In defence of [most] finance companies

Finance companies are coming under increasing scrutiny and criticism. David Chaston of www.interest.co.nz investigates.

Comment by www.interest.co.nz
8 Sep 2005
In defence of [most] finance companies

ASB's recent attack on finance companies follows in a long tradition of banks knocking these competitors. It is easy to do, and bank comment is often reinforced by other commentators. Between them there is a steady stream of 'warnings' about the risks of investing in secured debentures offered by finance companies.

The nub of what is actually said each time is not as corrosive as the relentless repetition of the essential message – "all finance companies are risky".

The whole issue of financial institution risk is not well debated by this type of publicity, that to some, looks like an orchestrated campaign by one set of financial institutions - the banks - against another competing, and up-and-coming set - the finance companies.

First, some background facts. Banks are big. They have attracted about $60 billion in retail term deposits. Although there are ten banks, the four biggest have over 90% of those deposits. For perspective, New Zealand's total exports in 2005 are expected to be only just over $30 billion.

Finance companies are relatively much smaller. They have attracted about $9 billion. But they are growing quickly, and are taking market share off the banks.

The ASB's criticism may be well made, but it is only part of the story.

$9 billion in deposits may be small compared with the banks, but the 65 institutions in the finance company sector cover a wide range – from those that may well be 'at risk' in the future, to those who clearly are unlikely to be.

The investment opportunities they offer fill a need. Some will suit depositors with a higher risk appetite, some will offer diversification from bank deposits, some even that are suitable only for the brave.

Lumping them all together with a broad-brush critique serves only to scare, not to inform.

Like every good debate, the real issues are in the detail, not the headlines.

When contemplating any investment opportunity, basic straightforward investigations should be made. There are many things that can be looked at, and the Securities Commission has recently focussed on information disclosures. However, a few key elements can focus the depositor on the key issues.

Here are three key things to look at.

1. how leveraged the institution is
2. what their maturity profile is
3. what the risks are in their loan book

Leverage

This is essentially their debt-to-equity relationship. It compares how much depositors and other creditors have exposed in the business, compared to what the shareholder's have at risk.

All financial institutions are highly leveraged, compared with most other businesses. This is essentially why they are more heavily regulated. Banks are 'supervised' by the RBNZ, while finance companies who take deposits from the public come under the Securities Commission requirements for disclosure.

d : e
Table 1 ratio

ANZ 9.3 : 1
ASB 16.7 : 1
BNZ 15.4 : 1
Westpac 9.0 : 1
All other banks (6) 16.6 : 1
All finance companies (65) 7.4 : 1
- 10 best 2.7 : 1
- Middle 10 7.3 : 1
- 10 worst 19.7 : 1

It may surprise some depositors that many good finance companies have a lower gearing, a better debt-to-equity ratio, than most big banks.

Maturity profile

There are many ways to analyse maturities, but from public records we can easily see the relationship between what any institution has falling due to depositors in the next 12 months, and compare that with what they expect to receive from their loan book within the same period.

Over time, this gives a good basic picture of their liquidity profile and how it is shifting, and the same analysis can be used to compare institutions.

CA : CL
Table 2 ratio

ANZ 0.8 : 1
ASB 0.7 : 1
BNZ 0.5 : 1
Westpac 0.9 : 1
All other banks (6) 0.6 : 1
All finance companies (65) 1.2 : 1
- 10 best 2.5 : 1
- Middle 10 1.2 : 1
- 10 worst 0.8 : 1

Although this is a basic analysis anyone can do, it is relevant and revealing. Again, it is clear that good finance companies have a healthier match than some of the big banks.

Loan-book risks

There are a number of ways to look at this, but by far the best way to judge it is to refer to a credit rating agency's research. That is available for all banks, but only a tiny handful of finance companies. However, in of itself, the unavailability of a full credit rating is not evidence of poor loan-book risks.

Asset-class is another short-hand way of making an assessment, but is very superficial. In our view, a well managed financial institution with a business in an asset-class that some may regard with suspicion (say, consumer credit) will invariably be a better prospect for a depositor that a poorly managed institution focussed on a solid asset class (say property). We say, management-skill trumps asset-class every time.

ASB's recent criticism focussed on risk as reflected by the return generated by the institution's loan book – and the margin over what it pays its depositors.

Any institution will naturally demand a high premium for perceived high risk – and the point is that depositors should be similarly compensated for the flow-on risks they are taking by depositing with them.

This is how these rates display risk.

Average Average
Loan deposit
Table 3 Interest interest Spread

ANZ 7.3% 5.0% 2.3%
ASB 7.1% 5.1% 2.0%
BNZ 7.4% 5.3% 2.1%
Westpac 6.5% 4.1% 2.4%
All other banks (6) 9.0% 5.2% 3.8%
All finance companies (65) 16.5% 8.3% 8.1%
- 10 'lowest' 10.0% 7.2% 2.8%
- Middle 10 14.4% 8.1% 6.3%
- 10 'highest' 27.9% 9.7% 18.2%

In terms of asset concentration, it should be noted that ASB has over 70% of its total loan book focussed on the 'hot' residential mortgage sector. Some of the smaller banks are even higher. Some observers might regard that as excessive, resulting in a risk profile for that bank in a 'high' range.

Criticising finance companies is easy. The points made will likely apply to some small proportion of them. But we believe it is wrong to ignore the deposit opportunities in many of the very well managed companies in this sector.

It makes more sense for depositors to research them as individual opportunities, understand the risks as individual companies, and take advantage of the good returns of offer when sensible criteria are met.

It may be true that in future some finance company (or more) may fail leaving its depositors with significant losses. But sensible enquiry with the aid of a professional investment adviser will go a long way to drastically reducing the risk of investing in the 'wrong' company. Selecting a good finance company opportunity is a risk you can manage.

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964 words excluding tables

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