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A tale of small branches: NBDT sector performance under increased regulatory scrutiny.

Non-technical summary

New Zealand's financial ecosystem is made up of a diverse range of products and services that help support a well-functioning economy. For example, banks and other lenders such as credit unions, building societies, and finance companies play the important economic role of connecting those who have funds available (investors and savers) with those who want funds (borrowers). This process is called credit intermediation and it sits at the heart of the banking business, along with other core services like making and receiving payments.

A useful purakau (story) to illustrate the Reserve Bank's role in the financial system is the legend of Tane Mahuta, guardian of the forest. In this story, Tane's roots have inherited mana from legislation; Tane's trunk is the payments and settlements system that connects the financial system together and allows the sap (our money) to flow, and Tane's branches are the entities we regulate, such as the banks. Just as Tane provides shelter and food for those in his forest, we care for New Zealand's financial ecosystem as kaitiaki (caretakers), working to promote soundness and efficiency in the financial ecosystem.

This paper takes a closer look at some of Tane's smaller branches, called Non-Bank Deposit Takers (NBDTs), which are lenders that were grafted onto Tane's trunk in 2008 following the government's Review of Financial Products and Providers in 2006. As suggested by their name, NBDTs hold deposits for the public and make loans to their customers. There are 24 licensed NBDTs operating in New Zealand, including credit unions, building societies, and finance companies. NBDTs are typically small and tend to serve niche markets, which means that they play an important role in complementing the services provided by registered banks. These characteristics also mean NBDTs have a different risk profile than the larger and more diversified registered banks.

In its caretaker role, the Reserve Bank sets prudential requirements in areas such as governance, risk management and capital, amongst others. These requirements strengthen the resilience of NBDTs without imposing excessive costs. The wave of finance company failures seen between 2007 and 2012, largely before the Reserve Bank was made responsible for NBDT regulation, serves as a useful reminder of the risks that can materialise in the absence of effective regulation and scrutiny. The Reserve Bank regularly reviews its rules to ensure that they remain fit for purpose and are achieving the desired outcomes. For NBDTs, these outcomes include restoring investor confidence and increasing resilience in the sector, ultimately helping to promote stability in the wider financial system. Even well-designed regulations impose costs, which should be measured against any benefits, such as improved trust and resilience.

This paper looks at the 2010-2018 period to see how the NBDT sector has adjusted to new regulations. This is a very challenging task at the best of times, but is made more difficult in our case because of data limitations, which reduce the strength of our findings somewhat. We analyse lending growth, investor confidence, profitability, and changes in the number of NBDTs to make our assessment about the health of the NBDT sector during this time. A quick overview of the evidence is in table 1.

Taken together, the indicators we have examined paint a picture of an NBDT sector that appears to have adjusted reasonably well to increased regulation since 2010. We do not find evidence of the regulatory framework having constrained the sector. The analysis also reinforces the different risk profile that NBDTs operate under compared to registered banks. For example, we have some lingering concerns about the ability of the smaller NBDTs to keep pace with technology changes and cover their strategic risks. One such risk is from fintech credit providers, such as peer-to-peer (P2P) and buynow-pay-later (BNPL) lending platforms, which are starting to make their presence felt in New Zealand. It is still too early to determine how these new fintech credit providers will affect the traditional banking business model over time but they do present a challenge to banks and NBDTs, which will likely need to innovate to stay relevant to their customers.

1 Introduction

Banks and other lenders play an important role in the economy

A simple way to describe what banks do is that they help move money around the economy. This happens in a very direct way when cash is withdrawn from ATMs or when payment cards are used to make purchases. Banks also provide a safe place for households and businesses to store their money, which in turn provides a source of funds that banks can use to provide loans to their customers. This process of channelling money between those who have funds available (investors and savers) and those who want funds (borrowers) is called credit intermediation and it sits at the heart of the banking business.

In New Zealand, these services are provided by a diverse group of entities, including registered banks, credit unions, building societies and finance companies. More recently, new groups such as buy-now-pay-later (BNPL) services and peer-to-peer (P2P) lending platforms have also started to provide lending services. While the vast majority of lending is still provided by registered banks, the other lenders, which we collectively call 'non-banks', also play an important role in the economy (1) (see figure 1). They tend to serve niche markets that are often underserved by banks and support financial inclusion for those who might not otherwise be able to access traditional banking services.

All lenders who offer deposit services are regulated to promote financial stability because risks can materialise in the absence of effective prudential controls.

In this article, we take a closer look at those non-banks that hold deposits for the public, called Non-Bank Deposit Takers (NBDTs). They are the credit unions, building societies, and finance companies that offer deposit services to the public. This group came under increased regulatory scrutiny from the Reserve Bank and other regulators starting in 2008. The need for more regulatory controls on NBDTs was identified by the IMF through its 2004 Financial Sector Assessment Program and confirmed by the Governent's 2006 Review of Financial Products and Providers. This also coincided with the collapse of nearly 50 finance companies between 2007 and 2012, although the principal decision to regulate pre-dated these collapses. With more than 170,000 depositors affected by the failures, the types of risks that can emerge without effective prudential controls on this sector quickly became clear. The failures also heightened the importance of restoring confidence and improving resilience via the new prudential regulatory scheme. This became the focus of the Reserve Bank, under its mandate to promote soundness and efficiency in the wider financial system (Barker & Javier, 2010).

