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Opinion piece by Prof Glenn Boyle
15 September 2007
Regulating Finance Companies: Act in Haste, Repent at Leisure

The woes of finance companies have been much in the news recently. A combination of small and/or undiversified loan portfolios, impenetrable business models, ructions emanating from the collapse of the United States sub-prime mortgage market, and a self-fulfilling loss of confidence by New Zealand investors in the safety of their money, have seen nine such companies collapse in the last 18 months. 

Predictably, this has lead to widespread calls for the government to impose further regulation on the finance sector, and to do so quickly. But will additional regulation enhance economic efficiency and welfare? And can it even succeed in providing meaningful protection to individual investors?

One of the most common recommendations (and one adopted by the government this week) is that all finance companies be required to obtain a credit rating from an established international rating agency such as Standard and Poor’s or Moody’s.

However, the recent round of global financial volatility has been characterised by the failure of ratings to provide any reasonable prediction of company failure. When one peers into the black box of the mechanics of credit ratings, this is unsurprising. Like most financial models, ratings are based on a combination of complex mathematical reasoning and sophisticated statistical analysis. Most of the time this works well, but the estimated relationships tend to break down when systemic problems arise – which of course is exactly when one needs them most. As a result, credit ratings are often little more than an expensive way of obtaining a false sense of security.

Another suggestion is that a system of continuous disclosure should be imposed on finance companies. Under such a regime, any piece of information that could potentially affect the financial viability of a company would have to be publicly disclosed as soon as the company became aware of it. At a superficial level, this sounds attractive, but its effectiveness is doubtful: NZX’s disclosure regime – via listed parent company VTL Group - patently failed to protect investors in Nathans.

And in the case of finance companies, it displays a rather weak understanding of how markets actually work. For securities with an active secondary market, continuous disclosure can be useful because it allows investors to adjust their portfolios in response to relevant news, the net effect of which is then reflected in the security’s price. But no organised secondary market exists for finance company debentures, so the only trading mechanism available to investors is to redeem their money directly from the company. If enough investors do this – and it wouldn’t have to be very many – the company may experience a serious liquidity crisis, even when the supposedly adverse information is of a relatively minor nature and the company’s asset portfolio is fundamentally sound. In short, applying a continuous disclosure regime to finance companies runs the risk of precipitating the very event it is supposed to prevent.

Another proposal advocates a deposit insurance regime for finance companies. By eliminating the need for investors to monitor their investments, and reducing the need for finance company managers to maintain prudent lending policies, the most likely consequence of attempts to “protect” investors in this way is an increase in the number of troubled finance companies. This is exactly what happened in the United States during the 1980s. An oil and real estate-fuelled boom, combined with fully insured depositors failing to impose discipline, saw the emergence of lax bank lending policies.

Eventually it all turned to custard – many banks collapsed, the insurance fund was bankrupted, and taxpayers were left holding a huge liability. While some limited form of deposit insurance for banks may be justified in order to protect the integrity of the payments system and maintain confidence, extending it to finance companies is a bridge too far. The systemic extent of the finance company “problem” is, in any event, easily oversold.

Currently, paper losses amount to a little over $1billion – much of which may eventually be recovered – a figure that is approximately equal to a 1% fall in the value of the NZ stockmarket. What then is driving this clamour for the government to “do something” about finance companies? When confronted with requests for additional regulation, the sensible economist asks a simple question: what’s in it for the group doing the requesting? Viewed in this light, things become clearer. Banks  and other financial advisors like credit ratings because they can use these as a substitute for detailed analysis, thereby reducing costs. But this reveals another potential drawback of mandatory credit ratings for finance companies – a decline in the quantity and quality of local analysis. And it is unsurprising that an incumbent stock exchange would wish to impose additional costs on competitor savings vehicles such as finance companies.

None of this denies the possible need for sensible oversight of finance companies (and the additional Trustee powers mandated by the Securities Commission may be a good example of this). But recent collapses have been largely precipitated by an international correction to credit risk pricing, against which no amount of local regulation can offer much protection. Ultimately, the best defence against unexpected loss is likely to come from two sources: enhanced financial literacy that enables investors to sensibly evaluate risk-return tradeoffs; and the inevitable consolidation in the finance company sector that will leave each company better able to withstand liquidity shocks. But the only government intervention that can guarantee investors won’t lose money is the one that prohibits them investing that money in the first place.

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