Kurt Hess: Keeping the market honest

Kurt Hess

You've no doubt seen all those newspaper ads from finance companies offering bigger and better rates of return on your money. You might even have read some of the warnings from the finance experts on the importance of checking out the real risks you might be running if you put your money into a finance company.

Such as - what happens if the company goes under, or if the investment goes bad? And as the economy begins to falter, the chances of that happening begin to rise.

Finance companies belong to what's called non-bank financial institutions (NBFIs).

These NBFIs are not bound by the same stringent Reserve Bank supervision and nor do they have the same disclosure requirements as registered banks, and yet they can do virtually every type of banking business - they just can't claim to be a bank, e.g. by using the word 'bank' in their name.

NBFIs are not totally unregulated; they're bound by provisions of the NZ Securities Act which requires them to produce investment statements and prospectuses. But during the past few years, concerns about inadequate risk disclosure have been growing and the Securities Commission and the government have started looking into aspects of NBFI regulatory regime.

But do investors really pay any attention to risk disclosure? And if so, does the quality of risk disclosure affect term deposit rates? After all, one might think that investors will reward NBFIs which are open and transparent about their risks. NBFIs provide a good 'lab case' to study these questions.

Mandatory risk disclosure is a tool to protect the investor. In markets with poor disclosure, financial institutions compete on price at the expense of quality of their loan portfolios as investors cannot reward them for taking less risk. Poor disclosure should therefore go hand in hand with higher risk.

So it would stand to reason that if investors are unable to properly monitor the risk choice of the NBFI, they will demand higher interest as a risk premium. You might also expect NBFIs with poor disclosure quality to be more risky.

At Waikato Management School we carried out a survey of 62 large and small NBFIs and an interesting picture emerged. As expected, more risky NBFIs generally offered higher rates but it was size of the institution that seemed to matter most for investors.

Looking at the effect of disclosure quality, the survey did not detect the slightest impact on the NBFI's deposit rates. What this means is that disclosure in the form of a prospectus or investment statements is not the primary driver in the decision to invest with a finance company. Possibly investors do not have the skill or time to interpret information contained in these technical documents.

It seems that the NBFI's brand recognition and presence in the market is, at the very least, just as important as disclosure. Established players like PSIS and building societies with moderate disclosure quality can attract funds at very tight spreads.

Our findings question the benefit of requiring companies to produce costly offering documents which are then not consulted by the investors. Perhaps it's time that the authorities dropped the requirement for a separate investment statement which many investment practitioners view as a mechanically structured and purely descriptive document.

The survey result will also provide arguments for those calling for a tighter supervision of the NBFI sector. In fact, it is difficult to see why all institutions taking deposits aren't subject to the same supervisory regime. This has been the solution adopted in Australia and the regulatory arrangements in New Zealand are quite unique in global comparison.

The flip side of tighter controls is higher compliance costs for yet another sector of the economy. There is always a trade-off and at the end of the day it must come down to 'Buyer Beware' for investors considering debentures offered by finance companies.

* Kurt Hess is a Senior Fellow in Finance at the University of Waikato School of Management.