Accordingly, from 2008 onwards, the sole responsibility for prudential regulation of the sector fell to the Reserve Bank, though the first regulations did not come into effect until 2010. The requirements covered policies to do with governance, credit ratings, solvency (capital), the ability to pay debts as they come due (liquidity), risk management and restrictions on lending to related parties, and were generally designed to prevent the significant damage that can arise in the event of an NBDT failure. (2) The calibration of these policies was based on those already in place for banks at the time, but adjusted to suit the smaller size and generally higher risk nature of NBDT business models. To ensure compliance, trustee companies are retained by NDBTs, which have since supervised the sector's compliance on behalf of the Reserve Bank. The licensing process for NBDTs was completed by May 2015. See Appendix A2 for full information on the regulatory phase-in process.

The Reserve Bank aims to ensure that its regulatory settings remain fit for purpose

As kaitiaki (guardians) for the financial system and its soundness and stability, the Reserve Bank actively monitors developments in the NBDT sector and routinely reviews its regulatory settings to ensure that they remain appropriate to the sector and are ultimately fit-for-purpose (Fiennes & O'Connor-Close, 2012). For example, the 2013 Review of the NBDT regime and the 2015 Regulatory Stocktake considered whether the regime was working as anticipated and if there was any room for improvements. These reviews largely determined that the prudential regime for NBDTs was meeting its objectives, but also resulted in some targeted adjustments. For example, several entities (such as small charities) were exempted from prudential regulations altogether and credit ratings exemptions were widened (Reserve Bank of New Zealand, 2015).

We look at the financial health of NBDTs to judge how the sector has adjusted to increased regulations

After nine years since the first prudential regulations came into effect, and four years since the licensing process for NBDTs completed, we are interested in assessing how the sector has performed in this time. Our approach is to analyse financial data and other indicators to help judge if the NBDT sector is operating as anticipated in light of increased regulatory controls. Specifically, we examine indicators of lending activity, investor confidence, profitability, and sector participation to achieve this. Some background detail on the non-bank sector is provided in the next section to give context to the various indicators we examine.

Regulations impose costs but also deliver benefits

Regulation can be costly for a sector, and even well-designed regulations impose some costs. These have to be measured against benefits, such as improved confidence and resilience. This is the lens through which we judge the health status of the sector in this paper. Throughout, we must distinguish between barriers that are necessary to promote resilience and those that impose unnecessary costs on competition and efficiency in making this assessment.

The analysis is backwards looking and may not be a good indication of what lies ahead

Finally, we are cautious to not make any forecasts about NBDT sector performance in this piece. Our emphasis on a retrospective lens is due to the inherent riskiness of many NBDT business models and the rapid pace at which the credit intermediation providers are being challenged by new Fintech services, many of which are still in their infancy. It also owes to the relatively mild economic conditions experienced in our sample window following global recovery from the Global Financial Crisis experienced in 2007-12 and a lack of data on the performance of NBDTs from prior to 2010. In short, the status quo for this sector is probably not a reliable indicator for what lies ahead. We caveat our conclusions accordingly; depositors should continue to assess the risks involved with banking at different types of institutions as new information is released and economic conditions continue to change.

2 The non-bank sector

Non-bank lenders grew rapidly by lending to the risky property development sector but risks materialised

Non-bank lenders grew quickly from the late 1990s until 2007, largely fuelled by lending to risky property projects. During this same period, several non-bank lenders also chose to become registered banks, which further reduced the size of the sector to around 3% of lending activity by 2013. (3) Since 2013, the non-bank sector (4) has been relatively stable and lending has resumed an upwards trajectory.

Licensed NBDTs have generally grown steadily since increased prudential controls have been in place ...

Aligned with the trends of the wider non-bank sector, licensed NBDTs have also experienced steadily growing lending books since 2010, shown as the red line on figure 1. Since 2010, licensed NBDTs have had to adjust to the new regulatory requirements set out by the Reserve Bank and other regulators. The introduction of oversight on the sector can be easily identified in figure 1; the first comprehensive data collection on NBDTs' performance by the Reserve Bank's statistics department starts in 2009.

The general observation that the growth trends of NBDTs broadly align with the growth of other non-banks already provides a fairly strong indicator that prudential regulations are having the desired effects of increased resilience and restored confidence to the sector. However, we want to dig below the surface to better understand how the sector has adjusted to prudential controls, which will ultimately help us to better judge whether regulatory controls remain fit for purpose.

NBDTs share some common characteristics that give context to the coming results

Before continuing, it is useful to set out clearly in one place the expectations we have for how the NBDT sector might have adjusted to increased regulatory scrutiny and some underlying characteristics of the sector that will help to contextualise our findings. This is difficult to do without foreshadowing the later conclusions, but doing so will help set out a spectrum for what is surprising or particularly unsurprising in the coming results.

Our main expectations for the 2010-18 adjustment period are that increased regulatory scrutiny will have:

* Increased resilience and investor confidence in the sector (which are the main objectives of imposing prudential requirements).

* Carried costs that will have increased barriers to entry for the sector, increasing the risk of 'regulatory arbitrage' to other sectors as some firms may have moved to operate in less regulated spaces. To an extent, some barriers are 'by design' and are essential for improving the resilience of the sector, but we want to check to see whether these barriers have been excessive.

Similarly, there are also some inherent features of this market that are worth noting:

* First, we highlight that there is an inherent risk in being a small player in the financial sector, and we have hinted at this already. A small size makes some NBDTs more vulnerable to shocks and downturns than some of New Zealand's larger banks. From time to time if risks materialise, we could expect to see an NBDT get into financial trouble. The minimum regulations we implement are designed to prevent that, but failure is not impossible.

