Licensing and Supervision of Leasing

Since only financial leasing should be regulated, the contours of the regulatory landscape will be determined by the definition of what constitutes a finance or financial lease. The two most distinguishing and relevant characteristics of a finance lease are that: (1) the lessee has selected the equipment and the supplier; and (2) the lessor has acquired the equipment specifically for lease to the lessee. The proper definition stops at that point - if it is defining a finance lease for commercial, transactional law purposes. These are the two distinguishing characteristics that justify different financial lease transactional rules than those usually attendant to traditional rentals. These different rules for finance leases include, are but not limited to, the lessor having no responsibility for equipment defects (the lessee must take those complaints directly to the supplier) and the lessee having an absolute duty to pay rent once it accepts the equipment. No further distinguishing characteristics are relevant for the purpose of making a different allocation of rights and responsibilities for those involved in the lease transaction. Nevertheless, a number of financial leasing laws, not necessarily involved with lease licensing and regulation, including the Unidroit Convention on International Financial Leasing, go further and reference the existence of full-payout status and/or nominal purchase options at the end of the lease term.

Nominal Purchase Options Nominal purchase options do render a lease transaction the functional equivalent of a loan, or in other words, describe a simple finance lease, in that they remove the sine qua non or hallmark of a true lease: the retention by the lessor, as of the inception of the lease, of a significant residual interest. Thus, in seeking to encompass simple finance leases in the regulatory scheme, the inclusion of the existence of a nominal purchase option in the definition would be appropriate. For example, in France leasing with a purchase option (credit-bail) is regulated but leasing without a purchase option (location financiere) is not. This would also be true for the most nominal purchase option at all, the transfer of the title to the equipment at the end of the lease for no additional payment or consideration at all. However, these items should still not be included in the transactional law definition of finance lease. Of course, this illustrates the third principle mentioned in the prior article: that the definition of finance lease for regulatory purposes can and should be different than the one in the transactional law.

Full Payout Status Full-payout status involves a different definitional issue. Full-payout status refers to the economic circumstance that the lessor will recover, in that first lease of the equipment, all or substantially all of its initial equipment cost and receive a profit from that expenditure. In short, the lessor «has been fully paid-out of its investment' in that single, initial transaction, hence the expression «full-payout lease.» Please note that this status make no reference to the existence or absence of purchase options. While many full-payout leases many indeed have a nominal purchase option at the end of the lease term or a transfer of title for no additional consideration, such end of term treatments are not critical. In fact, the equipment may still have a significant residual remaining and the lessor may want to retain it, providing the lessor with a greater profit. Such a full-payout lease remains a true lease, albeit, one that is more expensive to the lessee because the lessor is not using the residual to subsidize and reduce the lease payments. Full payout status does not tell us anything about whether or not the lease is a true lease; it simply tells us how quickly the lessor makes a profit. Thus, it is irrelevant for distinguishing leases for the purpose of transactional rules. It is also irrelevant for regulatory purposes. The major threat to a financial institution's solvency is that the loans it has made will not be repaid, and that the collateral taken to secure the loans, is inadequate to cover them. In the context of a lease, one of the major threats to a financial institution that engages in leasing is that the institution might assume too great a residual position (i.e., exposure). If the institution then uses that residual assumption to reduce the lease payments, it begins to take on an asset risk as well as the credit risk. In fact, the credit risk has not declined, but a risk that was not there before, the asset risk, is there now and has increased. However, if the lease is full-payout and the lessor retains the residual, it has actually increased its security in the transaction and its ability to be repaid. Stated another way, full-payout status reduces the threat to institution insolvency and therefore reduces the need for regulation. Thus, full-payout status need not and should not be part of the definition of finance lease for regulatory purposes, any more than it should be a consideration for the definition for transactional rule purposes.

Leasing has a tendency to be more regulated in emerging markets and unregulated in mature markets. This is partly explained by history. Leasing developed quietly in the United States and certain European countries without much attention from the government. This was possible because the banking laws were not written in such a way that leasing activity fell within the legal definition of banking activity that was reserved for business enterprises that had a banking or other financial institution license.

