Report from the Controller and Auditor-General, The Treasury: Implementing and managing the Crown Retail Deposit Guarantee Scheme

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1 Report from the Controller and Auditor-General, The Treasury: Implementing and managing the Crown Retail Deposit Guarantee Scheme Report of the Finance and Expenditure Committee Contents Recommendation 2 Introduction 2 Nature and cost of the scheme 2 Summary of the Auditor-General s findings 3 The Treasury s operational performance 4 The policy of non-intervention 4 Conclusion 6 Minority view of New Zealand Labour Party 6 Minority view of New Zealand First 7 Appendix 9

2 Report from the Controller and Auditor-General, The Treasury: Implementing and managing the Crown Retail Deposit Guarantee Scheme Recommendation The Finance and Expenditure Committee has considered the Report from the Controller and Auditor-General, The Treasury: Implementing and managing the Crown Retail Deposit Guarantee Scheme, and recommends that the House take note of its report. Introduction The Crown Retail Deposit Guarantee Scheme was a highly unusual measure implemented in response to urgent circumstances during the financial crisis. It was designed and announced within a day, on Sunday 12 October 2008, to avoid a flight of funds from New Zealand institutions to Australia, where the Australian Government was about to announce a similar deposit guarantee scheme for financial institutions. The Auditor-General carried out a performance audit of the Treasury s implementation and management of the scheme, publishing its 135-page report in late September We note that this is the only report inquiring into the issue. Nature and cost of the scheme The scheme s goal was to maintain the confidence of depositors, investors, and the wider public in New Zealand s financial markets. It offered a Crown guarantee for money that people deposited or invested with banks and non-bank deposit-takers. If an institution covered by the guarantee failed, the Crown would repay the money people had deposited or invested in it, up to a maximum of $1 million each. The Crown ended up guaranteeing $133 billion in funds. It was required to pay out about $2 billion to depositors after the failure of nine finance companies covered by the scheme. The Auditor-General s report noted that the final amount to be recovered by the Crown would not be known until receivership processes were completed. More recently, we were told by the Treasury that the net cost to the Crown was just over $500 million, after about $1 billion was recovered from receiverships and $500 million paid in fees by scheme participants. The scheme was initially put in place for two years and was due to expire in October It was revised from January 2010 to address some problems with the original design, and an extended scheme was established from October 2010 through December 2011 to ease the phase-out from the scheme and reduce the potential cost to the Crown. 1 1 Features of the revised and extended schemes are outlined on pages 77 to 82 of the Auditor-General s report. 2

3 Growth in the Crown s liability The Auditor-General notes that the decision to include non-bank deposit-takers under the scheme was significant. This group included finance companies and savings institutions such as building societies and credit unions. As it turned out, finance companies were the only institutions to fail and require the exercise of the guarantee. The Auditor-General notes that during early 2009 deposits with finance companies covered by the scheme grew, in some cases substantially: We saw one example where a finance company s deposits grew from $800,000 to $8.3 million after its deposits were guaranteed. At South Canterbury Finance Limited, the deposits grew by 25 percent after the guarantee was put in place. 2 Summary of the Auditor-General s findings Importantly, the Auditor-General s overall conclusion is that the scheme achieved its goal. No banks in New Zealand failed and there was no run on banks; the stability of New Zealand s financial system was maintained. However, this was achieved at a cost to the Crown. Nine finance companies failed, requiring the Crown to pay out about $2 billion to depositors. We understand from the Treasury that the net cost to the Crown was just over $500 million, after about $1 billion was recovered from receiverships and $500 million paid in fees by scheme participants. The Auditor-General s report deliberately does not question the policy choices made in setting up the scheme, such as the decision to include finance companies, which were known to be more risky. We were told that the Auditor-General s role also does not extend to examining the Reserve Bank, or private-sector institutions involved in the scheme. Its performance audit was therefore limited to the Treasury. The main findings were as follows: The Treasury s work to establish the scheme quickly and under great pressure is commendable. This was accomplished, however, at the expense of good governance arrangements and planning. In essence, the Treasury remained in a reactive, crisis-management mode for too long, responding to needs as they emerged rather than systematically preparing for and anticipating the next eventuality. The Treasury relied too heavily on the presumption of minimal intervention, at least in its early policy advice, and gave insufficient weight to the need to manage the potential overall cost to the Crown. We examine the Auditor-General s findings in more detail below. The findings focus on two issues: the Treasury s operational role in implementing and managing the scheme, and its policy approach to market intervention to safeguard the Crown s financial interests. 2 Auditor-General s report, p. 7. 3