* Similarly, we know that some NBDTs may find it strategically sensible to leave the sector over time, either to register as a bank or to use alternative sources of wholesale funding to make loans, possibly from sophisticated investors or a parent company willing to provide these funds. We also expect some entry by new players into the sector in a normally functioning market, except where a highly competitive market deters some entry (OECD, 2007).

* Finally, we note that consolidation and lack of entry among NBDTs is a broader trend we are observing in other countries over a range of business cycles. Our sector participation trends are likely reflecting more fundamental changes in the business of banking (like the long running shift to online banking and the resulting benefits of increasing scale), as well as changes in the regulatory regime.

3 Reference group

Mutuals and finance companies have notably different business models

We compare 'small NBDT finance' companies, which captures seven finance companies with less than $25m in assets in 2010, with 'NBDT mutuals' organisations, which includes the 18 credit unions and three building societies (a full list can be found in appendix A1) that operated in this time period. The distinction between groups is made to allow for nuanced discussion, as the business models for the two groups are quite distinct. For example, credit unions and building societies operate under a not-for-profit objective, whereas many small NBDT finance companies tend to invest in riskier property projects and are for-profit entities.

One group that is included in some cases and not others are the largest NBDTs in the sector: UDC Finance, Medical Securities Limited, and Fisher and Paykel Finance. This is because the three finance companies are particularly large and their inclusion distorts the results. They also have all exited or, in the case of UDC, are intending to exit the deposittaking sector by the end of 2019. Where the group is included in the analysis, we have labelled the group 'Small + Large NBDT Finance'.

Survivor bias is limited by looking at trends over time

Some other important exclusions are also made from the reference group. For example, around 60 deposit-taking entities are not included because of the charitable or religious exemptions they hold from our prudential regulations. A small number of non-banks that left the sector prior to licensing and three NBDTs that have been licensed are also excluded. While these groups are of interest for comparison purposes, they are necessary to exclude due to data limitations.

The presence of these limitations creates some potential for survivor bias in our results, though the direction of this bias is unclear as the excluded group might include both strong and weak performers. This is minimised in two ways. First, the reference group is fixed and includes NBDTs that have exited or consolidated and the analysis focuses on aggregate trends, which means that the impact of excluding weak performers reduces over time. Second, we compare the performance of licensed NBDTs to other non-banks not subject to our prudential regulations to help judge the possible extent of any regulatory arbitrage to less regulated areas. Still, some caution is warranted when interpreting the results.

4 Analysis: lending activity

Loan books continue to grow under increased regulatory scrutiny

The first indicator we look at to determine the sector's health is lending activity. As stated, we are interested in seeing how lending activity has been affected by regulations since 2010 and whether NBDTs are taking on more risk to stay competitive. From figure 1, we know that NBDTs have grown steadily since 2010 but it is also useful to compare this aggregate credit growth (which is an indication of the macroeconomic context) and with other lenders operating in the same niche markets but not subject to the same regulatory requirements. In this case, we are able to make a comparison with lending by other non-banks that do not take deposits from customers. Aggregated data for these groups are set out in table 2.

The numbers presented in Table 2 show lending growth by the NBDT sector as a whole was considerably higher than other non-banks in our reference group (5.5% compared to 1.4%) between 2010 and 2018 and somewhat higher than aggregate credit growth (at 4.1%). With the large finance companies removed, the remaining 25 NBDTs have grown considerably faster than aggregate credit growth (10.6% vs 4.1%), albeit from a smaller base. Comparatively, NBDT mutuals organisations reported double digit lending growth consistently over the 2010-2018 period. The profile of lending growth for small NBDT finance companies was more varied and at times these companies reported very rapid growth. The key observation is that NBDTs have grown faster than other non-banks; an early indication that lending activity has not been adversely affected by increased regulatory scrutiny since 2010.

Increase in residential mortgage lending since 2016 following tightening of Reserve Bank's LVR policies

Lending portfolios of NBDT mutual organisations have been stable since 2010. Credit unions and building societies are mostly involved in residential mortgage lending, which has accounted for about 60 percent of their total lending activity since 2011. For small NBDT finance companies, there has been a recent shift towards residential mortgages and away from consumer and business lending, which can be generally correlated with adjustments of the Loan-to-Value Ratio (LVR) restrictions for banks in October 2016. While residential lending for this group increased to $83 million in 2018, compared with $260 billion of housing lending by banks in 2018, the scale is still comparatively fairly minor. By comparison, the large NBDT finance companies predominantly dealt in consumer and business or agricultural lending over this time. There may be an increase in this lending activity by other NBDTs when UDC exits, though most likely this business will transfer outside of the NBDT sector with UDC.

As a reference, other non-banks have also been increasing their residential mortgage lending in recent years, shifting away from business lending, whereas consumer lending by these organisations has been comparatively stable since 2010. Most of the residential mortgage lending growth has been driven by a small number of lenders such as Mike Pero Group and Resimac, which can also be correlated with adjustments made to the Reserve Bank's LVR ratios in 2016.

No evidence of increased risk-taking by sector

One measure of risk taking is an entity's risk-weighted assets (RWA). Figure 2 shows NBDT mutuals institutions have a very steady risk appetite over the 2010-2018 period, while risk taking by smaller NBDT finance companies has declined after 2010-13 and remained relatively steady since, with a small rise in 2016. For these small NBDT finance companies, the level of RWA relative to total assets was lower in 2018 than in 2010.