Regulation of «Financial Activity» However, in a number of countries, particularly those with emerging markets, the definition of «financial activity» for which a banking or financial institution license is needed either directly or indirectly includes leasing activity. Most national banking acts contain a «list» of activities considered to be sufficiently «banking like» so as to require a «banking type» license from the central financial authority. Such a list includes the obvious, such as taking deposits, granting loans and the like, but leasing may or may not be specifically mentioned. If it is, then clearly a license is required. However, the usual situation is a bit more ambiguous, with a generalized focus upon the credit-extension elements of the activity. As financial leasing definitely has a strong credit-extension/financing element, it would then be encompassed by such a definition. Sometimes the term «financial leasing» will be used without a definition being supplied. The goal in that instance is usually to distinguish it from traditional rentals. Traditional rental activity is never subject to banking regulation.

Leasing as a Licensed and Regulated Financial Activity Nevertheless, it is generally advisable that leasing in emerging markets be licensed and, ultimately, mildly supervised, for the reason that the public usually perceives leasing to be a financial product and leasing companies to be part of the financial sector, along with banks. Because of that perception, a spectacular failure of a lease company, even though it is not accepting public deposits, has the possibility of impairing the public's confidence in banks. This perception is somewhat unique to emerging markets and does not exist in mature markets, where leasing is well understood to be its own unique service sector activity. A lease company failure in a mature market will not have an impact on the banking public. However, if leasing companies are not allowed to accept public deposits (and they generally should not be, for reasons that will be discussed later), heavy «bank style' regulation is inappropriate and inadvisable. The «mild supervision» needed involves mostly the maintenance of certain prudential norms, such as minimum capital requirements, gearing limitations, single customer exposures and the like. Nevertheless, depending upon how the banking laws encompass leasing, leasing may not receive any «special case» treatment and instead will be subsumed by the broadly applicable and more stringent banking regulations. This is more likely if leasing is simply ensnared by the definition of regulated financial activity than if it is has its own special mention and definition in the regulatory legal structure. Yet, the more common situation is that leasing is just not mentioned at all in the banking laws. In that instance, leasing may be able to start spontaneously under a standard, corporate business charter available to almost any kind of business. If financial leasing has already started in an emerging market country without licensing and supervision, it may be best to let it develop further without interference. This will be particularly true if the central bank or ministry of finance, the two most common regulatory bodies, does not have an existing non-bank financial institution (NBFI) structure already in place in its organization. Some banking laws may also not recognize the existence of NBFIs.

There are basically five types of lessors: 1) banks which engage in leasing directly (i.e., simply as a part of their routine banking business); 2) banks which engage in leasing indirectly (i.e., through a subsidiary or majority-owned affiliate); 3) licensed and/or regulated non-bank financial institutions; 4) regular (and unregulated) companies or other standard business entities; 5) divisions or subsidiaries of manufacturers and suppliers who provide leasing of their own products. These different types of entities present different licensing and supervision issues.

The first question that must be addressed is whether or not banks can engage in leasing activities, either directly as part or general banking operations or indirectly through a subsidiary. While almost every country allows banks to be in the leasing business, they differ in the method and manner by which such participation is allowed.

Some countries, including Canada, allow banks to engage in leasing activities as simply another of their traditional banking activities. As such, leasing is viewed as just another financial product. However, there are a number of problems with this approach, including: 1) the creation of an unfair competitive advantage over non-bank lessors; 2) potential bank reporting irregularities; 3) impairment of the development and growth of leasing in the local economy through: a) the unfair competitive funding advantage; b) the inappropriateness of «banking level» prudential norms to leasing activity; c) the complexities of residual risk management, and the threat to banking soundness that the poor management of residual risk might create.

Creation of an Unfair Competitive Advantage Over Non-bank Lessors Because banks are allowed to take public deposits, they will almost always have a lower cost of funds than will a non-bank lessor. The situation is aggravated further by the fact that most of a non-bank lessor's own funding for its lease transactions will come from a traditional bank loan from the very same bank or banks that it is competing against for leasing business. However, the non-bank lessor will have some advantage if it is free from regulation. The bank lessor will always be regulated in all of its activities, including its leasing activities. The full set of prudential norms, regarding single customer exposure, provisioning, gearing and the like, will apply to its leasing activities as well. Yet, this regulatory burden is not enough to «level the playing field» from the supreme advantage that a lower cost of funds provides.

