'A letter on behalf of the FSA and the FSCS to the British Bankers' Association, Building Societies

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Financial Services Authority Dr. Thomas Huertas Director, Banking Sector Direct line: 020 7066 2300 Local fax: 020 7066 2301 thomas.huertas@fsa.gov.uk 31 December 2008 Dear FSCS levies for deposit-taker defaults: implications for firms 1. On behalf of FSA and FSCS, I am writing to set out, for you and your members, a number of points relating to recent deposit-taker defaults, and the involvement of the Financial Services Compensation Scheme (FSCS) in resolving effectively these problems. 2. We, and the FSCS, have received a large number of queries from firms on the involvement of the FSCS in recent cases such as Bradford & Bingley plc (B&B), Heritable Bank plc (Heritable), Kaupthing Singer & Friedlander Limited (KS&F), Landsbanki "Icesave" (Icesave) and London Scottish Bank plc (London Scottish). Firms have understandably been concerned about the likely impact on them, now and in future, arising from their responsibility for future FSCS levies. The role of the FSCS 3. The role of the FSCS is, in general, to provide compensation to consumers of financial products when authorised firms are not able to meet their obligations. The existence of this compensation safety net protects consumers, leading to greater confidence in their dealings with financial firms, which is a benefit for all of those firms. Deposit takers have, of course, benefited from the existence of FSCS coverage without having to pay substantial levies in recent ...

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Financial Services Authority
Dr. Thomas Huertas Director, Banking Sector
Direct line: 020 7066 2300 Local fax: 020 7066 2301 thomas.huertas@fsa.gov.uk
Dear
31 December 2008
FSCS levies for deposittaker defaults: implications for firms
1.
2.
On behalf of FSA and FSCS, I am writing to set out, for you and your members, a number of points relating to recent deposittaker defaults, and the involvement of the Financial Services Compensation Scheme (FSCS) in resolving effectively these problems.
We, and the FSCS, have received a large number of queries from firms on the involvement of the FSCS in recent cases such as Bradford & Bingley plc (B&B), Heritable Bank plc (Heritable), Kaupthing Singer & Friedlander Limited (KS&F), Landsbanki "Icesave" (Icesave) and London Scottish Bank plc (London Scottish). Firms have understandably been concerned about the likely impact on them, now and in future, arising from their responsibility for future FSCS levies.
The role of the FSCS
3.
The role of the FSCS is, in general, to provide compensation to consumers of financial products when authorised firms are not able to meet their obligations. The existence of this compensation safety net protects consumers, leading to greater confidence in their dealings with financial firms, which is a benefit for all of those firms. Deposit takers have, of course, benefited from the existence of FSCS coverage without having to pay substantial levies in recent years – in fact, other than for base costs, the deposit class of the FSCS has been levied only once since the FSCS was established in 2001, for £3.9 million for the current (2008/9) levy year.
In each of the above cases, the validation by FSCS of the estimates of the cost of compensation may lead to a different final figure for the cost of compensation, which could be higher or lower than the estimates provided in the relevant transfer orders.
and
For Icesave, the FSCS is paying compensation directly to over 200,000 depositors, with the amount of FSCSfunded compensation, for which levies may be raised, 4 estimated to be £1.4 billion.
a)
b)
10.
9.
See the Transfer Order athttp://www.opsi.gov.uk/si/si2008/pdf/uksi_20082546_en.pdf. See the Transfer Orders athttp://www.opsi.gov.uk/si/si2008/pdf/uksi_20082644_en.pdfhttp://www.opsi.gov.uk/si/si2008/pdf/uksi_20082666_en.pdf. See the Transfer Order athttp://www.opsi.gov.uk/si/si2008/pdf/uksi_20082674_en.pdf. Seehttp://www.fscs.org.uk/files/documents/pdfs/bzlbowohfmkofuz.pdf. Seehttp://www.fsa.gov.uk/pages/Library/Communication/Statements/2008/lsb.shtml.
1 2
8.
For London Scottish, the FSCS is paying compensation directly to some 10,000depositors, with the total amount to be paid (i.e., including both FSCSfunded compensation and amounts above the FSCS limit to be paid by HM Treasury) 5 estimated to be £273million.
3 4 5
4.
6.
2 3 For Heritable and the Edge internet retail business of KS&F , the FSCS has contributed £0.5 billion and £2.5 billion respectively to the cost of transferring the large majority of the retail deposit books to ING NV. These figures are also to be validated in due course by FSCS. The FSCS is also paying compensation directly to a small number of Heritable depositors and to the nonEdge KS&F depositors.
7.