Collectively, the RWA of these firms show that NBDT business models appear to have been fairly stable since 2010. Evidence of business model stability is supported by trends observed at the aggregate level in figure 1, and it has also been echoed by KPMG (2016; 2017; 2018) in its recent annual FIPS reports on the non-bank sector.

Fintech growth likely to start competing for NBDT lending activity in coming years

The emergence of new financial intermediation services with a strong technology focus, collectively called Fintech, presents a new set of threats and opportunities for NBDTs and the wider banking sector. At this early stage, it is difficult to make predictions about the impact of Fintech in New Zealand for credit intermediaries, especially as data on P2P lending platforms, one of the more obvious sources of competition for NBDTs, have only been published by the Financial Markets Authority (FMA, 2018) since 2017. The data published shows that the use of P2P platforms is growing quickly in New Zealand and there are a growing number of participants using the services to access loans each year. For example, the balance of outstanding loans on P2P platforms reached $489 million in 2018, up 50 percent from 2017. This compares with about $4.6 billion in lending through the NBDT sector. Participation in P2P platforms was fairly widespread in 2018, with 270,000 borrowers and 10,176 active investors. The majority of loans made on P2P platforms are for less than $5000, but a bulk are also being financed by large players. For example, 459 users invested more than $100,000 in 2018, while 6,850 users invested less than $5,000. The full impact of these services on NBDTs and other lenders remains obscured, but further data collection over time will help in determining this; early numbers suggest it is likely to be significant. As the recent report on Fintech credit market by the BIS notes, it is fairly common for banks in other jurisdictions to be experimenting with P2P platforms, especially the use of automated credit decision tools (Claessens, Frost, Turner & Zhu, 2018).

Another emerging Fintech credit service with potential to disrupt the NBDT business model are the pay-later platforms. These platforms provide short-term, low-value, and interest-free loans to consumers who then pay back the value in 4-6 instalments or pay fees for missed payments. Similar in scale to P2P lenders, one prominent pay-later platform, Afterpay, had 220,000 participants in 2018. Between these two examples, it becomes clear that the Fintech credit market is growing in New Zealand and this inevitably poses threats and provides opportunities for NBDTs. We will continue monitoring these sectors to assess for signs of regulatory arbitrage and other risks emerging as a result of these new entities.

5 Analysis: investor confidence

Investors appear confident in the sector

Confident investors and the stable source of funding they provide are crucial to the ongoing viability of the NBDT sector and are consistent with a well-functioning prudential regulatory regime. In this section, investor confidence is assessed using three metrics; retail funding growth, reinvestment rates, and the average maturity of investments since 2010.

For retail funding, we compare NBDTs with registered banks because they tend to compete for this source of funding. In table 3, we see that since 2011, NBDT mutuals and small NBDT finance companies have reported positive retail funding growth that has generally exceeded that of banks. This is a good indication that investors are confident in the NBDT sector, but the strength of this indicator is limited somewhat because we are not able to make comparisons with retail funding growth from the period before increased prudential requirements were put in place. The negative growth rates for all NBDT finance companies between 2015 and 2018 reflect the exits of two of the large players from the sector (Medical Securities and Fisher and Paykel Finance).

Reinvestment rates remain high and stable

Reinvestment rates and the amount of time that money is placed with NBDTs (that is the maturity of investments) are further indicators of investor confidence. For most NBDTs, both of these measures are either steady or have increased over the sample window, which lends support to the view that people who invest in NBDTs remain confident in the sector (see figures 3 and 4).

The average reinvestment rate has been high and steady since 2011 for NBDT mutuals and since 2012 for small NBDT finance companies. Since 2014, nearly all funding for small NBDT finance companies has been from retail deposits. Anecdotally, we are also aware of several finance NBDTs that have been able to attract new equity investment in this time period, or else existing equity ownership has changed hands. These observations may also suggest that investors are confident in the sector but there are also alternative interpretations and we lack the data to make substantive conclusions at this stage. Taken together, the indications we have examined lend support to the conclusion that investors are exhibiting confidence in the NBDT sector following increased regulatory scrutiny.

6 Analysis: profitability

In this section, profits and operating costs are examined to determine if lending growth has been achieved in a sustainable manner. Reductions in profitability or increased operating costs after 2010 may indicate that compliance costs have been excessive and require further adjustment.

Low or variable profitability is a source of vulnerability for small NBDTs

First, profits are scaled by the value of the loan book to get a meaningful measure to compare over time. Figure 5 shows that NBDT finance companies have experienced high but also more variable profits over the sample period. The likely reason for the variability in profits for NBDT finance companies is because they tend to hold highly concentrated exposures to risky investments which can result in profit variability. In this case, we found the recent decline in profits by finance companies since 2015 to be largely idiosyncratic, rather than reflecting a sectorwide decline. Still, variable profits are an inherent characteristic of finance companies, and are often the trade-off for higher rewards when investments are successful. Profits for most of the group remain positive overall.