Potential Bank Reporting Irregularities Banks are almost always required to file periodic financial reports (e.g., monthly, quarterly, annually) with the governmental agency responsible for bank supervision. This is usually the central bank. These reports are designed, in the specific details of the items that must be included, to provide the government with a view of the financial soundness of the bank and whether or not the bank is proceeding in business with prudent and reasonable banking practices. As financial leases are generally accounted for as loans, with interest earnings and return of principal, the leasing data may be not be evident as such but simply lumped in with general loan data. On a country-by-country basis, leasing may be more or less risky than traditional lending; yet, regardless, it usually does have a different credit risk profile, and one that will be obscured in typical, generalized bank reporting. Moreover, bank supervisors typically are well versed in the standards of traditional lending practice but are often unfamiliar with those of the leasing business. Even if the leasing data is segregated, which it may not be, the supervisors may not appreciate what they are looking at.

Impairment of the Development and Growth of Leasing in the Local Economy A number of the ways in which direct bank leasing can impair the development of leasing have already been mentioned, such as the unfair competitive funding advantage, the inappropriateness of «banking level» prudential norms to leasing activity, and the complexities of residual risk management and the threat to banking soundness that the poor management of residual risk might create. Additionally, bankers world-wide are well-known to be a conservative lot. They are rarely financial product innovators. If the banking laws allow non-bank entities to engage in the leasing business without licensing and supervision, it will usually be risk-taking entrepreneurs operating through a general company who introduce leasing into the country's economy. Banks come to the party later when they find that they are losing their loan customers to this new-fangled financial tool offered by these financial upstarts, the independent leasing companies. If the initiation of the leasing industry is left to the banking community, it may have a slow start. This is particularly true if the banks enter leasing directly. In such case, there will be no separate company, no separate physical location, and even if bank personnel are assigned exclusively to work on leasing matters, there will a difficulty in creating the separate, entrepreneurial culture that leasing thrives upon. For all of these reasons, it is inadvisable to allow banks to engage in leasing directly.

The main reason to require that banks engage in leasing on an indirect basis is to deny them the direct ability to access public deposits for lease transaction funding when non-bank lease companies do not have that advantage. A fairly level playing field is desirable. This also helps to avoid some of the tax, accounting, audit, supervision and control issues that would arise if a commercial bank was also carrying finance leases on its books. Moreover, the failure of a separate leasing company, even if it is bank-owned, does not necessarily create the same public confidence problems that a bank experiencing problems with its leasing portfolio would encounter. If a bank is required to operate its leasing business through a subsidiary or majority-owned affiliate, the competitive environment amongst lessors will be enhanced, the segregation of reporting data will provide a clearer picture, and an opportunity will be provided for the more entrepreneurial «leasing culture» to take hold. There will still be the natural tendency for the parent bank to provide more generous funding terms to its related entity than to other entities, but excesses in that regard can be managed by the standard banking prudential norms as necessary, particularly the norms respecting single customer exposure and insider transactions. The end-result can still be, and should be, to disallow the affiliated lease company from effective access to the lower cost deposits that the bank is receiving from the public. With these proper controls, there is no legitimate reason to not allow indirect bank leasing activity.

Non-bank financial institutions (NBFIs) are by definition entities that provide financial services without being a bank but that are still licensed and/or regulated by the authority for banking supervision, usually the central bank. Typical NBFIs include bank-operated subsidiaries, finance companies, merchant banks, insurance companies, pension funds, factoring companies, pawn shops-and lease companies. The definition of NBFI varies from country to country and may include most or only a few of the entities from the foregoing list (from the prior article). NBFIs are regulated by the banking supervision authority because they are considered to be providing financial services. However, by being separately classified from banks, a different regulatory structure can be more easily imposed and managed. This structure almost always involves lighter supervision and looser controls than are imposed on the banks. Consequently, regulation of leasing companies under the NBFI umbrella is the typically preferred approach to leasing activity supervision.

