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Is There Market Discipline for New Zealand Non-Bank Financial Institutions?

Is There Market Discipline for New Zealand Non-Bank Financial Institutions?

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Is There Market Discipline for New Zealand Non-Bank Financial Institutions?

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  1. Is There Market Discipline for New Zealand Non-Bank Financial Institutions? Slides prepared by Kurt Hess, University of Waikato Management SchoolHamilton, New Zealand

  2. Motivation Market Discipline with Basel II conceptual framework New Zealand Non-Bank Financial Institutions (NBFIs) Research Questions, Data & Methodology Interpretation / Conclusions Market Discipline NZ NBFIs Kurt Hess, WMS

  3. Motivation • Regulations / supervisory regimes struggle to keep pace with financial innovation in the market place. • Regulators / supervisors of financial systems (in particular banks) look at mechanism of market discipline to complement their supervisory system.(e.g. embodied in Basel II Accord) Kurt Hess, WMS

  4. Motivation • Sector of New Zealand NBFI provides an almost perfect “lab case” to study effects of market discipline because of the absence of impediments to the actions/effects of market discipline. • Such impediments in banking systems include moral hazard problems (too big to fail), implicit guarantees etc. Kurt Hess, WMS

  5. Market Discipline & Basel II Basel on the Rhine RiverRetrieved from 21 September 2004 Kurt Hess, WMS

  6. Basel II Pillars • Pillar 1: • Minimum capital requirements • Pillar 2: • A supervisory review process • Pillar 3: • Market discipline (risk disclosure) Kurt Hess, WMS

  7. Market Discipline under Basel II • Part 4: The Third Pillar – Market Discipline, pgs. 175-190 • Section I:General considerations, p. 175-177 • Section II:The disclosure requirements, to p. 190 • contains 13 tables itemizing the detailed disclosure requirements Kurt Hess, WMS

  8. Market Discipline under Basel II • Pillar 3 under Basel does not represent a holistic view of market discipline • purely disclosure based focus • does not look at / include other measures to strengthen effects of market discipline in a comprehensive sense, e.g. observers must also be able to value the information / to impose a cost on the bank that releases negative information. Kurt Hess, WMS

  9. Market Discipline under Basel II Pages in New Basel Capital Accord (issued June 2004) Kurt Hess, WMS

  10. Pro Memoria: Calculation Capital Requirements under Basel II Unchanged Total Capital Credit Risk + Market Risk + Operational Risk  8% (Could be set higher under pillar 2) Significantly Refined Relatively Unchanged New Source: slide inspired by PWC presentation slide retrieved 27/7/2005 from , Kurt Hess, WMS

  11. Page Analysis Basel Accords (Analysis not to be taken too seriously) Page number of accord has increased by a factor of almost 8 (1988 vs. 2004).Where will we end up with future revisions? Kurt Hess, WMS

  12. Page Analysis Basel Accords (Analysis not to be taken too seriously) Kurt Hess, WMS

  13. Market DisciplineConceptual Framework Market discipline acts in two distinctive components: • Recognition / monitoring phase • Control / influencing phase The following simplified conceptual framework is inspired by Bliss & Flannery(2000), Flannery&Nikolova(2003), Hamalainen et al. (2005) Kurt Hess, WMS

  14. Market DisciplineConceptual Framework Kurt Hess, WMS

  15. Market DisciplineConceptual Framework Kurt Hess, WMS

  16. Overview NZ NBFI Sector • Identified approximately 400+ firms in this sector • Mostly smaller, privately held money lenders. • Public financial data available for a universe of about 100 firms who have issued securities and are thus subject to disclosure requirement of NZ securities regulations Kurt Hess, WMS

  17. Overview NZ NBFI Sector • Traditional view to distinguish between finance companies (general companies’ legislation) and special statutes companies (Building Societies, Credit Unions, Cooperatives) • … but distinction has become blurred. • SBS, PSIS provide near full banking services • Finance companies entering mortgage lending Kurt Hess, WMS

  18. Overview NZ NBFI Sector • While NZ registered banks are subject to strict a disclosure regime, comparably lenient rules for NBFI sector (Securities Act/Regulation 1978/1983) • Unique feature of the New Zealand regulatory regime: every company may offer (near) full banking services. • Can however not use “Bank” in name (but of course in advertising …) SBS ... Banking Like It Should Be ... Kurt Hess, WMS

  19. Overview NZ NBFI Sector Example advertising of some NBFIs Kurt Hess, WMS

  20. Overview NZ NBFI Sector • Regulatory review of sector is in progress both by • NZ government: review of general regulation / laws applicable to NBFIs • NZ Securities Commission: review of disclosure standards in sector Kurt Hess, WMS

  21. Overview NZ NBFI Sector New Zealand NBFIs by Asset Size (issued June 2004) Source: Data for end 2004 financial year from NBFI prospectuses Kurt Hess, WMS