By comparison, the co-operatively owned nature of NBDT mutuals makes it difficult to evaluate profitability movements, as their profits are typically low by design. In recent years, some credit unions have experienced losses, or lower than normal profits, which in some cases can be correlated with technology upgrades. We note that the extent of the decline among credit unions is being masked by strong profitability growth from building societies over this time, suggesting that macroeconomic conditions or market shifts have not been the primary cause of this decline. Accordingly, the comparative strength of building societies suggests that recent losses by credit unions could be temporary. In saying this, a broader question of sustainability and technological relevance is raised. There is perhaps a strategic risk where a low-profit environment prevents firms from investing for the future.

Operating costs also remain stable

We scale operating costs by income to help assess whether operating costs have increased in light of more regulatory controls. Although we are unable to assess the one-time costs of increased compliance from regulations introduced starting in 2009, we see that operating costs have remained fairly steady for NBDT mutuals as a group and have risen since 2016 for small NBDT finance companies. The increase in operating costs relative to income for finance companies also appears to be idiosyncratic, rather than reflecting a trend affecting the wider group.

Collectively, the data available on profitability and operating costs suggests that changing regulatory costs have not been excessive since 2010. However, there are other factors on profitability for NBDTs such as increased technology requirements that are likely putting pressure on these firms.

7 Analysis: sector participation

No new entry, exits of three largest NBDTs, and sector consolidation amongst credit unions

This section details changes in the number of licensed NBDTs since May 2015 (see table 4) to explore the question of whether prudential settings are appropriate. We look at changes in the sector after 2015 to only capture the firms that opted in to the licensing scheme after it had been fully phased in. We also use the word 'explore' here because of the inherent challenge involved in interpreting firm turnover. The challenge is where the same signals can have alternate interpretations. For example, some positive level of entry and exit can be expected from well-functioning markets, but a lack of entry can also be a sign that markets are operating competitively and not generating profits to a point that motivates entry (OECD, 2007).

Table 4 shows a decline in the number of NBDTs and a lack of entry by new players since the licensing process was completed in May 2015. Since this time, there have been eight NBDT licence cancellations; three due to consolidation among credit unions and one due to a name change and subsequent 're-entry'. The remaining four cancellations were companies that exited the sector entirely. Further consolidation among credit unions can be expected; a merge of four credit unions occurred in May 2019. We also note the likely exit of UDC, which has recently stopped taking new retail deposits and will most likely wind up its deposit taking activity by September 2019.

Declining number of non-bank lenders is a wider trend and not necessarily concerning but will be monitored

New Zealand's experience with the turnover of firms in the NBDT sector (like numerous exits, the lack of any new entry, and consolidation among credit unions) is similar to the experiences of other jurisdictions such as Australia and the United States. For example, consolidation of credit unions in the United States has occurred at a rate of 4 percent (about 250 credit unions) per year for over two decades (National Credit Union Association (NCUA), 2016). This consolidation has been explained by the NCUA (2011) as necessary to promote economies of scale in the sector and to ensure its long-term viability, although it also cites concerns around concentration risks for the wider financial system brought about by fewer operators in the sector.

Like the NCUA, we share similar concerns for New Zealand, although the credit union movement is considerably smaller in New Zealand compared to the US. Our view on the lack of any new entrants to the NBDT sector is that the same trend is also apparent in the broader banking industry in recent years. Another likely reason relates to the recent growth of Fintech providers into the business of credit intermediation. It may be easier for a start-up to compete with less regulation (while posing less system risk because they are not offering deposit services to the public) on the perimeter of the banking sector than compete with established bank and non-bank entities. Further monitoring of Fintech growth in future years will help fully quantify this assessment.

There may be an incentive for larger NBDTs to shift to wholesale funding

The exit of some large NBDTs is noteworthy because these are businesses that have opted to change their funding model following several years making profits operating as licensed deposit takers. The question is whether this change in funding model is to avoid regulatory requirements, a reflection of underlying economic incentives such as possible cost advantages of wholesale funding compared to retail-deposit funding, or a mix of the two. It is reasonable that an unintended consequence of increased regulatory scrutiny on NBDTs has been that wholesale funding has become comparably cheaper, so some large NBDTs may be incentivised to shift towards wholesale funding sources and away from retail deposits. This is especially likely if ownership of an NBDT is transferred to an entity that is able to easily access wholesale funding, which we have seen in the case of Fisher and Paykel Finance. A shift in funding models like this aligns with our overarching expectation that larger NBDTs may 'graduate' from the regime from time to time. We will continue to monitor the situation.

A further experience in Australia is worth discussing. Australia's Productivity Commission (2018) recently cited a number of initiatives that have been introduced in recent years aimed at encouraging new entrants in the Australia banking sector. These include reducing minimum size requirements for smaller banks, equivalent to our NBDTs, by loosening restrictions on the use of restricted words such as 'bank' or 'banking', and establishing a special class of banking licence with fewer requirements to support new firms that want to develop and test their business models before committing to a full banking licence.

In comparison to this, we note that prudential regulatory settings for NBDTs in New Zealand are comparatively less intensive than for ADIs (the equivalent of non-banks in Australia) and there is less obvious room to reduce costs without compromising our stability mandate. For example, there is no minimum size requirement for NBDTs to operate in New Zealand, which has resulted in several very small entities becoming licensed. Small NBDTs are also exempted from other requirements, such as having a credit rating, albeit with the quid pro quo of higher capital ratio requirements. That said, the fact that NBDTs pay for supervision by trustees, whereas registered banks do not, is a pain point for NBDTs and a possible area for further consideration should lack of entry continue (Reserve Bank of New Zealand, 2015).

