Editorial: Safety net needed for minnows

Opinion

Eleven months ago, Western Bay Finance dismissed criticism that money placed in finance companies by unenlightened investors was, in many cases, anything but safe. While it was valid to urge caution, said chairman Jim Smylie, it was up to the market to decide whether the return on their risk was appropriate. He was right, but only up to a point.

In the wake of this month's failure of Western Bay Finance, and the earlier collapses of Provincial Finance and National Finance 2000, many mum-and-dad investors would surely appreciate a little extra help to make sound decisions.

At the moment, they rely on finance company prospectuses and investment statements for information on debentures being offered. Companies are also required to provide an update if their fortunes deteriorate. That is fine, but only in so far as it goes. Some companies do not comply fully with the requirements. Worse still, many investors, and some advisers, do not study the documentation. Indeed, unsophisticated investors are more likely to be attracted, and misled, by statements such as "first ranking secured deposits".

Many investors, therefore, put their money with a finance company unaware of what it invests in or who owns it. They have little idea of the level of risk. Many will not know, for example, that the company is lending money to highly geared property developers, or, as in the case of Western Bay Finance, was heavily dependent on loans to used-car buyers. Nor will they know that, in relation to the risk involved in such activities, their return could be well below what it should be. Some, indeed, have little awareness of the realities of risk and reward. A period of strong economic growth has whetted their taste for high yields and apparently certain returns.

That appetite has been dulled by the three company failures, and the whole sector has been tarred with the same brush. That is unfortunate because many finance companies are solid, secure and well managed. Equally, the sector serves an important role in providing loans to businesses and individuals who cannot get them from banks. It is important, therefore, that steps are taken to restore public confidence.

This can be done by enabling investors to differentiate more easily between companies. The obvious way of doing this is to make credit ratings mandatory. Ratings provide an immediate reference point and means of comparing companies' risk profiles. Critics say no suitable credit-rating agency now operates in New Zealand. But if an independent, internationally recognised rating was made compulsory, agencies would soon set up shop here.

This, and other responses, are being considered by a Ministry of Economic Development review, the prelude to Government action. An alternative is the Australian model of approved deposit takers, which involves a voluntary regime of finance companies boasting adequate credit ratings, minimum capital ratios, and enhanced disclosure. If this was introduced, investors could place their money with banks, earn a little more with approved deposit takers, or take a bigger risk, with the prospect of a better return, through a less regulated third tier.

That option would ensure finance-company money remained available for risk-takers. It would also serve sophisticated investors well. Those less financially literate would have the choice of a safer alternative. Events of the past few months should also have made these mum-and-dad investors more aware. The failure of Western Bay Finance and others was a sharp reminder that the greater the return, the higher the risk.