Depositor Compensation Scheme: Green Paper.

STATES OF JERSEY

DEPOSITOR COMPENSATION SCHEME: GREEN PAPER

Presented to the States on 25th May 2010 by the Minister for Economic Development

STATES GREFFE

2010   Price code: C  R.62

Economic Development Department

Green Paper

D  epositor Compensation Scheme  May 2010 PURPOSE OF CONSULTATION

The purpose of this consultation is to seek the views of the public on various issues relating  to  the  recently  introduced  Jersey  Bank  Depositor  Compensation  Scheme (DCS).

DEADLINE FOR RESPONSES Friday 2nd July 2010

PLEASE SEND RESPONSES TO:

Public submissions – Please note that responses submitted to all States public consultations may be made public (sent to other interested parties on request, sent to the Scrutiny Office, quoted in a final published report, reported in the media, published on a States of Jersey website, listed on a consultation summary, etc.). If a respondent has a particular wish for confidentiality, such as where the response may concern an individual's private  life,  or  matters  of  commercial  confidentiality,  please  indicate  this  clearly  when submitting a response.

1. Introduction

1. The Banking Business (Depositors Compensation) (Jersey) Regulations 2009 ("DCS Regulations") were adopted by the States on 6th November 2009 and immediately  introduced  a  Depositor  Compensation  Scheme  ("DCS")  in Jersey.
2. Although the protection of depositors continues to be achieved principally through strict licensing standards and strong oversight of the Island's banking industry, in the unlikely event of a Jersey bank failure the DCS would aim to prevent hardship by ensuring that depositors would have timely access to funds without having to wait for recoveries in the bank liquidation.
3. The key features of the DCS are that –

• Subject to certain conditions, it provides protection of up to £50,000 per person, per Jersey banking group, for local and international depositors in line with international standards.
• Retail deposits (i.e. those held by private individuals) are protected but protection  does  not  extend  to  deposits  held  by  companies,  small  and medium enterprises ("SMEs"), partnerships or trusts.
• In the event of a bank failure, the States would lend liquidity to the DCS to enable it to pay up to £5,000 compensation within 7 working days and the balance of compensation within 3 months of receiving a valid claim.
• The £50,000 limit will apply per person, so a £100,000 deposit held in a joint account by 2 people would be completely covered.
• The maximum liability of the DCS will be capped at £100 million in any 5 year period, in line with the Guernsey scheme.
• The majority of the cost of the compensation will be borne by the banking industry, but levies will be capped with the States making up any shortfall.
• Claimants would assign their rights to recoveries in the failed bank's liquidation to the DCS.
• In most cases, the DCS would be funded solely by levies on the banking industry with any States shortfall funding being fully repaid from the liquidation proceeds.

2. Board – Constitution and Governance

1. The DCS will be administered by an independent Board. Members of the Board will be nominated by the Minister for Economic Development ("the Minister") and appointed by the States for a renewable 5 year period. The Economic Development Department is working with the Jersey Appointments Commission  ("JAC")  to appoint  members  of  the  Board.  The Minister  is currently carrying out the functions of the Board and will continue to do so until the Board is ready to take over these functions.

2. The Board  will  be  independent  of  Ministers,  the  States,  and  the  Jersey Financial Services Commission and will be a corporate body that can sue and be sued in its own name, enter into contracts and acquire, hold and dispose of property of any type.
3. The DCS Regulations set out certain requirements relating to the corporate governance of the Board. There will be a minimum of 3 members of the Board, who will be appointed by the States on the nomination of the Minister after consulting with the JAC. A person appointed to be a member of the Board will hold the appointment for a term of up to 5 years on terms and conditions agreed between the person and the Minister.
4. The quorum for a meeting of the Board will be half the number of members appointed at the time of the meeting. Except as otherwise provided in the DCS Regulations or by the Minister, the Board will determine its own procedures.
5. The Board  will  be  able,  with  the  Minister's  approval,  to invest  money standing to the credit of the fund, borrow money for the purposes of the DCS and insure against its liabilities.

