This Brief Counsel is the second in our series focusing on the interim report from the Royal Commission in the Banking, Superannuation and Financial Services Industry. It looks more closely at the issues surrounding consumer lending, including summarising the relevant case studies of misconduct, reviewing Commissioner Kenneth Hayne's comments on the underlying causes of misconduct, and examining the possible implications for New Zealand.
What does the report mean for New Zealand’s
financial service providers?
Financial services providers
engaged in consumer lending should consider whether they have been exposed to
the types of misconduct identified by the Commission and review aspects of
their practices accordingly – in particular, remuneration structures,
mechanisms for identifying misconduct, staff training programmes, and
complaints and remediation processes.
stated in our earlier Brief Counsel, the Financial Markets Authority
and Reserve Bank have indicated they will take a rigorous approach to their
review of banks’ conduct and culture to ensure such issues do not pervade the
sector in New Zealand.
The Commission’s interim report and final report (when
published) are likely to guide regulatory and legislative reform in Australia, inevitably
influencing developments to consumer credit regulation and enforcement in New Zealand.
Consumer lending: an overview of findings
The success of the retail banking
sector depends on effective competition, which in turn hinges on the trust and
confidence the public holds in the banking system. As identified in the report,
this trust and confidence is eroded when consumers feel they have been treated
unfairly or dishonestly through ‘misconduct’ or ‘conduct falling below
community standards and expectations’. The subject matter of the Commission’s
first round of hearings garnered a great deal of public attention — a sign that
local financial services providers ought to be wary of their consumer lending
As the case studies show, the
practical outcome of ‘misconduct’ and ‘conduct falling below community
standards and expectations’ is that consumers are provided with products which
are unsuitable for their needs, or products that do not meet their expectations
based on what they were told during the sales process. The report traverses 13
discrete case studies which highlight several determinants of poor conduct,
- remuneration structures
- issues in automated systems and processes
- ignorance of lender responsibility principles
- ineffective misconduct identification and management
- inadequate staff training, and
- poor complaints and remediation procedures.
The Commissioner discussed
the remuneration of financial advisers at length, concluding that the remuneration structures of many financial services
providers contribute to unethical behaviour in which sales are prioritised above
all else. As such, remuneration is an “important contributor to misconduct and
conduct falling short of community standards and expectations”.
Of particular concern to the Commissioner were remuneration
structures that created a conflict of interest between the objectives of the adviser
and the objectives of the consumer. Some schemes the Commission examined in
detail were: (a) flex commission schemes, where an agent was paid the percentage
of the margin achieved over a base rate of interest; and (b) commission that
was tied to the size and/or duration of the loan. In many cases, these
incentives schemes led the agent to use forceful and dishonest sales
techniques, or to misrepresent the customer’s circumstances to the bank in
order to gain approval to sell a particular product. The agent would acquire a
handsome commission, and the consumer would end up with a loan larger than they
The Commissioner strongly endorsed reforms to eliminate value-based and volume-based commissions. Instead, he proposed that remuneration structures should accord with a "customer-first duty" (but did not elaborate on what such a duty would entail).
Additionally, in acknowledging the information asymmetries between lenders and consumer-borrowers, the Commissioner recommended that lenders disclose to borrowers the criteria by which remuneration will be calculated. While this information may not be relevant to most consumers, without it the borrower is missing information that they might reasonably consider to be important.
Automated systems and processes
A number of poor consumer outcomes resulted from operational
issues with a bank’s automated systems and processes. In some cases, these led
to consumers being provided with unsuitable products, for example:
- errors in an automated home-loan serviceability calculator meant that consumers were given loans that did not suit their repayment ability, and
- a failure to include a 'knock out' employment question in an online credit-card insurance questionnaire led to customers buying insurance they could not benefit from due to employment status.
In some cases, customers were charged incorrect fees and
interest, placing the bank in breach of contract.
In many cases, the bank took a long time to identify and/or
remediate issues, amplifying the loss for the customer.
The Commissioner made three propositions in relation to the
- by offering a certain fee or discount but not charging the proper rate or fee, an entity is offering to sell something they cannot deliver (thus acting in bad faith and in breach of contract)
- an entity should have the right systems in place before the first sale is made, and
- if an entity does not deliver what it has promised, it must remedy the default as soon as practicable.
Lender responsibility principles
A number of banks were found to have breached their
obligations under the National Consumer Credit Protection Act 2009 (which is similar
to New Zealand’s Credit Contracts and Consumer Finance Act 2003) to make reasonable
inquiries about and take reasonable steps to verify a customer’s financial
situation. This meant that the bank relied on an incomplete picture of the
customer’s financial situation when making their lending decision.