In considering all of the available information, we suspect New Zealand's experience with the turnover of NBDTs likely reflects a mix of both increased compliance costs and a wider experience of sector decline that is bringing about reduced sector participation and entry in other jurisdictions beyond New Zealand. We note the framework for registered banks and NBDTs is being considered by the Government during its Phase 2 review of the Reserve Bank Act this year.

8 Conclusion

This analysis has been backward looking and no projections have been made about the ongoing viability of the NBDT sector in New Zealand. It is important to emphasise this, because the performance of NBDTs will continue to change as new risks are realised, economic conditions change, and competitive pressures brought about by fintech developments continue to grow. What we have been able to do is bring together a range of evidence on the sector performance of NBDTs under increased regulatory scrutiny between 2010 and 2018. This has been particularly useful in assessing whether regulatory costs have achieved the right balance between promoting soundness and preserving competition and efficiency at this time, and to see if NBDTs are performing as per our general expectations for the sector.

These are some of the main conclusions drawn throughout the analysis:

NBDT businesses are performing as expected under increased regulatory scrutiny

We discussed four main indicators of sector performance in this paper, related to data the Reserve Bank collects on NBDT entities each quarter. The data largely showed that the sector has been performing as anticipated through the sample window; lending activity has increased without heightened risk-taking, investors appear to remain confident in the sector, profitability generally has been satisfactory though declining in recent years for portions of the sector, and sector consolidation trends are largely unfolding as per the experiences of other jurisdictions. Altogether, we find considerable evidence of underlying business model stability following increased regulation starting in 2009.

NBDTs continue to have a different risk profile from banks. In spite of increased regulatory scrutiny, they can have a bigger exposure to risk, largely due to their small size, unique business models, and niche lending markets. Extending this, low or variable profitability means that NBDTs can be more vulnerable to financial stress or may find it more challenging to adequately invest in their systems to keep pace with technology. Similarly, although compliance costs have gone up and remained steady due to the current regulatory framework, this has also come with improved investor confidence. Overall, we have a sector that is performing relatively as expected, with some exceptions regarding entry.

A marked decline in the number of sector participants raises some concern for competition and efficiency

A defining observation for this sector has been the reduction in participants over time. This trend is also evident in Australia and the United States. This is likely a broader phenomenon and not a direct consequence of prudential regulations, although we acknowledge that compliance costs will have increased for NBDTs and this is likely to be deterring entry. We will be highlighting these issues during the Government's Phase 2 review of the Reserve Bank Act this year, which considers the NBDT regulatory scheme.

No evidence that lending activity has migrated to other lenders or P2P platforms at this stage

Based on current evidence, we do not believe lending activity is migrating away from the NBDT sector in a meaningful way as a result of prudential settings, but the continued rapid growth of Fintech credit markets (especially P2P lending platforms) may change this assessment if they continue to grow rapidly. We also acknowledge that an unintended consequence of increased regulatory scrutiny on deposit takers may have been that wholesale funding has become comparatively cheaper for some large NBDTs, and this is likely driving some exits by larger NBDT finance companies. Further monitoring will be required to better understand the forces driving funding market dynamics for this sector.

Taken together, the indicators we have examined point to an NBDT sector that appears to have adjusted reasonably well to increased regulation since 2009, and there are no obvious indications that excessive regulatory costs are adversely affecting the sector. However, there are some lingering concerns about sector consolidation trends and the ability of smaller NBDTs to keep pace with technology and cover strategic risks from a relatively low profit base, but at this stage we do not see need for further intervention. Overall, we conclude that the sector has performed relatively as expected between 2009 and 2018.

References

Barker, F. Javier, N. (2010). Regulating non-bank deposit takers. Reserve Bank Bulletin, Vol 73 (4)

Claessens, S. Frost, J., Turner, G., Zhu, F. (2018). Fintech credit markets around the world: size, drivers and policy issues. Retrieved from https:// www.bis.org/publ/qtrpdf/r_qt1809e.htm

Fiennes, T and C O'Connor-Close (2012). "The evolution of prudential supervision in New Zealand", Reserve Bank Bulletin, Vol 75 (1)

Financial Markets Authority. (2018). Peer-to-peer lending and crowdfunding: sector snapshot 2018. Retrieved from https://public. tableau.com/profile/fmaadmin#!/vizhome/Reg_returns_final_version_0/Story1

KPMG. (2016). FIPS Non-Banks: Review of 2016. Retrieved from https://home.kpmg/nz/en/home/insights/2016/12/fips-non-banks-review-of-2016.html

KPMG. (2017). FIPS Non-Banks: Review of 2017. Retrieved from https:// home.kpmg/nz/en/home/insights/2017/12/fips-non-banks--review-of-2017.html

KPMG. (2018). FIPS Non-Banks: Review 2018. Retrieved from https:// home.kpmg/nz/en/home/insights/2018/12/fips-non-banks-2018.htmls

National Credit Union Association. (2016). 2015: A Strong Year for Credit Unions Overall. Retrieved from https://www.ncua.gov/newsroom/ncuareport/2016/2015-strong-year-credit-unions-overall

National Credit Union Association. (2011). Large Consolidation Issues. Retrieved from https://www.ncua.gov/regulation-supervision/corporatecredit-union-guidance-letters/large-consolidation-issues

Productivity Commission. (2018). Competition in the Australian Financial System. Report no. 89: Canberra

Organisation for Economic Co-operation and Development (OECD). (2007). "Competition and barriers to entry", Policy Brief, January

