KEY POINTS:
Accusations were flying thick and fast again this week after the failure of Nathans Finance, the fifth finance company to collapse in 15 months. This accelerated yesterday when Property Finance Group requested suspension of its shares on the NZAX after directors "became concerned about the company's ability to
manage its current liquidity position".
North & South columnist Warwick Rodger blamed the media for his failed investment in Bridgecorp. Others grumbled about poor advice from financial planners and analysts pointed the finger at poor lending practices and inadequate regulation. Meanwhile, the auditor and trustee communities argued that they did everything they could under the current regulatory regime.
The finance company sector is relatively small but its crisis of confidence could have widespread implications for the financial sector and the domestic economy.
As the first table on the right indicates, there has been a big increase in the value of non-bank deposits, mainly finance company, since 1990. Reserve Bank figures show the non-bank sector had $29 billion or 9 per cent total deposits at the end of last year compared with just $10 billion or 5 per cent in December 2000.
More importantly, individuals had $84 billion invested in deposit-taking organisations, of which $12 billion, or 15 per cent, was in non-banks, mainly finance companies.
Quarterly figures, which are available only from December 2004, show that the non-bank sector experienced particularly strong growth until mid-2006 (second table).
In 2005 these non-banks had a net inflow of $1.54 billion from households, representing 23 per cent of net deposits by individuals during that 12-month period. This dropped to 19 per cent in the first half of 2006 and plunged to a measly 1 per cent in the second half after investors diverted their funds from finance companies to banks after National Finance, Provincial Finance and Western Bay Finance collapsed.
Confidence in finance companies was partially restored in the first half of the present year when the non-bank sector had net deposits of $362 million, or 9 per cent of total new deposits.
This newfound confidence has been severely dented by the collapse of Bridgecorp and Nathans Finance and this quarter is expected to be a repeat of the September 2006 quarter as far as net deposit inflows are concerned.
The ups and downs of the finance company sector are a classic example of the problems created by over-confidence, particularly if this channels investors towards an unregulated sector of the economy.
During buoyant economic conditions, as we have had throughout the world in recent years, investors chase higher returns with little regard for risk. This is the primary cause of the sub-prime mortgage problems in the United States, the international credit crunch and finance company collapses in this country.
An important point to recognise about the New Zealand financial system is that the word "bank" is extremely important.
Any entity can set itself up as a deposit taker and lender, but the Reserve Bank determines which entities can use the word "bank". If an organisation calls itself a bank, it has been approved by, and is under the full supervision of, the Reserve Bank.
Deposit takers and lenders that do not use the word "bank" are subject to little supervision and regulation.
Entities must meet a number of criteria before they are granted the right to call themselves a bank. These include:
* They must have a minimumcapital of $15 million.
* The applicant must have a positive reputation, a proven track record and have demonstrated the capacity to conduct banking business in a reputable way.
* Applicants must have two independent directors and a chairman who is not an employee of the bank in New Zealand. The Reserve Bank takes into account the quality of the applicant's directors and senior management when deciding.
* The Reserve Bank will look at the adequacy of the disclosure made by the applicant in its home country.
When an entity receives approval to use the world "bank", it has a number of requirements including.
* It must publish quarterly accounts.
* Have no more than 1 per cent of its activities in non-financial and insurance businesses.
* Have a credit rating from Standard & Poor's, Moody's or Fitch Ratings.
Most of the five collapsed finance companies would have met few, if any, of these requirements.
In contrast to most other countries, non-bank deposit takers and public issuers do not require a licence. They operate under a disclosure regime, which requires them to publish sufficient information to allow a prudent but non-expert investor to make a relatively well-informed investment decision.
The main purpose of this light-handed regime is to reduce costs. Deposit takers are allowed to advertise as long as they refer to the availability of an investment statement and there are no untrue statements or any information likely to deceive, mislead or confuse investors.
This approach is fine in theory, but a number of high-risk and woefully inadequate businessmen have run their finance companies into the ground and lost huge sums for their conservative investors. Most finance companies are well run but the failed ones, many of which have attracted an excessive amount of funds through advertising, are now causing huge problems for the sector.
An important indicator is the reinvestment rate, the percentage of maturing money that is reinvested back in finance companies.
Dorchester Pacific chief executive Andrew Walker told shareholders at Thursday's annual meeting that its finance company reinvestment was normally 60 to 70 per cent but had dipped to 50 to 55 per cent after the Bridgecorp crash and was expected to fall below 50 per cent after this week's developments.
Kevin Podmore of Auguste Finance (formerly St Laurence), who is a Dorchester Pacific director, told the meeting his reinvestment rate declined to about 65 per cent after Provincial Finance collapsed but had climbed to 75 per cent earlier in the year. In recent weeks it had eased back to 68 per cent.
Both men emphasised the amount of cash they held in the bank, a clear sign of the defensive attitude now pervading the sector. There is a slow but steady run on finance companies and the directors and executives are frantically trying to maintain investor confidence and have sufficient cash to meet redemptions.
Although a large number of factors have contributed to the problems the unregulated nature of the sector has been an important factor.
The 1980s sharemarket boom and bust, which took years for the domestic economy to recover from, was mainly due to the absence of almost any effective regulations. The argument at the time was that a light-handed regulatory regime reduced costs for market participants.
We have learned nothing from the 1980s as the same arguments have been used to justify an unregulated finance company sector.
In light of this, it is not surprising that a number of individuals, including Rod Petricevic, jumped from the unregulated sharemarket of the 1980s to the unregulated finance company sector.
Finance companies should be subject to more regulation but the first priority of the Government, Reserve Bank and Securities Commission is to ensure the sector is stabilised and well-run finance companies are not pulled down by the crisis of confidence affecting the sector as a whole.
* Disclosure of interest: Brian Gaynor is an investment strategist and analyst at Milford Asset Management.