- In three cases, banks sent unsolicited overdraft and credit limit increase offers to certain customers. The customers were asked to acknowledge that they could repay the enlarged loan without substantial hardship. The Commissioner commented that a customer's declaration was insufficient for a bank to actually ascertain whether a customer could service a loan. Tellingly, the Commissioner noted that the statutory obligation to assess serviceability was non-delegable, and should not be passed on to the borrower.
- Two banks took no steps to verify income and expenditure information provided to them by a third-party intermediary, despite acknowledging that they had reason to doubt the reliability of the information.
- A number of banks verified a customer's declared income, but took no steps to verify their declared expenditures (thus not truly verifying their 'financial situation'). When asked why a bank required a customer to provide documentary evidence of their declared expenditures, but did not ever use the evidence as verification, a representative simply explained that the assessment was “ultimately not necessarily that helpful". The policy tensions between properly fulfilling compliance obligations and operating at the lowest possible cost are evident.
In response to allegations that banks failed to fulfil their
obligations to inquire and/or verify, some argued that their obligations were
‘scalable’. By this it was meant that an in-depth inquiry was not considered
necessary, or reasonable, for a relatively small loan.
The Commissioner vehemently rejected that the concept of
‘reasonableness’ could be used to obviate the requirement to inquire and
verify, as “there [could] be no case where taking no verification step at all
is taking a ‘reasonable step’ to verify”.
Identification and management of misconduct
During the course of proceedings, it became evident that
most banks had taken too long to identify misconduct that had occurred,
inevitably hindering the ability of the bank to promptly rectify problems and
remediate consumers. For example:
- due to the lack of review processes and feedback loops, several banks failed to detect fraud on the part of its intermediaries, and
- a bank's credit models failed to flag that a customer who had disclosed his gambling addiction was unsuitable for a credit card.
Further, the banks were unable to produce misconduct-related
data when called to give evidence.
The Commissioner reprimanded these banks for a “piecemeal
approach to compliance”, a comment which aligned with the Commissioner’s
overall view that “compliance appeared to have been relegated to a cost of
Importantly, poor issue identification and data collation
inhibits an entity’s ability to identify the root causes of recurring issues,
instead leading the entity to view issues as ‘random’ and ‘isolated’.
The ‘last stop’ in maintaining a customer’s trust and
confidence is an effective complaints management and remediation programme.
Many cases showed that providing quick and effective redress was not a primary
concern to the bank, which inflated the detrimental effects of an inefficient
The Commissioner was particularly concerned with banks that
attempted to circumvent their obligation to provide redress. For example, one
bank proposed an ‘opt-in’ arrangement, knowing that the rate of customers
opting-in would be low.
Training of front-line staff
The Commissioner noted that many of the above issues could be avoided with better staff training. In this context, 'training' extends beyond technical aptitude to a deeper understanding of values and culture. The Commissioner reiterated that it was the role of management (at every level) to educate staff about their compliance obligations, and more importantly, why they should comply with those obligations. Through leading by example, management must prevent improper conduct and encourage desirable conduct.
In his interim report, the Commissioner did not propose any
specific reforms. However, the report makes clear that we can expect the following
recommendations in the final report:
- Remuneration – the Commissioner expressed deep concern with the conflict of interest between an adviser's interests and a consumer's interests. Advisers were only ever rewarded for large sales, and never for 'doing the right thing'. Given that some banks had ended commission programmes, the Commissioner questioned whether they were commercially necessary.
- Misconduct identification – the Commissioner concluded that in all cases of misconduct, a bank's processes were lacking in efficiency, meaning it took too long to identify and resolve issues.
- Remediation processes – the Commissioner concluded that when misconduct was uncovered, affected customers were not redressed quickly, nor was much of the redress satisfactory.
- Management roles – the Commissioner reiterated that the role of management was to echo the bank's consumer-centric culture and values throughout the enterprise.
Chapman Tripp comment
The tenor of the
Commissioner’s commentary in relation to the first round of hearings was, at best, scathing. He concluded by stating that much, if not
all, of the abovementioned misconduct “can be traced to entities preferring
pursuit of profit to pursuit of any other purpose”.
However, the Commissioner acknowledged that the bank’s
officers and directors had a duty to their shareholders to pursue profits –
though, according to the Commissioner, this was overridden by the duty to
secure the long-term reputation of the enterprise. This sentiment reveals a
stark tension between the legitimate pursuit of profits and ‘doing the right
We hope the Commission’s final recommendations for proposed
reforms strike a balance between these two tensions, and acknowledge that the
banking industry serves a legitimate purpose and provides substantial benefit
to the majority of its consumers.
Nevertheless, in light of the cautions given by the Financial
Markets Authority and the Reserve Bank, domestic financial institutions ought
to be wary of the types of misconduct identified in the interim report, and should
consider their own remuneration packages, training programmes and management
Our thanks to Anna Chernyavskaya for writing this Brief Counsel.