4 The Treasury s operational performance The Auditor-General s first set of findings is that the Treasury responded well to immediate operational needs, but did not appreciate how important it was to get ahead of the wave and plan for issues that were likely to arise. It reports that the department managed to get the scheme up and running quickly in challenging circumstances: it was initiated on a Sunday when Parliament was dissolved for a general election; there was subsequently a change of Government; and other aspects of the global financial crisis also demanded attention. It was clearly a hectic time. However, as well as launching the scheme and starting to process applications, the Auditor-General considers that the Treasury should have also been working to set up good governance arrangements for the scheme s overall management, and to plan ahead. The Auditor-General found that it did not appear to have started doing so for several months. The Treasury did not begin monitoring individual financial institutions and carrying out documented planning for many activities until March There was no evidence of mechanisms for formal oversight by senior management, such as a steering committee. The Auditor-General also considers that the Treasury should have recognised the likelihood of problems arising from a scheme set up in such haste, and should have set up a work stream to address them. In the Auditor-General s view, some problems were obviously probable; others could have been predicted if the Treasury had conferred with its counterparts in the US and UK, who had experience in running such schemes. The Treasury did take steps to improve the scheme s effectiveness, and it was eventually modified twice, but such work did not begin until The Auditor-General s report offers several recommendations covering project planning, monitoring, and reporting for large and complex initiatives. It also recommends that the Treasury, with help from the Reserve Bank, document the analysis and thinking undertaken when considering how to deal with South Canterbury Finance Limited. It suggests this could form the basis of a framework for dealing with distressed institutions. The Auditor-General states that the Treasury has accepted its recommendations, and is now taking a more structured approach in its response to crises. This is reflected in its recent work on Government support for AMI Insurance Limited. The policy of non-intervention The Auditor-General notes that the main point of difference between its office and the Treasury concerns the Treasury s adherence to New Zealand s long-standing policy of minimal government intervention in the financial markets. The Auditor-General points out that the retail deposit guarantee scheme was in itself a significant intervention. The guarantee distorted the market, as depositors could increase their returns by moving their investments into finance companies without worrying about the increased risk, which the Crown would bear. The finance companies, in turn, had less reason to minimise risk in their investment activity. The Auditor-General notes that advice from officials recognised from the outset that including finance companies in the guarantee scheme increased the risk to the Crown. In this situation, the Auditor-General found it curious that the Treasury continued to operate on its usual basis of non-intervention despite evidence of finance companies increasing their deposits significantly during the first half of 2009, once the guarantee scheme was in place. A table on page 74 of the Auditor- 4

