Part 2: Background

2.1
In this Part, we discuss:

• the financial landscape in New Zealand in the early 2000s; and
• the regulatory and supervisory framework for banks and NBDTs.

2.2
In summary, in October 2008 the stability of banks (rather than other types of financial institutions) was most important to New Zealand. No banks failed in New Zealand during the global financial crisis.

2.3
The decision to include other institutions – NBDTs and, specifically, finance companies – in the Scheme was significant. Finance companies were regarded as a small but important source of lending to particular sectors of the economy, and some were important to particular regions. Forty-six finance industry entities (including 28 finance companies) had failed in the two years before the Scheme was introduced, and there were known weaknesses in the regulatory framework for NBDTs.

Financial landscape in New Zealand in the early 2000s

2.4
The financial sector comprises registered banks, insurance companies, NBDTs, non-deposit-taking finance companies, and other financial institutions, such as collective investment schemes and superannuation funds. Of these, registered banks are by far the most financially significant (see Figure 2).

Figure 2
Types of institutions in the financial sector (and the value of the assets they hold)

Source: Reserve Bank of New Zealand, Financial Stability Report, November 2010.

Note: The data is as at 30 June 2010 except for the insurance company data, which is as at 31 December 2008. The Scheme did not cover insurance companies, non-deposit-taking finance companies, and most "other financial institutions".

2.5
Registered banks hold almost 80% of the sector's total assets. There are 20 registered banks in New Zealand, 17 of which are locally incorporated subsidiaries of foreign-owned banks. The five largest registered banks hold 84% of all 20 banks' assets.

2.6
NBDTs hold less than 3% of the assets held by the financial sector. NBDTs include savings institutions (such as building societies, PSIS Limited, and credit unions) and deposit-taking finance companies (finance companies). Most NBDTs are finance companies, and they have increased in number in the past decade alongside a boom in property development.³

2.7
Finance companies provide loans and/or financial services to different parts of the economy than other financial institutions. Although savings institutions tend to provide mostly retail lending (residential mortgage lending and personal secured lending), finance companies are often involved in more diverse lending activities, including motor vehicle and vendor finance, property development, and commercial and consumer finance (see Figure 3).

Figure 3
Comparison of savings institution loans and finance company loans (at June 2007)

Source: Reserve Bank of New Zealand, NBDT Standard Statistical Returns, 2007. Note: Comprises finance companies with assets greater than $100 million.

Problems experienced by finance companies

2.8
Figure 2 shows that finance companies are a small part of the financial system. However, Figure 3 shows that they play an important role in the economy by providing the public with alternative investment options, as well as lending to sectors of the economy often not serviced by savings institutions.⁴ Problems in the finance company sector could affect the broader economy and some regional economies.

2.9
Some finance companies had been growing dramatically in the years leading up to the introduction of the Scheme, lending heavily to property developers and those in other higher risk sectors. Analyses of the reasons why some failed have shown that many finance companies did not have staff with adequate skills to make good lending decisions. Many also suffered from poor corporate governance, poor risk management and data systems and processes, large amounts of lending to related parties, low levels of capital, and high concentrations of lending to one sector, organisation, or individual.⁵

2.10
High growth rates, coupled with poor quality lending, inadequately skilled people, and deficient processes, increased the vulnerabilities of the finance company sector generally, but particularly when the economy and property markets slowed.

The beginnings of the global financial crisis

2.11
In the second half of 2007, the global financial crisis that had its origins in the United States of America in 2006 made its way to New Zealand. The global financial crisis affected many aspects of the New Zealand economy. Initially, it increased the cost at which registered banks and other companies could borrow funds in offshore markets. Over time, this led to increases in borrowing costs for the public⁶ and increased uncertainty about the outlook for the economy.

2.12
Investor and depositor uncertainty was common in most developed countries around the world and a reason why the global financial crisis spread so far and lasted so long. Uncertainty in September 2008 was so great that the international market for short-term liquidity essentially froze. This led many countries to implement or adjust deposit guarantee schemes to give depositors confidence that they would see the safe return of their deposits should their bank fail. Without this, governments, central banks, and regulators were concerned that a great many depositors would withdraw their deposits from banks, which would significantly disrupt their domestic economies.

2.13
Ireland was the first country to grant a temporary government guarantee of deposits for its largest banks in response to the global financial crisis.⁷ Ireland's guarantee, granted on 30 September 2008, was controversial because it encouraged depositors to move funds to Irish banks. Other countries followed Ireland by implementing temporary or permanent guarantees, or by increasing the current levels of deposit insurance coverage.⁸ In all, 48 countries implemented or adjusted their deposit insurance schemes during the global financial crisis.

