The Reserve Bank will lend to building societies if needed

The Reserve Bank quietly made clear yesterday that it would act to support a building society or finance company that was facing some sort of financial crisis by lending them cash in exchange for AAA -rated mortgage backed securities. This is an extension (in the public's mind at least) of a policy announced in May with the Reserve Bank's last Financial Stability report. The bank said back then it would widen the type of security it would accept when lending to financial institutions to include AAA rated mortgage-backed bonds. Everyone assumed this meant the Reserve Bank was referring to banks alone. But yesterday the Reserve Bank's head of prudential supervision Toby Fiennes told a business audience in Auckland that the bank would accept Residential Mortgage Backed Securities (RMBS) as security when lending cash, "giving institutions an additional funding avenue." They key word here is "institutions" plural. These institutions include Building Societies and Finance Companies, the bank has indicated. This is despite the bank not formally regulating these institutions...yet.

Legislation is before parliament that would give the Reserve Bank regulatory oversight over building societies and finance companies, although the level of oversight is likely to be far less than for banks. The Reserve Bank has said it expects Trustees will continue to provide the frontline oversight over finance companies, while the bank will oversee a system for credit ratings. See our previous story here on the likely RBNZ oversight of finance companies. The Reserve Bank does not expect this widened 'lender of last resort' type facility will have to be used. "This facility, like those used by other central banks, has been designed in case the global credit markets deteriorate further and make cash difficult to access, but the likelihood of this being needed remains extremely low," Fiennes said. Realistically, this widened group is only likely to include the biggest building societies (a couple of whom are considering applying for banking licenses anyway) because the finance companies and mortgage trusts who have frozen NZ$5.62 billion of investments in 171,476 accounts don't have enough strong loans to group together to create AAA-rated RMBS. This quiet acknowledgement from the Reserve Bank that it will lend to more institutions than the banks is a significant move. It is a sign that there remains the potential for the contagion of financial stress to spread to fundamentally sound institutions such as building societies, simply because of a lack of confidence. This is a sensible thing for the Reserve Bank to do. It has drawn a line in the sand to stop any type of contagion before it gets started. It is similar to the US Federal Reserve's actions in March when it guaranteed JP Morgan's takeover of Bear Stearns and widened its lender of last resort facility to investment banks as well as the core banks. However, the RBNZ's actions are obviously on a much smaller scale and at a time of stability rather than crisis. There will be questions though about moral hazard and about whether this is beyond the scope of what a Reserve Bank should do. Should a Reserve Bank be effectively guaranteeing a line of credit to an institution that may be in trouble because of its own weaknesses? Our building societies have consistently and endemically borrowed short from Mums and Dads through term deposits and lent long to other Mums and Dads for mortgages. This mismatch of funding and assets makes them even weaker than the usual vulnerability banks face to runs on funds. Also, should the Reserve Bank be making these sorts of promises to institutions it does not yet regulate? The proposed regulatory arrangements before parliament are also remarkably light-handed. I think the idea of effectively 'sub-contracting' the front line supervisory role for finance companies to trustees is a mistake. Trustees, or at least a couple of them (Covenant and Perpetual Trustees), have proved themselves inadequate as watchdogs. They are box tickers with a focus on ensuring compliance with the Securities Commission's (relatively hands off) requirements and other reporting requirements. Trustees are employed and paid for by the finance companies themselves. The finance company is the trustee's customer, not the debenture holder, despite the structure of trustee deeds apparently making trustees the investors' champions. Finance companies need advocates for investors aggressively and proactively challenging managers and blowing the whistle when things look shaky. Trustees appear not to have done that, a least for the 39 companies and mortgage trusts that have got into trouble so far. I think the Reserve Bank should be the frontline regulator for building societies and finance companies, particularly if, in the unlikely event, they have to lend to one of them facing financial stress. Your views?