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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? Slides prepared by Kurt Hess, University of Waikato Management School – PowerPoint PPT presentation

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

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

Market Discipline NZ NBFIs
  • Motivation
  • Market Discipline
  • with Basel II
  • conceptual framework
  • New Zealand Non-Bank Financial Institutions
  • Research Questions, Data Methodology
  • Interpretation / Conclusions

  • Regulations / supervisory regimes struggle to
    keep pace with financial innovation in the market
  • 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)

  • 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.

Market Discipline Basel II
Basel on the Rhine RiverRetrieved from
http// 21 September 2004
Basel II Pillars
  • Pillar 1
  • Minimum capital requirements
  • Pillar 2
  • A supervisory review process
  • Pillar 3
  • Market discipline (risk disclosure)

Market Discipline under Basel II
  • Part 4 The Third Pillar Market Discipline,
    pgs. 175-190
  • Section IGeneral considerations, p. 175-177
  • Section IIThe disclosure requirements, to p.
  • contains 13 tables itemizing the detailed
    disclosure requirements

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.

Market Discipline under Basel II
Pages in New Basel Capital Accord (issued June
Pro Memoria Calculation Capital Requirements
under Basel II
Total Capital Credit Risk
Market Risk Operational Risk
? 8
(Could be set higher under pillar 2)
Significantly Refined
Relatively Unchanged
Source slide inspired by PWC presentation slide
retrieved 27/7/2005 from http//
downloads/Basel20II20Update20-20ACC.ppt ,
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?
Page Analysis Basel Accords
(Analysis not to be taken too seriously)
Market DisciplineConceptual Framework
Market discipline acts in two distinctive
  • Recognition / monitoring phase
  • Control / influencing phase

The following simplified conceptual framework is
inspired by Bliss Flannery(2000),
FlanneryNikolova(2003), Hamalainen et al. (2005)
Market DisciplineConceptual Framework
Market DisciplineConceptual Framework
Overview NZ NBFI Sector
  • Identified approximately 400 firms in this
  • 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

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

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 ...
Overview NZ NBFI Sector
Example advertising of some NBFIs
Overview NZ NBFI Sector
  • Regulatory review of sector is in progress both
  • NZ government review of general regulation /
    laws applicable to NBFIs
  • NZ Securities Commission review of disclosure
    standards in sector

Overview NZ NBFI Sector
New Zealand NBFIs by Asset Size (issued June 2004)
Source Data for end 2004 financial year from
NBFI prospectuses
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
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
  • How does the disclosure quality impact above
  • Expect good disclosure to be rewarded with
    tighter spreads (controlling for risk)

Research Questions (contd)
  • How does disclosure quality affect risk choice of
  • 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)

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

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

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.

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

Data Methodology
Disclosure Quality Index
  • Assesses quality of risk disclosure in NBFIs
    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

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 ..
  • GowthDiff2 (p-value 5.44)
  • If combined, only asset size remains significant
    (p-value 1.07)

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)

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)

Risk Choice of NBFI Given Disclosure (2)
  • Not significant correlation asset size /
    disclosure (surprise?) though positive sign for
    coefficient (as predicted)

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.

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)

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.)

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?

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
  • Develop evaluate methods of measuring
    disclosure quality (paper in progress)

Interpretation / Conclusions
  • 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
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