  22. NBFI Sample Details • Narrowed sample down to 62 NBFIs issuing term deposit type products on an ongoing basis (excludes Credit Unions) Lending Categories of New Zealand NBFI Sample Kurt Hess, WMS

  23. Research Questions • Do investors exercise market discipline on NBFIs by asking for higher returns (wider spreads) for more risky NBFIs? • Expected effect under risk / return paradigm in finance • How does the disclosure quality impact above relationship? • Expect good disclosure to be rewarded with tighter spreads (controlling for risk) Kurt Hess, WMS

  24. Research Questions (cont’d) • How does disclosure quality affect risk choice of NBFI? • Expect NBFIs with good disclosure shift from price competition & high risk to competition on quality & lower risk profile(as predicted by Cordella & Yeyati, 1998 competition model) Kurt Hess, WMS

  25. Data & Methodology OLS analysis on cross-sectional data using the following proxies: • Interest spread compared to 3 year deposits with NZ banks. • Credit risk: SQP score, asset size, risk due to growth measure • Disclosure: developed disclosure quality index Kurt Hess, WMS

  26. Data & Methodology Credit Risk Proxies • No widespread, official credit ratings in NZ NBFI sector • Exception a few NBFIs rated by S&P (2) and Australian based Rapid Ratings (6) • SQP Relative financial strength ranking measure developed by JDJL Ltd published in its website Kurt Hess, WMS

  27. Data & Methodology Credit Risk Proxies (continued) • SQP means • S – Balance Sheet Strength • Q – Asset Quality • P – Profitability • Strongest quartile on each criteria gets A through to D for weakest quartile. • JDJL Ltd does not disclose details as to which ratios / weightings are used. Kurt Hess, WMS

  28. Data & Methodology Credit Risk Proxies (continued) Two additional credit risk proxies: • Asset size to reflect capacity of NBFI to diversify credit risk • Divergence of growth from average in industry (squared difference to growth of NZ banks) • i.e. more risk for slow/negative growth and rapid expansion Kurt Hess, WMS

  29. Data & Methodology Disclosure Quality Index • Assesses quality of risk disclosure in NBFI’s prospectus along a total of 24 criteria, including …. • Qualitative components for depth of information in verbal text. • Quantitative amount of information, mainly as part of financial statements Kurt Hess, WMS

  30. Results Effect of Credit Risk on Spreads • Significant effect of all risk proxies on spread offered (sole factor regression) • Most dominant effect is • asset size (p-value 0.02%), … • SQP (p-value 0.29%) and .. • GowthDiff^2 (p-value 5.44%) • If combined, only asset size remains significant (p-value 1.07%) Kurt Hess, WMS

  31. Results Effect of Disclosure Quality on Spreads • No significance of disclosure quality as measured through prospectus based-based disclosure quality index, neither • As a sole regressor, nor .. • After controling for risk (joint regression with risk proxies) Kurt Hess, WMS

  32. Results Risk Choice of NBFI Given Disclosure • Positive SQP score coefficient (p-value 3.52% , i.e. companies with good disclosure are less risky (as predicted by Cordella & Yeyati,1998) • Similarly, lower disclosure quality for extreme growth companies (p-value 0.28%) Kurt Hess, WMS

  33. Results Risk Choice of NBFI Given Disclosure (2) • Not significant correlation asset size / disclosure (surprise?) though positive sign for coefficient (as predicted) Kurt Hess, WMS

  34. Interpretation / Conclusions Effect of Credit Risk on Spreads • Risk sensitivity of spreads as expected but are they adequate? • Further research required but default data in NZ NBFI sector (still) lacking. Kurt Hess, WMS

  35. Interpretation / Conclusions Effect of Disclosure Quality on Spreads • Lacking significance of disclosure quality most important result of this study. Potential interpretations of result: • Inadequate measurement of prospectus based disclosure quality (too narrow) Kurt Hess, WMS

  36. Interpretation / Conclusions Effect of Disclosure Quality on Spreads Potential interpretations of result (continued): • Information in prospectus & investment statement is not primary driver of trust into NBFI. Other factors? (brand recognition, history etc.) Kurt Hess, WMS

  37. Interpretation / Conclusions Effect of Disclosure Quality on Spreads Potential interpretations of result (continued): • NBFIs are inherently opaque and any level of disclosure will not change this. Accordingly investors will not reward good disclosure (in line with Morgan 2002).Policy implications: revise discl. rules? Kurt Hess, WMS

  38. Interpretation / Conclusions Potential Expansion of This Research • Use panel data and develop proprietary risk proxies based on information collected so far. • Improve understanding of spread dynamics (collect history) • Develop & evaluate methods of measuring disclosure quality (paper in progress) Kurt Hess, WMS

  39. Interpretation / Conclusions Outlook • Very topical area of research given great dynamics in NZ NBFI sector with strong growth over past 2-3 years • In a slowing economy, true credit risks of NBFIs might soon become apparent. • This will increase pressures on policy maker to speed up current review of regulatory/supervisory regime. Kurt Hess, WMS