2.14
These measures, although regarded as having contributed to financial stability and containing the global financial crisis to some extent, could not reverse its effects. In the first half of October 2008, global financial markets deteriorated markedly. The G7 finance ministers⁹ met on 10 October 2008 and called for "urgent and exceptional action" to stabilise markets. Bailouts and government intervention continued around the world.

The local environment

2.15
While global events were threatening to significantly affect the local economy, finance companies were experiencing problems of their own. Although some finance companies had been in trouble for some time, the property development market had begun to decline and investors became increasingly uncertain about the health of the finance company sector. The global financial crisis compounded these problems by introducing additional funding pressures and investor uncertainty. In a slower economy with public confidence low, depositors were reluctant to invest and finance companies in particular were finding it hard to attract new funds.

2.16
A number of finance industry entities, including 28 finance companies, failed from 2006 to 2008. This included some larger finance companies such as Bridgecorp Finance (New Zealand) Limited, Provincial Finance Limited, and Hanover Finance Limited (see Figure 4).

Figure 4
Summary of finance industry entity failures before the Scheme, from 2006 to October 2008

Source: Compiled from data available at www.interest.co.nz/saving/deep-freeze-list.

2.17
At this time, in contrast to finance companies, New Zealand's registered banks and savings institutions were withstanding the economic downturn relatively well. Although funding costs increased, net interest margins narrowed, and lending growth slowed, the sector remained reasonably strong compared with banking systems in many other countries. However, the banking sector was beginning to face substantial liquidity pressures and the sharp decline in investor confidence that had taken place in financial systems all around the world was looming for banks in New Zealand.

Regulatory and supervisory framework

2.18
Up until the mid-2000s, banks and NBDTs had very different regulatory and supervisory frameworks. This has changed substantially. The main change during the past few years has been recognition of the need for a stronger framework for NBDTs. This was driven more by the unique difficulties experienced by the sector than it was by the global financial crisis, although the global financial crisis served to highlight the weaknesses that needed to be addressed.

2.19
Although there have been some changes to the regulatory and supervisory framework for banks, these changes have not been anywhere near as substantial as those in the NBDT sector. Banks continue to be registered and supervised by the Reserve Bank, consistent with the Reserve Bank's powers under Part 5 of the Reserve Bank of New Zealand Act 1989 (the Reserve Bank Act). The Reserve Bank monitors registered banks' compliance with banking supervision policies. The Reserve Bank continues to emphasise market discipline through disclosure. It sets disclosure requirements rather than detailed prescriptive requirements on banks' activities and financial positions (but has imposed more substantial capital, liquidity, and similar prudential requirements on banks in recent years).

2.20
An important aspect of the Reserve Bank's supervision framework is its focus on maintaining a sound and efficient financial system. The Reserve Bank's regulatory and supervisory framework aims to avoid the significant damage to the financial system that could result from the failure of a registered bank or NBDT.

2.21
Neither the Reserve Bank nor the Government provides a guarantee that a supervised institution will not get into difficulty or fail.

2.22
Importantly, the Reserve Bank also does not supervise financial institutions with the explicit objective of protecting depositors, which is different to the supervisory objective in many other countries. Rather, the Reserve Bank regulates banks primarily to promote soundness and efficiency in the financial system, leaving the responsibility for assessing the risk associated with deposit decisions largely with depositors.

2.23
Before the Scheme, New Zealand was the only country in the Organisation for Economic Co-operation and Development (OECD) without any sort of depositor insurance or depositor preference arrangements. New Zealand applied a less intrusive and disclosure-based regime to banks than did most other OECD countries.

Changing regulatory and supervisory framework for NBDTs

2.24
In contrast to the supervisory framework for banks, the framework for NBDTs changed significantly during the past decade. Somewhat coincidentally, these changes largely aligned with the introduction of the Scheme in 2008.

2.25
Before October 2008, NBDTs operated under a complex framework of multiple regulators and pieces of legislation. All NBDTs were subject to some regulation, including the need to comply with product and issuer disclosure requirements and basic governance, financial disclosure, and audit requirements, as well as basic consumer protection law.¹⁰

2.26
The Reserve Bank had no formal role in regulating NBDTs and there was no prudential oversight of finance companies (that is, to establish and enforce minimum standards and practices for prudent management).