2 
5.
to Icesave depositors, an amount equal to the compensation they are entitled to receive from the Icelandic compensation scheme, and
to certain Heritable, KS&F, Icesave, and London Scottish (as set out in paragraph 8) depositors, amounts above the FSCS limit.
In addition to the compensation that the FSCS itself is liable for, the FSCS is paying certain additional amounts on behalf of HM Treasury:
In addition to the items above, the FSCS will necessarily incur other costs during this period, in relation to the validation of the amounts contributed to the deposit book transfers; for the processing of compensation claims, including the verification of eligibility; and so on. The FSCS’s current estimate of noninterest management expense costs for the current year (2008/9) is £19.5 million and for 2009/10 it is £13.3 million.
As these payments are being made on behalf of HM Treasury, the costs arising from them will not be covered by FSCS levies but met from funding provided by HM Treasury.
1 For B&B, the FSCS has contributed £14 billion to the cost of transferring the retail deposit book to Abbey. That is an estimate of the cost of compensation, which is being validated by FSCS.
6
Interest on the FSCS's borrowings
12.
15.
3 
As you are aware, the FSCS does not maintain a large standing fund to meet claims when needed. Rather, the FSCS raises levies each year to enable it to meet its anticipated obligations in respect of compensation costs in the following twelve months and to meet management expenses in the current financial year. The FSCS can raise additional levies at any point during the year, as necessary, subject to consideration of the Management Expenses Levy Limit and levy limits for compensation costs (see paragraph 20). The FSCS can also use recoveries from a failed firm to reduce the levies it needs to raise (see paragraphs 32 to 36 for details on recoveries and repayment of principal).
The FSCS will pay interest in arrears, with interest for the period to 31 March each year being payable on 1 October of that year. So, for the period to 31 March 2009, interest will be payable on 1 October 2009; and so on.
All the loan facilities are on an interestonly basis for the first three years, with the interest rate set at 12 month LIBOR plus 30 basis points for this period. The interest rate is reset at the first of each month for that month, using the average of 12 month LIBOR over the preceding five working days.
18.FSCS will need to raise levies on the industry to enable it to fulfil its obligations. Interest costs on borrowings by the FSCS are classed as a specific cost of the 6 management expenses levy , not compensation costs. This means that the interest
The Banking Bill includes powers that should put the ability of the FSCS to borrow from government on a more permanent basis going forward. The FSA and FSCS will discuss with HM Treasury how to implement these powers once they come into force.
It is important to be clear that meeting the funding needs of the FSCS in this way avoids the FSCS having to levy firms immediately for compensation costs, at the maximum levels allowed under FSA rules. It represents, therefore, a better deal for levy payers.
13.
In the case of recent bank defaults, the FSCS originally borrowed the necessary funds through separate shortterm facilities from the Bank of England and (for London Scottish) from HM Treasury. The Bank of England facilities are being refinanced with longer term loans from HM Treasury.
14.
11.
Levies
16.
17.
The management expenses of the FSCS are split into two parts: base costs, which represent the core costs of the FSCS as an organisation, and specific costs, which are the costs directly attributable to carrying out the business of paying
The total amount of the FSCS's borrowings was, at 16 December, £19.7 billion, representing the amounts to fund the deposit book transfers for B&B, Heritable and KS&F, plus drawings to fund the compensation costs for the claims from KS&F non Edge depositors, Icesave depositors, the direct Heritable compensation claims and London Scottish depositors.
Funding the FSCS's involvement
How is the levy divided amongst firms?
costs are attributable solely to the class in which the defaults arose, namely the Deposit class.
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7 8
25.
24.
22.
23.
Having taken due account of the potential impact on deposit takers of current and future FSCS levies, the Authorities have agreed that the total amount levied to meet interest and other operational costs (i.e., management expenses) arising from recent defaults will, in the next three years, not exceed £1 billion per annum. This is distinct from the formal limits set in FSA rules on the amount the FSCS can levy each year for management expenses or compensation costs. Any interest costs above this annual cap will be waived by HM Treasury rather than recharged later.
21.
20.
The annual limit on the FSCS management expenses levy for 2008/9 is set at £1 billion. In addition, the levy limit on compensation costs for deposit takers in any one year is currently £1.84 billion.
Limits on levies
19.
The FSCS will, in deciding what levies it needs to raise in the next three years, have to consider both the interest costs and the other costs of paying compensation noted in paragraph 10. Levies raised after this period will also need to cover repayment of outstanding principal on the loans and will, in part, depend on the level of recoveries made.