3. Functions of the Board

1. It is envisaged that the Board will meet from time to time as necessary to ensure that the appropriate measures are in place to allow the Board to act quickly in the unlikely event of a bank default.
2. Information-sharing pathways will be developed between the Board and other safety-net  participants,  such  as  the  Jersey  Financial  Services  Commission ("JFSC") and the Viscount's Department so that the Board is kept informed of  any  potential  problems  that  could  lead  to the  DCS  being  triggered. Provision  for  information-sharing  is made  in the  law  but  a  separate Memorandum  of  Understanding  is also  being  drawn  up  to formalise  the relationship between the Board and the JFSC.
3. Although it is believed that the best method of informing depositors of the details of the DCS is through the banks themselves, itis envisaged that the DCS will have a public profile through, for example, the establishment of a web presence.
4. In  the  unlikely  event  that  a  Jersey  bank  should  fail,  the  DCS  will  pay compensation to depositors up to a maximum of £50,000 per depositor per Jersey banking group, subject to certain limitations. The overall amount of compensation that the DCS could pay out is limited to £100 million in each 5 year period.
5. The Board would publish the relevant date of the bank default and invite applications from depositors for compensation. It would send out a notice to the insolvency administrator of the bank in default and to all the other Jersey banks requiring them to provide the necessary information in order to be able to calculate the levy for each of the banks. It may be that States funding will

be required, in which case the Board would also send a notice to the Minister for Treasury and Resources.

6. Regardless of whether shortfall funding is required, as banks will be permitted to spread the payment of levies over up to 5 years, the States will provide liquidity funding to the DCS in order for the DCS to be able to pay the first £5,000 of each valid claim within 7 working days and the balance within 3 months. Income to the DCS from bank levies and/or assigned recoveries in the  liquidation  would  then  be  applied  to repaying  the  States  loan.  It  is envisaged that the required revolving credit agreement will be in place before the Board assumes its functions.

4. Accounts and Audit

1. The DCS Board will be an independently audited States body for the purposes of the Public Finances (Jersey) Law 2005. This fulfils Principle 5 of the Basel Committee on Banking Supervision's Core Principles for Effective Deposit Insurance  Systems,  which  requires  the  body  administering  a  DCS  to be operationally independent from undue political and industry influence.
2. There are a number of measures in place to ensure the highest standards of financial reporting. The Comptroller and Auditor General is also given the express power to audit the accounts, providing the additional assurance of independent  oversight  of  the  DCS.  When  requested  to do  so  by  the Comptroller  and  Auditor  General  the  Board  must  make  the  records  and accounts available to him.
3. The Board must keep records that permit the financial position of the DCS to be ascertained with reasonable accuracy at any time. In addition, for any financial year that the Board receives, holds or expends money, the Board is required to keep accounts prepared in accordance with generally accepted accounting principles ("GAAP") that show a true and fair view of the surplus or deficit of the DCS for the financial year and of the state of the Board's affairs at the end of the financial year.
4. The DCS Regulations provide for the DCS accounts to be properly kept and independently audited. The Comptroller and Auditor General will still have the power to make a report on the accounts of the DCS under Article 48 of the Public Finances (Jersey) Law 2005.
5. Within 3 months after the end of the financial year the Board must have the DCS accounts audited and must provide these to the Minister for Treasury and Resources within a further 3 months together with a report on its activities during the financial year. The Minister will then lay the accounts and report before the States as soon as reasonably practicable.

5. Accountability and oversight

1. The Board is obliged to ensure that the DCS is administered in a prudent and economical manner and that resources are used efficiently and effectively.

2. In order to ensure proper oversight, the Comptroller and Auditor General is also  responsible  for  considering  and  reporting  on  the  general  corporate governance arrangements of the DCS under Article 46(3)(c) of the Public Finances  (Jersey)  Law  2005,  and  may  make  recommendations  for improvements in this regard.
3. In line with similar public bodies, such as the JFSC, Board members (along with any member, officer, servant or agent of the Board) will not be liable for anything done or omitted in the discharge of their functions unless the act or omission was in bad faith.
4. Should a depositor be unhappy with a decision of the Board in respect of the amount of the compensation to which he or she was entitled, the depositor would be able to appeal to the Royal Court on the ground that, on the facts available to the Board, its decision was unreasonable. A right of appeal to the Royal Court is also given to banks, concerning the amount of the levy they are liable  to pay  the  DCS,  and  to the  Minister  for  Treasury  and  Resources concerning the amount of States shortfall funding required by the DCS. On appeal, the Royal Court has a wide power to make any Order it considered appropriate.