5 General s report shows that the deposit books of many finance companies had been shrinking, but then grew by several hundred million dollars in the months immediately following the scheme s introduction. They then declined again, the decline in part driven by the collapse of some finance companies. In the Auditor-General s view, the evidence of increasing deposits in finance companies should have prompted more policy work by the Treasury about ways for the Crown to minimise this increasing liability. While the Auditor-General notes that the objectives of the scheme did not explicitly mention a need to minimise the Crown s liability, it considers it reasonable to assume that this was an important consideration for the Treasury in its implementation of the scheme, given the role that the Treasury has as guardian of the Crown s funds. 3 The Auditor-General notes that after the first finance company failed in March 2009 the Treasury started to take a more active role in obtaining information and seeking to minimise the cost to the Crown. However, it states that at least in the initial five months, the Treasury s view appeared to be that it was better to recover what funds it could after an institution failed, than to try to influence events before a failure. 4 We questioned the Auditor-General closely on this issue, as it is not clear whether any effort to intervene in finance companies behaviour would have improved the situation, or might instead have precipitated their failure, worsening the position for depositors and the Crown. We also asked about the flow of information to the Treasury, as the growth in deposits and hence the Crown s eventual liability under the guarantee scheme might have been less evident at the time than with hindsight. The Auditor-General agreed that the outcome of any intervention could not be predicted. The report noted that the Treasury s ultimate sanction, withdrawal of the guarantee, could well cause an institution to fail because of the resulting loss of depositors confidence. Also, since all deposits up to the date of withdrawal would remain covered by the guarantee, the Crown s potential payout might be about the same. The Auditor-General emphasised that it was not saying the Treasury should have intervened. Rather, since the scheme was itself an intervention in the financial markets, the Treasury should have asked questions of itself about how things might be done differently from the usual approach of non-intervention in order to minimise the Crown s exposure. As to what it might have done differently, the Auditor-General said the Treasury had the right to contact finance companies directly and ask them to report on growth in their deposits, and therefore in the Crown s exposure. Eventually it did so, but in the early months of the scheme it chose to follow the chain of communication set out in the existing regulatory model. This involved finance companies providing information to their trustees, who passed it on to the Reserve Bank, and then to the Treasury. Unfortunately this process took time, and finance companies initial provision of information was often slow, so the growth in deposits had occurred by the time the Treasury was aware of it. We asked whether the Minister of Finance had sought information about the growth in the Crown s liability, or had directed the Treasury to seek ways of limiting the Crown s 3 Ibid, p Ibid, p. 7. 5

6 exposure. The Auditor-General told us it had no documentary evidence of what the Treasury reported to the Minister, or of any such request by the Minister when the scheme was set up. We were subsequently informed that a document from late February 2009 considered the proposition that the disadvantages exceeded the benefits of intervening in financial institutions. The Auditor-General also noted that from March 2009 after the first finance company failed the Treasury began work on measures to limit the cost to the Crown, which were incorporated into the extended scheme from October It also undertook more detailed monitoring and inspection of finance companies deemed at risk of failure. Conclusion We believe it is clear that the scheme was a necessary measure to stabilise New Zealand s financial markets and prevent an outflow of funds during the financial crisis. It achieved this aim. On the whole, the majority of us consider that the Treasury coped well in difficult circumstances. Delays in receiving information for monitoring purposes were compounded by the unusual circumstances of the five months immediately after the scheme s introduction, with Parliament dissolved for a general election, then a change of government, in addition to the rapidly-moving events of the financial crisis itself. We are, however, of the view that adequate control and reporting mechanisms should have been implemented by the Treasury more quickly in the initial months of the scheme. In this, the Treasury should have done better. We concur with the Auditor-General s observation that all entities are likely to face unexpected situations, and need not only to respond rapidly to immediate operational needs, but also to set up strategic oversight and governance arrangements to carry them through and beyond the crisis. We hope that the Auditor-General s work will encourage the application by all public entities of the lessons learned from the scheme. Minority view of New Zealand Labour Party The Treasury s and Minister of Finance s handling of the Crown Retail Deposit Guarantee Scheme is a matter into which there has not been proper inquiry. The process has been limited and serious questions raised by the Auditor-General have been papered over and remain unanswered. The only opportunity we have had to question the Treasury on its handling of this matter was limited to a small number of tangential questions during the much earlier Treasury financial review process. New material raising serious issues was presented during the Auditor-General s appearance before the committee. Other material was highlighted in a way that made the matter seem even more serious than was submitted in the written report. No opportunity has been provided for committee members to raise critical concerns with the Treasury since this new information has come to light. The Auditor-General s advice to the committee was that during the first five months of the guarantee scheme Treasury did not monitor whether finance companies deposits were 6