The PD figure for 31 December 2007 that we are currently using is £951.7 billion. It should be noted that PD figures are not static; they change as firms cancel their
Any levy the FSCS needs to raise from deposit takers is divided between firms based on their share of the total PD figure for the relevant year. So in order for firms to perform the calculation themselves, they need to know their own PD figure, the total PD figure and the expected levy figure.
Each year, as part of the normal collection exercise for fee tariff data, the FSA writes to all firms that are required to provide a Protected Deposits (PD) figure; this usually happens in mid to late January (firms will also, as part of this exercise, be asked to provide relevant data for other FSA fee blocks, FSCS subclasses or FOS industry blocks they are in where the data does not come from other sources. The PD figure 8 used to apportion levies for the current FSCS levy year (2008/9) is the figure firms reported, in January and February of this year, as at 31 December 2007. We will repeat this exercise early in 2009, to obtain a PD figure as at 31 December 2008, which will be used for the apportionment of levies for the 2009/10 FSCS levy year.
compensation. These terms are defined in the Glossary to the FSA's Handbook, which can be found at http://fsahandbook.info/FSA/html/handbook/Glossary. Protected Deposits are defined in COMP 5.3.1R; see http://fsahandbook.info/FSA/html/handbook/COMP/5/3. The FSCS levy year runs from 1 April to 31 March.
Levies are apportioned between firms on the basis of their shares of the tariff base, 7 which for deposit takers is Protected Deposits .
deposit taking authorisations, either because they are giving up their business or on 9 merger or takeover (but see paragraph 37).
For the avoidance of doubt, to calculate their own potential levy, firms should take their own PD figure as previously reported to the FSA, and use the figures from paragraphs 25 (the 31 December 2007 PD total (or PDindustry)), and 26 (the forecast management expenses levy (or MEL2008/9) as follows:
(Own PD / PDindustry) * MEL2008/9= potential levy for 2008/9
5 
9  When firms merge, and the combined firm has one deposit taking authorisation, the PDs of the ‘vanishing’ firm currently are removed from the PD total applicable for that year. From 1 January 2009, on merger the combined firm will be levied (if levies are needed) based on the combined PD total of the two firms. 10  This figure reflects the actual interest rates applicable to the loan facilities from 29 September to the end of December 2008. It assumes that the interest rate applicable at 1 December 2008 will also be applicable to the period from 1 January to 31 March 2009. Given the recent movement of interest rates, it is possible that this represents an overestimate of future interest costs for the remainder of 2009. 11  The difference between the PD figures at 31 December 2007 and 2008 represents those firms who have merged during the year, so their PD figure does not count in the 2007 total but is included (as part of the new merged firm) in the 2008 total. An example of this would be the Derbyshire Building Society merging with the Nationwide Building Society. 12  As explained in footnote 10, given the recent movement of interest rates, it is possible that this represents an overestimate of future interest costs.
The current figure being used by FSA and FSCS for forecast interest costs for the 12 2009/10 levy year is £852.3 million. Using the estimate of noninterest costs from paragraph 10 (£13.3 million), the current forecast for the management expenses levy for 2009/10 is £865.6 million.
26.
29.
27.
28.
When will levies be raised?
It is expected that levies will be raised on behalf of the FSCS by the FSA, as usual. Under the terms of the recent funding arrangements, it is expected that deposit takers will be asked to remit settlement of levies arising from the loan facilities directly to the FSCS account at the Bank of England.
How will levies be raised?
31.
The PD figure we are currently using for 31 December 2008 (so applicable to the 11 2009/10 levy year) is £970.7 billion .
The current figure being used by FSA and FSCS for forecast interest costs for the 10 2008/9 levy year is £468.0 million . This figure will be reviewed as appropriate and updated figures provided. However, the management expenses levy will include other costs, in addition to interest, and so (assuming no change in the level of interest) the actual levy would be higher than this figure. Using the estimate of noninterest costs from paragraph 10 (£19.5 million), the current forecast for the management expenses levy for 2008/9 is £487.5 million.
FSCS does not presently intend to levy deposit takers before 31 March 2009 for costs already accruing. FSCS will update the industry in February about its plan and budget for next year, including proposed timings for levies for the recent banking defaults.
30.
Although the Transfer Order for B&B does not provide for interest on the liability 13 owed to FSCS, it does provide that – in the final reckoning – the FSCS will not recover less than it would have recovered if B&B had gone into liquidation. The FSCS are working with HM Treasury and B&B to model what the recoveries would have been in this case, and will ensure that after receipt of the recoveries under the B&B runoff plan currently being developed, FSCS will be no worse off.
As a result of the payments it has made to facilitate deposit transfers, the FSCS now stands as a creditor of B&B, which is now in public ownership, of Landsbanki, and as a creditor in the administrations of Heritable, of KS&F, and of London Scottish.