ISSUES

6. Funding the administration costs of DCS

1. The DCS will be administered by an independent Board, which will be an independently audited States body. Although the DCS was designed with a view to keeping running costs to a minimum, there will be some one-off costs associated with setting up the scheme and the DCS Board. Once the Board is established, it is expected that there will be recurring costs relating to the administration  of  the  scheme.  Those  may  include  the  expenses  of  Board members,  administrative  support,  accounting/audit  costs,  legal  advice  and insurance premiums.
2. In order to expedite the implementation of the DCS, during the course of the States debate on the DCS in November 2009, the Minister for Economic Development agreed to fund the initial set-up of the DCS Board and the first year's  administration  costs.  The  purpose  this  pledge  was  to allow  the Department  to consult  properly  on  the  issue  of  who  should  pay  for  the recurring administration costs of the DCS Board after the first year.
3. It should be noted that the recurring administration costs of the DCS Board are separate to the costs that would be incurred if the DCS were activated. In the unlikely  event  of  a  Jersey  bank  failure,  the  costs  of  the  DCS  Board  in administering the scheme in relation to that particular bank failure would fall on the remaining banks along with the compensation costs, subject to the cap on bank levies.
4. A comparative analysis of DCS schemes in other jurisdictions shows that the administration costs of such schemes are typically met by an annual levy on the banks that are covered by the scheme. The rationale for this is essentially the same as that for making the banks primarily responsible for funding DCS

compensation in the event of a bank failure, namely, that banks benefit from the existence of the DCS through the added reassurance it provides to banks' customers and the stability of the banking system.

5. In  the  United  Kingdom,  the  Financial  Services  Compensation  Scheme ("FSCS") covers deposit takers and other areas of financial services business such as investments and insurance. The FSCS's management expenses' are split between so-called base costs' and specific costs'.
6. All classes of financial firms contribute to the base costs of the FSCS, which are the day-to-day costs of running the scheme, i.e. those that are not related to the payment of compensation. They pay contributions in proportion to the periodic  fees  they  pay  to  the  financial  services  regulator,  the  Financial Services Authority ("FSA").
7. Specific costs relating to assessing claims and making payments are allocated to the relevant classes and sub-classes of financial firms.
8. In Guernsey, which established a DCS in 2008, the administration costs of the scheme for the first year were met by the States. The relevant legislation enables the Guernsey DCS to levy an annual fee on each bank covered by the scheme, which is paid into an administration fund. An annual administration fee was levied in 2009 and is expected to be levied in 2010.
9. The method of allocation of administration costs in Guernsey is not known. However, part of the Guernsey DCS is based on a risk assessment of the banks and it is possible that the scheme may take a similar approach with regard to the allocation of administration costs.

Proposal

10. It is proposed that the Economic Development Department (EDD) funding of administration costs should cease after December 2010. An amendment will be made to the DCS Regulations to provide the Board with an additional power to levy Jersey banks for its recurring administration costs.
11. The Board's obligation to ensure that the DCS is administered in a prudent and economical manner and that resources are used efficiently and effectively extends to DCS administration costs.
12. It is difficult to estimate the likely administration costs of the DCS at this time as there are no existing models that reflect the likely set up of the Board. Pending further investigation, the following estimates give some indication of how the recurring annual costs of the DCS Board are likely to break down –

Insurance  £10k – £50k Banking, accounts and audit  £5 – 10k IADI1 costs  £0 – 10k Board expenses  £2 – 3k Contingency (e.g. legal fees)  £0 – 20k

Total:  £17k – £93k

1 IADI stands for the International Association of Deposit Insurers.

It is also assumed that secretarial administration will be provided by EDD.