Reserve Bank (2015) "Summary of feedback from NBDT industry bodies and Reserve Bank responses". Retrieved from: http://www.rbnz.govt.nzA/media/ReserveBank/Files/regulation-and-supervision/stocktake/nbdtsummary-of-responses.pdf?la=en

Reserve Bank of New Zealand. (2015). Summary of feedback from NBDT industry bodies and Reserve Bank responses. Retrieved from: http://www.rbnz.govt.nz/-/media/ReserveBank/Files/regulation-andsupervision/stocktake/nbdt-summary-of-responses.pdf?la=en

Appendix 1
Table A1

Reference and comparison groups

Licensed non-bank deposit taking (NBDT) lenders

NBDT Mutuals

Alliance Credit Union
Aotearoa Credit Union
Caxton Employees Credit Union
Christian Savings (excl. from analysis)
Credit Union Auckland
Credit Union Baywide
Credit Union Central
Credit Union South (Trading as NZCU South)
First Credit Union
Fisher & Paykel Credit Union
Heretaunga Building Society
Napier Building Society
Nelson Building Society
Nelson Enterprise Loan Trust (excl. from analysis)
New Zealand Employees Credit Union
New Zealand Firefighters Credit Union
Police and Families Credit Union
Steelsands Credit Union
Wairarapa Building Society
Westforce Credit Union

Other non-bank lenders (non-deposit-taking, assets >100m)

Advaro Financial Services Limited
American Express
ASAP Finance
Avanti Finance Limited
Basecorp Finance Limited
Bluestone Mortgages NZ Ltd
BMW Financial Services Limited
BOQ Equipment Finance Limited
CSG Finance (NZ) Limited

Finance companies

Asset Finance Limited
FE Investments Limited
Finance Direct Limited
Fisher & Paykel Finance Limited
General Finance Limited
Gold Band Finance Limited
Liberty Financial Limited
Medical Securities Limited
Mutual Credit Finance Limited
Property finance Securities Limited (excl. from analysis)
UDC Finance Limited

Table A2

Summary of recent NBDT sector regulatory developments

Date      Regulatory development

2008      Part 5D inserted into the Reserve Bank
          of New Zealand Act. Reserve Bank becomes
          the prudential regulator of NBDTs

2009      NBDT credit rating and risk management
          requirements come into effect. AML/CFT
          Act enacted

2010      NBDT governance, capital, related party
          exposure and liquidity requirements come
          into effect

2011      Financial Markets Supervisors (FMS) Act
          (trustee licensing legislation) enacted.
          Establishment of the Financial Markets
          Authority

2013      Non/bank Deposit Takers Act 2013
          enacted. Financial Markets Conduct (FMC)
          Act 2013 enacted. Transitional
          arrangements under the AML/CFT Act end

2014      Reserve Bank starts issuing NBDT
          licences. Changes to financial reporting
          legislation come into effect

2015      Reserve Bank completes issuing NBDT
          licences

2016      Transitional arrangements under the
          Financial Markets Conduct Act and new
          financial reporting legislation end

Table A3

Relevant legislation and summary of
implications for the NBDT sector

Legislation               Implications for the NBDT
                          sector

NBDT Act (2013)           Minimum prudential
                          requirements that licensed
                          NBDTs must comply with:

                          Capital

                          Credit ratings

                          Governance

                          Liquidity

                          Related party exposure limits

                          Risk management

                          Minimum entry requirements for
                          licensing.

AML / CFT Act (2009)      A regime for the supervision,
                          monitoring and enforcement of
                          AML/CFT obligations.

                          Set of requirements for
                          reporting entities (such as
                          customer due diligence,
                          account monitoring and
                          suspicious transaction
                          reporting requirements).

                          New civil and criminal
                          offences and a framework to
                          detect and deter money
                          laundering and terrorist
                          financing.

FMC Act (2013) &          New disclosure requirements
FMS Act (2011)            for product offerings

                          Revised rules around trustees
                          and trust deeds


(1) Registered banks accounted for 97% of outstanding loans in 2018

(2) See Tables A2 and A3 in the appendix for details of major regulations introduced in this period that affected NBDTs.

(3) SBS Bank in 2008; Co-Operative Bank in 2011 and Heartland Bank in 2012.

(4) This includes NBDTs and other non-bank lenders that do not take deposits, but instead fund their lending with 'wholesale funds' from investors.

Caption: Figure 1: Total claims for banks and non-banks ($millions)

Caption: Figure 2: Risk weighted assets as a percentage of total assets

Caption: Figure 3: Call funding and reinvestment rates for NBDT mutuals

Caption: Figure 4: Retail funding share and reinvestment rates for small NBDT finance companies

Caption: Figure 5: Profits scaled by the loan book

Caption: Figure 6: Operating costs scaled by Income
Table 1 Summary of results

Indicator      Evidence               Interpretation

Lending        NBDT lending is        Fairly stable NBDT
growth         growing at a           business models.
               reasonable pace
               without an             Evidence against
               apparent increase      lenders trying to
               in risk taking.        avoid regulatory
                                      scrutiny by the
               NBDTs are growing      Reserve Bank.
               faster than other
               similar lenders        Fintech credit
               that work under        providers are a
               less regulation.       growing competitor
                                      to traditional
               Use of fintech         banking business
               lending platforms      models.
               (person-to-person
               (P2P) networks and
               buy-now-pay-later
               (BNPL) schemes) is
               growing quickly.

