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

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 buy-now-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.