13. It is proposed that administration levies would be paid by the DCS Board into a single administration fund that would be separate from any fund established in respect of a failed bank.
14. In  the  unlikely  event  of  a  Jersey  bank  failure,  the  Board's  recurring administration costs would continue to be met from the administration fund, whereas its administration costs in respect of the bank in default would be met from the fund established in respect of the bank in default. The administration fund  would  be  subject  to the  accounts  and  audit  requirements  set  out  in Regulation 14 of the DCS Regulations (see Section 4, above).
15. It is considered that the simplest method of allocating costs would be to levy banking groups equally, rather than attempting to link levies to the level of regulatory fees paid to the regulator (as in the UK) or by applying some form of risk assessment, which could be complex and costly to implement.
16. In order to avoid costs that would result from the DCS Board having to maintain an overdraft in relation to its administration costs, it is proposed that the Board would estimate these costs for the forthcoming year and levy for these annually in advance.
17. If  at  any  point  in the  future,  the  administration  fund  had  accumulated sufficient funds to meet the Board's estimated costs for the forthcoming year, the Board would not have to charge a levy for that year. Conversely, if during the course of the year it transpired that the Board had underestimated its costs for that year, the Board would be able to demand an interim administration levy.
18. On receipt of a demand for an administration levy, any banking group would be able to appeal to the Minister for Economic Development on the grounds that the estimated costs of the Board are unreasonable.

Questions:

1. Do you agree that banks should fund the recurring administration costs of the DCS?
2. Do you agree that the Board should establish a separate administration fund to meet its recurring administration costs?
3. Do you agree that the administration costs of the DCS should be paid by banking  groups  equally?  If  no,  what  method  of  allocation  would  you favour?
4. Do you agree that the DCS Board should levy annually in advance with the power to demand an interim levy if necessary?

7.  Depositor priority in bank insolvency

1. Generally  speaking,  when  a  bank  fails,  all  of  its  assets  and  liabilities (i.e. debts)  fall  to be  dealt  with  under  an  insolvency  procedure,  such  as liquidation. A liquidator (by whatever titled described) is typically appointed to turn the insolvent bank's assets into cash and distribute the proceeds to the bank's creditors according to their ranking.
2. Secured claimants generally have the highest ranking because they have a claim against specific assets of the bank. Secured claimants are followed by various  categories  of  creditor  whose  claims  are  accorded  priority  over unsecured claimants by statute. There then follows a much larger class of claimants, which typically includes depositors and other unsecured claimants who  do  not  have  any  specific  or  priority  claim  on  assets.  Holders  of subordinated debt, preferred shareholders, and common shareholders follow unsecured creditors in terms of ranking.
3. In  order  to offer  greater  protection  to  depositors,  some  countries  have introduced legislation that effectively elevates the claims of depositors over those of other unsecured creditors for bank insolvencies. This is referred to as either  depositor  priority  or,  less  commonly,  depositor  preference.  Some countries  give  depositors  a  priority  that  supersedes  the  rights  of  secured creditors of a failed bank.
4. Broadly speaking, legal priority rules can be viewed in 2 ways. On the one hand, by giving priority to some claims, the legislator restricts the contracting options  of  private  parties  and  may  prevent  them  from  reaching  optimal arrangements. On the other hand, legal priority rules have the advantage of giving greater certainty where there are multiple private contracts and may be particularly relevant for banks, with their large number of non-professional unsecured creditors (i.e. depositors).2

Position in other jurisdictions

5. There is a great deal of variance between the systems adopted by countries concerning the ranking of depositors compared to other creditors of failed banks. These differences can be attributed to different legal traditions as well as different public-policy objectives.3
6. In the United States, depositor preference' was granted to all deposits in 1993, though similar rules had already been in place in 27 States. The Federal Deposit  Insurance  Corporation  ("FDIC")  insures  deposits  up  to 100,000 USD.4 It has been argued that the primary beneficiaries of depositor

2 Birchler, Urs W, 2000. "Bankruptcy Priority for Bank Deposits: A Contract Theoretic

Explanation," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 13(3), pages 813–40.

3 Federal Deposit Insurance Corporation (FDIC), Business Plan for the Sub-Working Group

Committee.

4 The standard insurance amount of 250,000 USD per depositor is in effect through 31st

December 2013. On 1st January 2014, the standard insurance amount will return to

100,000 USD per depositor for all account categories except certain retirement accounts.

preference are the FDIC itself, which acquires depositors' priority claims on making payouts, and those with deposits exceeding 100,000 USD (Birchler, Urs W, 2000).