The FSCS expects over time to receive funds from the winding down of the banks in default. These recoveries will be used to reduce the principal amount outstanding on the FSCS's borrowings (see paragraph 13). This will reduce the interest costs that the FSCS will have to pay and the extent to which compensation cost levies will be needed to repay the principal of the loans.
32.
After a threeyear interest only period, a schedule for repayment of any remaining principal outstanding (after recoveries) on the borrowings will be agreed between the FSCS and HM Treasury. This repayment schedule will take due account of the market situation at that time, and of any possible impact on financial stability.
The FSCS now also has the power (in FEES 6.7.6R(3)) to raise exit levies which look at the deauthorising firm's potential liability to pay levies in future years, as well as in the current levy year. The FSCS will determine shortly whether, and if so how, it may exercise this power at this time.
38.
37.
The FSCS has for many years had the power to raise levies on firms who have ceased to participate in the scheme and are in the process of ceasing to be authorised (so called "exit levies") for the amount that the firm would otherwise have been asked to pay during that levy year.
34.
Repayment of principal by the FSCS
6 
Principal amounts and recoveries
13  See Article 30(6) of the Transfer Order.
39.At the present time, the FSCS does not expect to receive recoveries in the year to March 2009 from the windingdown of the banks in default, so the interest due for 2008/9 is expected to be based on the full amount of principal borrowed and as a minimum this would be reflected in any exit levy imposed. There is uncertainty around the extent to which recoveries will be received in 2009/10 (or subsequent years), although the FSCS believes it is reasonable to assume that there will be some recoveries which will reduce principal, and thus interest payments, between 31 March 2009 and 31 March 2012.
The FSCS will, from that point, need to levy for both principal repayments (compensation costs) and interest and any other related costs (management expenses).
36.
Exit levies
35.
33.
Many of your member firms will have securities traded on public exchanges with the result that they will generally be subject to ongoing obligations as regards disclosure. This includes, in some circumstances, the need to make specific market announcements. Clearly any listed firm that is affected by these FSCS levies should give full consideration to the disclosure obligations that it faces on an ongoing basis.
48.
In addition a business plan for the winding down of Bradford & Bingley will be drawn up early in the New Year and discussed between HMT and the FSCS. This should provide greater clarity over the timing and amount of recoveries the FSCS can expect and thus over the likely extent of any exit levies with respect to this institution.
Further information will be provided to firms as soon as possible in 2009. Thereafter, the FSCS will provide periodic updates about actual and predicted costs of repaying the loans. The value and timing of recoveries will become clearer and interest costs will become known rather than forecast, so firms should be aware that those exiting at different points may face different exit levies.
Listing and disclosure obligations
47.
However, it is not possible to give a firm view on accounting treatment until the question of exit levies, as discussed above, is resolved. We expect to be able to provide an update to you on this before the end of January 2009.
Nonetheless, given the implications for the calculation of prudential data (especially regulatory capital), we have had conversations with a number of leading auditors, who highlighted some key considerations. As firms may find a brief summary of these points to be helpful as background, this is set out below.
The requirement to pay the FSCS levies creates an obligation at the balance sheet date as a result of past events which is likely to require recognition as a liability  see international accounting standard IAS 37 and UK GAAP standard FRS 12Provisions, Contingent Liabilities and Contingent Assetstext of these is substantively (the identical).
The FSA has no role in determining the appropriate way in which to account for the fact pattern described above. A firm’s directors are responsible for its accounts. Accounting standards are set by the International Accounting Standards Board in the case of IFRS and the UK Accounting Standards Board for UK GAAP.
46.
A key issue is the period over which accrual should be made. In the case of IFRS, our understanding is that this should be decided having regard to the Interpretation IFRIC 6Liabilities arising from Participating in a Specific Market – Waste Electrical and Electronic Equipment.This interpretation makes clear that the obligating event is participation in the market during the measurement period.
A number of firms have raised queries as to how they should account for the future FSCS levies.
43.
41.
45.
40.
42.
Accounting
44.
7 
Yours sincerely,
8 
Thomas Huertas
In addition, if your association finds itself in possession of data relating to FSCS levies and your individual members, could I take the opportunity to remind you of the need to maintain the confidentiality of those data.
Next steps
Further queries
50.
49.
Both the FSA and the FSCS will communicate further with trade associations and directly with firms in the weeks ahead, to provide as full a picture as possible of the situation as regards FSCS levies.
51.
If you or your members have any queries on the matters discussed in this letter, please can they be sent toFSCSLevyQueries@fsa.gov.ukcan firms copy them to their and supervisor.