Investor       Depositors and         Depositors and
confidence     investors continue     investors show
               to place their         confidence in the
               funds with NBDTs.      sector.

Profit-        Low and stable         Pattern of profits
ability        profits for credit     reflects
               unions and             underlying
               building societies     business models
               (relative to           and reveals
               fianance               sources of risk.
               companies). The
               recent decline in      Business models
               profits for some       that deliver low
               credit unions          and stable profits
               since 2016 should      may find it more
               be monitored but       difficult to
               could be related       absorb cost
               to IT system           increases (e.g.
               investments.           technology
                                      upgrades).
               High and more
               variable profits       Business models
               for finance            that deliver high
               companies              but variable
               (compared to           profits are
               credit unions and      inherently more
               building               vulnerable.
               societies).

Changes in     Steady decline in      The common
the number     the number of          experience across
of NBDTs       licensed NBDTs         several countries
               since the              suggests that
               completion of          consolidation and
               licensing in 2015      the lack of entry
               due to mergers, a      are from broader
               few exits and the      market forces
               lack of any new        rather than the
               entrants. This         result of
               trend is not           regulation.
               unusual by
               international          Exits of large
               comparison and         NBDTs suggest some
               might continue.        incentive exists
                                      to move to a
               A simlar pattern       wholesale funding
               is observed in         model if size
               other countries        allows.
               such as Australia
               and the United
               States, but over a
               longer period of
               time.

Table 2

Lending growth

(average year on year change in total claims)

                                           Full sample     1st half

                                            2010-2018     2010-2014
All sectors (aggregate credit)                4.13%         2.37%
Other non-banks (>100m A) (24 firms)          1.37%         -1.77%
NBDT all (28 firms)                            5.5%         4.84%
  --NBDT x (25 firms) **                      10.61%        9.86%
  --NBDT mutuals (18 firms)                   10.49%        10.37%
  --Small NBDT finance (7 firms)              10.77%        1.94%

                                            2nd half

                                           2015-2018
All sectors (aggregate credit)               6.33%
Other non-banks (>100m A) (24 firms)         5.14%
NBDT all (28 firms)                          6.33%
  --NBDT x (25 firms) **                     11.56%
  --NBDT mutuals (18 firms)                  10.63%
  --Small NBDT finance (7 firms)             21.8%

* Other non-banks are the non-deposit taking entities that rely
on wholesale sources to fund their operations.

** This group excludes the Large Finance companies, UDC Finance,
Fisher & Paykel Finance and Medical Securities Limited.

Table 3

Retail funding

(annual percentage change)

                                         Full sample     1st half

                                          2011-2018     2011-2014

Banks                                       8.58%         8.76%
NBDT all (28 firms)                         10.06%        20.68%
--NBDT x (25 firms) *                       23.39%        34.92%
--NBDT mutuals (18 firms)                   24.47%        38.04%
--All NBDT finance (10 firms)                1.8%         13.98%
--NBDT finance small x (7 firms) **         20.10%        15.47%

                                          2nd half    Since 2017

                                         2015-2018

Banks                                      8.39%         7.03%
NBDT all (28 firms)                        -0.56%       -6.85%
--NBDT x (25 firms) *                      11.87%       11.34%
--NBDT mutuals (18 firms)                  10.91%       10.00%
--All NBDT finance (10 firms)             -10.38%       -22.37%
--NBDT finance small x (7 firms) **        24.74%       28.27%

* This group excludes UDC Finance, Fisher & Paykel Finance and
Medical Securities Limited.

Table 4

NBDT licence cancellations since May 2015

Name of NBDT           Date of licence     Reason for licence
                       cancellation        cancellation

Napier Building        Dec 2016            Consolidation: NBS
Society (NBS)                              transferred its
                                           loan portfolio to
                                           Heretaunga
                                           Building Society.

Alliance Group         Dec 2016            Consolidation: ACU
Credit Union (ACU)                         transferred the
                                           business to
                                           Steelsands CU.

Propertyfinance        Nov 2016            Exit: PFSL was in
Securities Limited                         moratorium when it
(PFSL) *                                   was licensed and
                                           expected to be
                                           wound up when the
                                           moratorium
                                           arrangements were
                                           completed in 2016.

Medical Securities     Sept 2016           Exit: MSL wound up
Limited (MSL)                              its deposit taking
                                           activity and
                                           cancelled its NBDT
                                           licence.

Nelson Enterprise      July 2017           Exit: NELT was
Loan Trust *                               expected to exit
                                           to operate under a
                                           small offers
                                           exemption when it
                                           became licensed as
                                           an NBDT. It moved
                                           to operate as a
                                           small offer taker
                                           under the FMC Act
                                           when it could
                                           comply with the
                                           exemption
                                           requirements.

Christian Savings      September 2017      Consolidation and
Incorporated *                             re-entry: Changed
                                           name and licence
                                           to Christian
                                           Savings Limited.

Fisher & Paykel        March 2018          Exit: Fisher and
Finance                                    Paykel Finance
                                           wound up its
                                           deposit taking
                                           activities and
                                           shifted to operate
                                           under a different
                                           funding model.

Caxton Credit          November 2018       Consolidation:
Union                                      Following its
                                           transfer of
                                           engagements to
                                           Credit Union
                                           Central, Caxton
                                           Credit Union
                                           subsequently
                                           cancelled its NBDT
                                           licence.

* these organisations are not in our reference group but are
included here for completeness.
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Date:May 1, 2019
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