7. In Switzerland, bankruptcy priority (privilège en cas de faillite') for savings deposits was introduced in 1934 and extended in 1997. Under the present rules, deposits up to an aggregate amount of 100,000 CHF (approximately 60,000 GBP) per depositor have priority over all other deposits and liabilities. Although there is no official deposit insurance, under a private agreement within the Swiss Bankers Association (SBA), banks mutually guarantee deposits that have priority in bankruptcy up to 6 billion CHF (approximately
   6. billion GBP). Like the FDIC in the US, the SBA acquires depositors' priority claims when it pays out depositors.
8. Other countries, such as Hong Kong, Malaysia and Argentina have also introduced deposit priority rules. In Hong Kong, deposits up to 100,000 HKD (approximately 8,200 GBP)[5] have priority over all other bank liabilities. In Malaysia, domestic deposits have a priority claim against domestic assets of a bank. Several other countries have deposit priority rules, either in connection with deposit insurance, such as Chile and Peru, or without, such as Australia, Russia and Mongolia.
9. There are no statutory provisions in Guernsey for depositors to take priority over other unsecured creditors. Under emergency laws put into place in Iceland in October 2008, Icelandic depositors in Landsbanki had their deposits guaranteed in full whilst non-Icelandic depositors covered by the Icelandic DCS were granted a priority over all other creditors of the Icelandic banks.
10. In the United Kingdom, prior to December 2001, the Deposit Protection Board was automatically entered as a creditor of the failed bank and had preferential rights to recoveries due to the depositor. This no longer applies to the Financial Services Compensation Scheme ("FSCS"), which took over responsibility for providing deposit protection in the UK.
11. The ability of the FSCS to make recoveries is dependent on depositors assigning their rights against the bank to the FSCS in exchange for receiving a compensation payment. The FSCS then stands in the shoes' of the depositor. Although the situation with recoveries varies between sub-schemes of the FSCS, for depositor claims, the FSCS ranks the same as the depositors who assign their claims to it – i.e. as an unsecured, ordinary creditor.

Current position in Jersey

12. Currently, in the unlikely event of a Jersey bank failing, the claims of depositors in the bank insolvency would not benefit from priority status. Depositors would therefore be paid on an equal footing with all the other unsecured creditors of the failed bank.

13. On  either  the  declaration  of  a  désastre  under  the  Bankruptcy  (Désastre) (Jersey) Law 1990 or on the court making a winding-up order under the Companies  (Jersey)  Law  1991,  there  is a  statutory  order  of  priority  for repaying  creditors.  The  order  of  priority  is set  out  in  Article 32  of  the Bankruptcy (Désastre) (Jersey) Law 1990 and can be summarised as follows –

1. Viscount's or liquidator's costs;
2. employees' salaries (for previous 6 months) plus holiday pay/bonuses up to £3,500 and £1,000 respectively;
3. all sums due to the Social Security Department;
4. all sums due to the Comptroller of Income Tax for the current year and the preceding year (including Goods and Services Tax (GST) and Income Tax Instalment Scheme (ITIS);
5. Sums due to debtor's landlord for the payment of rent (if it qualifies for preference under customary law);
6. rates due to parishes for the current year and the preceding year;
7. all other proved debts (which would currently include depositors in a bank insolvency).

14. The debts referred to in paragraphs (ii)–(vi) have equal priority as between themselves and are paid on an equal footing. If the property of the debtor is insufficient to pay them all off in full, they are reduced in equal proportions.
15. Hypothecary creditors6 are entitled to preference with regard to the proceeds of sale of any property upon which their hypothecs are secured in the order of the date of creation of their respective hypothecs. If the proceeds of sale of such property are insufficient to meet the claim of a hypothecary creditor in full, the balance of the claim ranks for payment on the same footing as all other proved debts.
16. Where any property of the debtor is subject to a security interest the proceeds of sale of the collateral are applied in the manner provided by Article 8(6) of the Security Interests (Jersey) Law 1983.