If the banking laws are not written in such a way to preclude leasing activity by regular companies and other standard business entities, their leasing activities can be commenced and maintained outside the financial system's supervisory structure. Indeed, this is typically how leasing got started in the markets that are now considered mature leasing markets. The lack of a regulatory burden can allow for maximum creatively and flexibility in the development of not only the individual lessor's business but also the development, growth and innovation of leasing as an industry. The risk, of course, is that a spectacular failure of a well-known lessor can generate terrifically bad publicity for a new industry striving for its initial public recognition and acceptance. The pall that such a failure can cast over the industry could cripple it in its infancy. In most emerging markets, who almost by definition, are struggling with an inadequate capital base and capital markets infrastructure, this risk is just too great and leasing too valuable a macro-economic development tool to allow leasing activity to be pursued by completely unsupervised entities. However, if leasing in an emerging market has already spontaneously started on its own without and regulatory supervision, it may be best to let it proceed unregulated. If problems later develop, supervision can then be imposed. It should be noted that this «spontaneous start» by regular companies and other standard business entities will only be possible in countries that do not preclude leasing activities by their definition of financial activity reserved for banks.

Divisions of manufacturers and suppliers who provide leasing of their own products rarely have their leasing activities supervised. Their financing activities are indeed the providing of financial services, but they are considered to be more in aid of the sales of their products than a financial business enterprise. In fact, the most common name for this type of activity is «sales-aid leasing,» a descriptively accurate term. However, if the manufacturer or supplier sets up a separate finance subsidiary, even for the purpose of financing its own products, it may meet the local NBFI definition and have to submit to the authority of banking supervision. This is not unreasonable, as the new entity has a specific focus on financial activity as a business. Moreover, most manufacturer's and suppliers who go to the trouble of setting up their own finance captives ultimately plan on providing financing for products beyond their own, taking them even further into the broad, general financial services sector.

A country may already have the authority for leasing licensing and supervision in place in existing laws and regulations and yet may not appreciate that fact. Of course, if the local, domestic banking law requires or is interpreted to require a bank license to engage in financial leasing, a bank license will be required. Leasing companies will be no different than banks and leasing will simply be another bank product. This situation will impair the introduction of financial leasing into the country. Yet, a more common situation is that the central bank's enabling legislation is seen as explicitly or implicitly giving it the authority to address «financial services» as the central bank may so construe that (or a similar phrase) from time to time. In other words, the central bank may already have some discretion to determine whether or not it needs to involve itself as a licensor, supervisor or regulator and when. This legislative circumstance allows enterprises that might be on the innovative edge of quasi-financial services to proceed with their business. If the central bank raises an objection or expresses concern at a latter date, then the matter is addressed and solutions negotiated. This approach also has the advantage of dealing with only problems that are problems, rather than forcing speculation about what the problems might be for a business activity that does not exist yet because there is no regulation to allow it. Adoption of a principle of «implicit authority» to address matters within its sphere of responsibility would be reasonable and legally justifiable under generally accepted legal principles. This approach would also allow independent lease companies, i.e. those not affiliated with a bank, to form. Leasing may then be allowed to commence sooner in a country rather than later. Yet, this approach is not always the best for an emerging market with a new leasing industry that has started spontaneously.

There are only five principal prudential norms relevant to the supervision of leasing activity: 1. Minimum Capital 2. Single Customer Exposure 3. Insider Transactions 4. Provisioning/Reserves 5. Gearing/Leverage A sixth one common to banks, a liquidity requirement, is unnecessary for reasons that will be discussed.

Whether arising from the country's companies act or a leasing-specific central bank regulation, there will always be a minimum capital requirement. If a traditional banking license is required for leasing, the minimum capital requirement will be the same as it would be to start a bank. This amount is usually measured in millions of dollars (US equivalent) and is often higher for a foreign entity seeking to enter the domestic market. Needless to say, this will present a significant barrier to the start of a leasing business. If leasing is unregulated and only a standard companies act charter is required, the minimum capital required is the same as for any standard company, often an extremely small amount. In this case, there is effectively no capital barrier to entry. If leasing is considered an NBFI activity, the capital requirements for an NBFI will have to meet. This capital level is almost always less than a bank's, but is usually not trivial. There will also usually be different capital levels required for different types of NBFI's. In other words, an insurance company would have one minimum, a merchant bank another, and a finance company a different one yet. In this environment, leasing companies will have their own, usually at the lower end of the NBFI scale, but significantly above the companies act base.

