate determined by the Government, with unfettered discretion. The current annual interest rate of 4.5% is far higher than FSCS - or most of the Deposit Class levy payers - would pay in the market, yet as matters stand it is unable to challenge that rate.
The process of agreeing FSCS loan (re)financing needs to be overhauled so as to ensure the interests of the levy payers are adequately and fairly represented. Whilst this may not be directly in scope of the current FSA consultation, it should nonetheless be made a precondition of any formal move away from cross-subsidy between the deposit class and other contribution classes.
Q7: In the absence of direct funding support from the PRA classes, do you agree with our recommendation to establish an FCA retail pool?
Given the proposed absence of cross subsidy from the PRA classes to the FCA classes, and the relatively low levels of the proposed thresholds for the intermediary classes, there is a clear need for a mechanism to meet compensation costs where these exceed the thresholds. The proposed retail pool would appear to be a sensible mechanism for addressing this.
Q8: Do you agree with our proposal to set the class threshold for the deposits class at £1.5 billion a year?
It is welcome that the FSA has introduced the concept of affordability to its assessment of appropriate class thresholds. Affordability is a key consideration for BSA members. The Deloitte analysis includes consideration of the affordability of levies by building societies and other deposit takers. We welcome the fact that Deloitte has assumed zero cost pass through by building societies. This represents a big improvement on the original Deloitte model which assumed a high rate of cost pass through to customers by building societies - an assumption which we challenged as unrealistic. However, the Deloitte analysis is presented at an aggregated level and does not show the impact on particular sectors of the various scenarios examined. So, although we can see that Deloitte is predicting 18 firms would be unprofitable were the deposits class threshold to be set at £1.5billion, they do not break this down by banks, building societies and other mutual lenders so it is difficult to assess or challenge the Deloitte analysis at a building society sector level.
While FSCS levies have increased considerably since the beginning of the current financial crisis, they have been nowhere near the level now posited by the FSA as being affordable to the industry. In fact, cumulatively, since the start of the crisis, the total FSCS levies due to Specified Deposit taker Defaults (SDDs) have been less than £1.5billion and these have been spread over four years:
Of this, approximately 23% or £340m has been borne by BSA members.
We challenge the assumption, implicit in the Deloitte analysis, that FSCS levies for the deposit class of £1.5 billion per annum are “affordable”. The estimates of affordability are based on an estimate that £1billion per annum of potential predetermined costs would be known by firms in advance and that £0.5billion could be absorbed by the industry on a post-hoc funded basis. The distinction the FSA draws between costs that are known in advance and those that arise on an ad hoc basis is likely to be largely academic for building societies, given the very limited scope to pass costs through to customers.
As noted above, Deloitte’s own projections show that 18 deposit-takers would be non-profit making faced with such levies and as is noted in a very understated footnote on page 37 of CP 12/16, “if there were prolonged periods of unprofitability the impact could be exacerbated”! However, neither the FSA’s analysis nor Deloitte’s consider the impact that sustained periods of non-profitability could have on the sector, or the wider economy. This is a clear shortcoming of the analysis.
The impact on the housing market of a sustained squeeze on profitability of building societies and other mutuals is likely to be stark. Building societies and other mutual lenders have increased their gross mortgage lending over the current year by 39 % (while mortgage lending by plc banks has declined). Such levels of lending would not be sustainable in an environment where FSCS levies trebled or quintupled - as implied by the FSA’s assumptions about predetermined and post hoc costs in the future. Indeed, a dramatic contraction in the propensity to lend could be expected - the profound implications for the wider economy of this needs to be factored into the FSA’s analysis. A shortcoming of the analysis is that it does not appear to consider the macroeconomic impact of FSA’s policy decisions in regard to FSCS funding.
Q17: Do you have any comments on the proposal to extend the period over which expected compensation costs are assessed?
We support the aim of reducing the volatility of changes in the FSCS levy. However, it is not clear to us that a move to extend to three years the period over which the levy is assessed would have much impact on volatility - and no evidence has been provided by the FSA as to how forecasting over a longer term would be more accurate than over a single year. On the contrary, we fear that increasing the forecast period may lead to an increase in uncertainty, thereby encouraging FSCS to err on the side of caution and issue higher levies sooner in anticipation of potential future losses, which may not materialise.
Q23 Do you agree that the arrangements proposed for approving The MELL post legal cutover are reasonable?
Yes, it is appropriate that the PRA and the FCA each approve the limit for the classes for which they are respectively responsible. The 50/50 split of base costs should be reviewed periodically to ensure it remains appropriate.
Q24: Do you agree we should define interest as a compensation cost rather than specific cost?
Yes. The current treatment of interest as a management expense is anomalous. As suggested in the CP, the huge quantum of the interest costs has distorted the MELL and compromised its utility.
Q25: Do you agree that we should make specific costs attributable to a class rather than claims in a particular class?
Yes, this will correct an anomaly in the current arrangements.
Q26: Do you agree that the thresholds should apply across both the compensation costs and specific costs raised by the FSCS?
Yes, it is appropriate that levies for specific costs, as well as compensation costs, are subject to affordability.
14 September 2012