Discussion

17. It is considered that the introduction of depositor priority in Jersey would provide additional protection to many depositors beyond that currently offered by the DCS.
18. As  part  of  the  UK  response  to the  recent  banking  crisis,  the  Tripartite Authorities (The Bank of England, H.M. Treasury and the Financial Services Authority) consulted on measures to bolster depositor protection. Although

6 A hypothec' is a kind of legal interest that gives a creditor certain preferential rights with

regard to certain property. They can arise automatically by operation of law or can be created by an agreement between private parties.

this included giving further consideration to reintroducing priority for depositors in insolvency proceedings,[6] largely due to concerns specific to the U.K. banking model, it was decided that the current priority of creditors on insolvency should remain unchanged.[7]

19. Although different factors apply in a Jersey context, the U.K. consultation highlighted several issues that are relevant to the consideration of depositor priority in Jersey.
20. The main issue highlighted by respondents to the U.K. consultation was the potential for depositor priority to change the behaviour of other (non- depositor) unsecured creditors. In an U.K. context, respondents noted that the introduction of depositor priority could increase the likelihood that creditors would require security for lending to banks and/or charge higher interest rates for such lending, due to the increased risk of loss.[8] Ultimately, such costs could be expected to be passed on by the banks to their customers. There was also considered to be a risk that the introduction of depositor priority may lead creditors to shorten the terms of loans to banks or to seek alternative investments, which could cause the liquidity of U.K. banks to be impaired.
21. In a Jersey context, itis understood that our banking model, which relies almost totally on deposit taking rather than unsecured wholesale lending for liquidity, would be far less susceptible to the potential issues outlined above. However, the final outcome of depositor priority on costs and the behaviour of stakeholders depends on a wide variety of country-specific legal and economic factors and it is important that feedback is received from both the banking community in Jersey and creditors of Jersey banks in order for a fully considered approach to be taken.
22. In addition, the potential benefit to depositors of introducing depositor priority in Jersey would appear to be greater than in other jurisdictions, where average deposits are lower. Because a significant proportion of depositors with Jersey banks have balances totalling more than £50,000, giving depositors priority would provide protection beyond that offered by the DCS. This would provide an additional potential benefit for many customers who bank in Jersey.
23. The scale of that benefit cannot be estimated at present, but would depend on the extent to which the giving of the priority to depositors affords an advantage over non-depositor unsecured creditors of Jersey banks. There would also be a potential benefit to the DCS scheme itself, as the DCS would become a priority creditor in respect of the priority claims assigned toit by depositors.

Proposal

24. It is proposed to introduce legislation that ranks the claims of depositors in Jersey banks over the claims of other unsecured creditors (i.e. those listed at

(ii) to (vi) in paragraph 7.13 above) but behind secured creditors.

Questions:

5. Should  depositor  priority  be  introduced  in Jersey  in line  with  the proposal?
6. Please comment on:

1. What level of priority should be afforded to depositors, i.e. where in the current statutory order of priority should depositors rank?
2. Should priority be limited in scope (e.g. to individuals' deposits covered by the DCS) or should it apply to all deposits (including those held by corporations, trusts, partnerships, etc.)?
3. Should priority be limited in extent (e.g. to £50,000) or should it apply to the total value of deposits?

7. What problems or issues, if any, do you see arising if depositor priority were introduced?

Full list of Questions:

1. Do you agree that banks should fund the recurring administration costs of the DCS?
2. Do you agree that the Board should establish a separate administration fund to meet its recurring administration costs?
3. Do you agree that the administration costs of the DCS should be paid by banking  groups  equally?  If  no,  what  method  of  allocation  would  you favour?
4. Do you agree that the DCS Board should levy annually in advance with the power to demand an interim levy if necessary?
5. Should  depositor  priority  be  introduced  in Jersey  in line  with  the proposal?
6. Please comment on:

1. What level of priority should be afforded to depositors, i.e. where in the current statutory order of priority should depositors rank?
2. Should priority be limited in scope (e.g. to individuals' deposits covered by the DCS) or should it apply to all deposits (including those held by corporations, trusts, partnerships, etc.)?
3. Should priority be limited in extent (e.g. to £50,000) or should it apply to the total value of deposits?

7. What problems or issues, if any, do you see arising if depositor priority were introduced?

Please submit responses to the address above by: Friday 2nd July 2010