Key Points:

The Reserve Bank is taking a tough approach in its new role as prudential regulator for finance companies, proposing stringent new rules requiring firms to bolster their balance sheets and moving to unwind excessive related party lending.

Industry experts expect some firms will elect to become banks anyway while others will be forced out of business altogether.

The RBNZ, which was given the role of prudential regulator for the non bank deposit taking sector via legislation passed in September last year, released a discussion paper dealing with related party issues and minimum capital ratios in late December.

In a concession to concerns that the new regulations as originally proposed would force smaller players out of business, the RBNZ has decided to raise the asset threshold above which companies are required to obtain a credit rating from $10 million to $20 million.

However, there are a number of other proposals which at least some finance companies are likely to find unpalatable.

Among these is the suggestion that finance companies will be required to have a "Tier One" capital ratio of 8 per cent of risk weighted assets. Registered banks are required to hold half that level.

Capital ratio requirements set out the level of shareholders' equity, debt funding and retained earnings an institution must hold as a buffer against shocks or tough operating conditions.

Tier One capital is restricted to ordinary shares, perpetual fully paid up non-cumulative preference shares and retained earnings.

What's more, the risk weighting the RBNZ proposes to apply when calculating firms' assets will likely have the effect of increasing the nominal amount of Tier One capital needed to meet the 8 per cent requirement.

Previously the level and quality of capital firms were required to hold varied from company to company and was set out in their trust deeds.

PricewaterhouseCoopers partner Sam Shuttleworth said companies would inevitably have to hold Tier One capital in excess of the new requirements in order to provide a margin of comfort against breaching the minimum, "and in the current market that might be difficult". "If you require further capital would the shareholders require further return? And would that in turn require repricing of assets?"

It may also be a catalyst for some finance companies to think that because the rules are tougher for finance companies they will explore the opportunity to become a registered bank.

It may require some players to get out altogether and force industry consolidation."

However, looking back at the events of the past couple of years, "it's hard to argue with the underlying principle here that further capital's required".

Similarly, Shuttleworth said it was hard to argue against the RBNZ's proposal to limit related party lending to 15 per cent of Tier One capital.

A number of finance companies that have struck difficulties over the last couple of years, notably Hanover Finance, have faced stinging criticism for the amount of cash they lent to related parties.

In its discussion document, the RBNZ recognises that some non bank deposit takers, "have related party exposures above the proposed limit, and will therefore need time to comply with regulations".

It is proposing giving these companies a one year transition period.

Shuttleworth said the proposals were "a step in the right direction to ensure that risk is appropriately factored in to this type of business".

Submissions on the proposals close on February 16 and Shuttleworth said it was likely at least some of the industry would take issue with the RBNZ's risk weighting methodology.

Executive director of industry body the Financial Services Federation Justin Kerr confirmed his group had made a submission but declined to give any details until the deadline passed.

Hanover Finance chief executive Peter Fredricson said his company was still working its way through the RBNZ proposals and had yet to make its submission.

Adding it up

The Reserve Bank's proposed new rules for finance companies:

* They must hold Tier One capital in excess of 8 per cent of their risk weighted assets.
* Related party lending must not exceed 15 per cent of risk weighted assets.
* The calculation of risk weighted assets will take into account the generally riskier profile of finance company loans.
* The minimum asset threshold at which finance companies must obtain a credit rating will now be $20 million, up from $10 million as originally proposed.