What a trustee is and what a trustee does

2.27
The regulatory framework was, and largely still is, based primarily on a trustee supervisory model under which an NBDT appoints a trustee corporation or person approved for the purpose. Under this model, the NBDT agrees with the trustee a trust deed that sets out requirements that the NBDT must meet. Before 2008, there was no minimum standard for the requirements in the deed. The role of a trustee was to supervise and enforce the NBDT's compliance with the terms of the trust deed. The trustee could also place the NBDT into receivership if that power was included in the trust deed.

Weaknesses in the framework for NBDTs

2.28
In 2005, the Minister of Commerce announced the Review of Financial Products and Providers, to be led by the Ministry of Economic Development (the Ministry). The Review found deficiencies in the NBDT regulatory framework. As a result, in December 2005, Cabinet agreed in principle that prudential supervision of the financial sector (including NBDTs and insurers) was to be consolidated into the Reserve Bank. The Reserve Bank supported this decision.

2.29
The Ministry released a number of discussion documents in August 2006, including one about NBDTs. The NBDT discussion document noted several deficiencies in the NBDT sector, including inconsistency in regulatory requirements and supervision for different NBDTs, the absence of minimum entry requirements for NBDTs, lack of governance requirements, and not enough information to enable depositors to assess and compare the risks of depositing with NBDTs.

2.30
On 12 September 2007, the Minister announced a new regulatory framework for NBDTs that required all NBDTs to be registered with the Reserve Bank and comply with minimum prudential requirements. Other components of the new framework included:

• a credit rating from a rating agency approved by the Reserve Bank (for all NBDTs with more than $20 million in liabilities);
• a minimum amount of capital of $2 million;
• a capital ratio, measured on a standardised and comprehensive basis;
• restrictions on lending to people related to people in charge of an NBDT; and
• "fit and proper person" requirements for the directors and senior managers of NBDTs.

2.31
Changes to the framework were implemented in stages (see Figure 5).

Figure 5
Staged introduction of prudential requirements for non-bank deposit takers

2.32
Stage 1 began in September 2008 with changes to the Reserve Bank Act that empower the Reserve Bank to prescribe requirements and regulate NBDTs. Obligations under this act came into force in September 2009, and included a requirement for NBDTs to have in place a risk management programme that outlines how the NBDT identifies and manages its main risks. This programme is submitted to, and approved by, the NBDT's trustee.

2.33
Stage 2 of changes to the framework involves amendments to the Reserve Bank Act to empower the Reserve Bank to license and remove licences from NBDTs, and apply "fit and proper person" requirements to NBDT owners, directors, and senior managers. Stage 2 will also provide the Reserve Bank with stronger powers to direct an NBDT or to gather more information. A Bill to give effect to these changes was introduced in July 2011. Although weaknesses in the NBDT sector were evident in 2005, the last legislative changes will not come into effect until 2013.

2.34
Notwithstanding the shift of regulatory responsibility to the Reserve Bank, trustees remain the primary supervisors of NBDTs.

3: Of the $13.2 billion of assets held by NBDTs in Figure 2, finance companies held $9.4 billion, building societies and PSIS Limited held $3 billion, and credit unions held $0.8 billion.

4: In 2006, the Ministry of Economic Development noted that finance companies fill the gaps in the credit market left by the big banks, including residential mortgage lending, higher-risk property lending, and vehicle, plant, and machinery leasing.

5: See the Report of the Commerce Committee, 2007/08 Financial Review of the Ministry of Economic Development, Appendix B, and Financial Stability Reports of the Reserve Bank of New Zealand (in particular, the reports from May 2006, November 2007, May 2008, November 2008, and May 2009).

6: The Reserve Bank of New Zealand attempted to counter increased funding costs by reducing official cash rates (from a high of 8.25% to 2.5%).

7: Press Statement – Guarantee Arrangement (www.centralbank.ie/press-area/press-releases/Pages/PressStatement-GuaranteeArrangement.aspx), Central Bank of Ireland, 30 September 2008.

8: Although there are technical differences between the terms “insurance” and “guarantee”, in this context a guarantee scheme tends to be a temporary arrangement in response to a particular issue. An insurance scheme is long-term and is funded either by the government or by the institutions.

9: The “G7” is a group made up of the finance ministers from seven countries: France, Germany, Italy, Japan, the United Kingdom, the United States of America, and Canada.

10: Building societies and credit unions were subject to some limited additional regulation.