7 growing in a way that increased the Crown s risk (and eventual losses paid by the taxpayer) through more risky behaviour on the back of the Crown guarantee. The Auditor-General notes that during early 2009 deposits with finance companies covered by the scheme grew, in some cases substantially: We saw one example where a finance company s deposits grew from $800,000 to $8.3 million after its deposits were guaranteed. At South Canterbury Finance Limited, the deposits grew by 25 percent after the guarantee was put in place. The funds were used for increasingly risky new loans, including capitalised interest and second mortgages, which added to the Crown s losses. Treasury s excuse that it did not want to interfere in financial markets was not accepted by the Auditor-General, who pointed out to the Finance and Expenditure Committee that the grant of the guarantee was already a substantial interference. The Auditor-General has found the Treasury s monitoring of the growing taxpayer exposure to risk was inadequate there appears to be no evidence of Treasury written communications with the Minister of Finance raising concerns during the scheme s first five months no evidence that the Minister of Finance raised any questions in respect of Treasury s management of risk. There are also uninvestigated allegations of poor practice which caused high losses upon realisation of the likes of South Canterbury Finance. Because neither we, nor anyone else, has been able to enquire properly into the matter, we are unable to quantify the loss attributable to the Treasury s handling of the scheme. In our view, it is almost certain that the losses were at least $100 million higher, and quite possibly they were between $300 million and $500 million more. Treasury s mishandling of the scheme has contributed to the biggest unnecessary loss of Crown revenue since the INCIS computer scandal. Our previous request to have the Treasury appear before us so we could hold them to account and question them was blocked by National members of the committee. We have signalled that there should be a full inquiry into the Treasury s handling of the scheme. We feel that anything less would be a scandal and amount to an abrogation of the Finance and Expenditure Committee s proper responsibility to New Zealanders. Minority view of New Zealand First The objective of the Crown Retail Deposit Guarantee Scheme was to maintain the confidence of depositors, investors, and the wider public in New Zealand s financial markets. This objective has largely been met. However, serious questions remain about the design and implementation of the scheme. A number of concerns raised in The Treasury: Implementing and managing the Crown Retail Deposit 7

8 Guarantee Scheme have not been adequately explored. The committee has been seriously constrained in its ability to investigate the matter further. We are principally concerned with the Treasury s operational performance and its policy of non-intervention. In terms of operational performance, the Auditor-General has found the Treasury wanting in the area of governance and risk management. It is reasonable to expect that the Treasury should have had mechanisms for formal oversight of the scheme in place well before March We note the decision to include finance companies in the scheme as non-bank deposit takers. This appears to have led to a significant increase in Crown liabilities. The Auditor- General reports that during early 2009 deposits with finance companies covered by the scheme grew, in some cases substantially. 5 However, officials did not take action until after the first finance company collapsed. The Treasury should have identified and managed risk from the beginning. The Treasury could have taken a number of preventative measures. For example, officials could have conferred with their counterparts in the United States or the United Kingdom, where similar schemes already existed, to identify possible defects. Common sense would have indicated the need for a cap on the government s guarantee to avert the kind of future investment mistakes which are the subject of this report. The Treasury s claim that it did not want to interfere in the financial markets is contradicted by the scheme itself. The view, apparently held by the Treasury, that it was better to recover what funds it could after an institution failed, than to try to influence events before a failure, 6 is unacceptable. Furthermore, questions must be asked about the extent to which the Minister of Finance was involved in monitoring the scheme. The Treasury s mishandling of the scheme resulted in the biggest unnecessary loss of Crown revenue since the failed INCIS computer system of the early 1990s, and has amounted to losses to the Crown in excess of $1 billion. We note that of the nine financial institutions to receive payments from the scheme, all were NBDTs. The largest of these, South Canterbury Finance, received approximately $1.6 billion. Of this amount, the Government expects to recover only $600 million. The Finance and Expenditure Committee has a responsibility to ensure that those who implemented the scheme are held accountable. We call for a full inquiry into the Treasury s actions and inactions in respect of the Crown Retail Deposit Guarantee Scheme. 5 Auditor-General, The Treasury: Implementing and managing the Crown Retail Deposit Guarantee Scheme, September 2011, p Ibid. 8

9 Appendix Committee procedure We met on 28 March, 4 April, and 2, 9, 23, and 30 May 2012 to consider the Controller and Auditor-General s report The Treasury: Implementing and managing the Crown Retail Deposit Guarantee Scheme. We heard evidence from the Office of the Controller and Auditor- General. Committee members Todd McClay (Chairperson) Maggie Barry David Bennett Dr David Clark Hon Clayton Cosgrove Paul Goldsmith John Hayes Dr Russel Norman Hon David Parker Rt Hon Winston Peters Hon Dr Nick Smith 9