Limitations on the number of leases to a single customer, including the customers related business enterprises, is often set at nearly the same percentage as the general banking rule. Since this rule is designed to preclude a concentration of credit exposure, the credit risk exposure remains the same in both the banking environment and the leasing environment, when leases are just the functional equivalent of loans, i.e., when leases are just simple finance leases. As the nature of lease products mature and asset risk enters the picture through the retention of a residual interest by the lessor, a loosening of the single customer exposure rule is justified. Of course, a concern about asset risk concentration may now arise. Yet, as the industry moves from being credit based to asset based, the need for regulation itself declines. Percentage limitations on single customer exposures vary widely, from a conservative 10% to a liberal 50%. The mean would be around the middle, 20-30%. It should also be noted that a special bank single customer exposure rule (different from the general single customer exposure rule) may be needed for bank lending activity to its own leasing subsidiary or affiliate because of the special relationship they share.

Insider transactions refer to leases to the management of the lease company, or more relevantly, to companies owned or effectively controlled by the members of the lease company management team. If lease companies are allowed to take public deposits, the concerns in this regard are the same as for the banking community and the prudential norm is usually at a substantially similar percentage, often around 10-20%. However, if leasing companies are not allowed to take public deposits, and particularly if they are funded from private investment capital rather than publicly-raised capital, the risk of abuse or misappropriation of other people's money is reduced, and restraint on insider transactions should be lightened.

All businesses have a potential for suffering losses, and all prudent businesses «provision» for them or create a reserve fund so that when they occur, there is less disruption to current operations. In the financial sector, provisioning is mandated by regulation. Provisioning requirements for banks can be quite stringent. If unexpected losses occur, banks may not have sufficient funds on hand to meet the deposit withdrawal needs of their customer base. A denial of a legitimate withdrawal request because of inadequate liquid funds is the time-proven way to generate a bank panic or a potential collapse of the whole banking system. This nightmare is just what provisioning requirements seek to avoid. If lease companies do not take public deposits, a «run on deposits» is not possible. Provisioning in this circumstance is no different than the generally prudent business practice of creating a reserve for losses. It need not be as rigorous as the requirement for banks. A related bank prudential norm that usually is not imposed on lease companies is a liquidity requirement. Though related to provisioning, it has a different focus. While provisioning operates to create an asset base of reserves available to meet losses, a liquidity rule goes to a need to have those assets readily available in cash, specifically so that depositor withdrawal requests can be immediately met. If there are no depositors of a lease company, there is no need for a prudential norm on liquidity. Of course, this would not be the case if lease companies are allowed to take public deposits.

Gearing, also known as leverage in the United States, refers to a companies' debt-to-equity ratio. In mature markets, like the United States, respectable leasing companies will often operate at average gearing of 7 to 1. In fast growing emerging markets, this may be at 10-1 or even 15-1. On the other hand, some emerging markets may operate at a very conservative 3 or 4-1. History would seem to favor gearing below 10-1 as prudent.

Inherent in any regulatory structure is the necessity that the regulated provide information to the regulators. In the case of leasing, this would be specific information showing compliance with the prudential norms imposed, along with more general financial information indicative of how the business is doing. Usually, this means profit and loss statements, balance sheets, and related financial statement information. Interim reports (e.g., monthly, quarterly) are usually unaudited compilations but the annual filing may have to be auditor certified. These reports are usually just reviewed within the offices of the supervising agency. Field audits may be authorized by the regulations but are only occasionally conducted, often due to budget constraints, a lack of auditor familiarity with leasing, and the more pressing demands of better-understood matters. Yet, rumors, reports or information of substantial irregularities would almost always generate regulator scrutiny.

For any regulatory scheme to have effectiveness, it must have penalties for non-compliance with the rules. Common enforcement measures include the ability to: a. issue written warnings; b. issue an order requiring remedial action to be taken within a certain time; c. stop or limit certain activities; d. impose fines; and e. suspend temporarily or revoke the license. Obviously, the two most significant penalties are suspension of the business license or its outright cancellation. Parities feeling aggrieved by the regulators actions usually have to take their appeal to the local courts.