Change the constant in financial sector

This is the third instalment in our Finance Trends & Insights Series. Read our first two releases here: Continuing disruption and Tensions in pricing.

The key issues we look at in this edition are:

• the early impacts of the increased regulatory capital requirements
• consumer credit law reform
• Fair Trading Act (FTA) changes, and
• financial markets conduct reforms.

The direction of legislative change is strongly toward consumer protection. This is a worthy objective but requires that the right balance is struck between protecting the vulnerable and managing the administrative burden. Where this is not achieved, the costs will be passed to consumers in a variety of ways – as higher charges, through unnecessarily intrusive lending policies and processes, and as reduced choice if lenders withdraw from markets where the regulatory impost is too high.

This risk is accentuated where there is overlapping regulation among or between RBNZ, the Commerce Commission and the Financial Markets Authority (FMA). An example is the overlap between:

• the FTA unconscionable conduct reforms
• the oppressive conduct requirements for loans in the Credit Contracts and Consumer Finance Act 2003 (CCCFA), and
• the Financial Markets (Conduct of Institutions) Amendment Bill.

The financial sector is always going to be heavily regulated due to its fundamental importance to the New Zealand economy, and it is right and necessary to ensure that the system operates fairly.

But we would encourage regulators to ensure that any new regulation is consistent with existing laws and balanced so that the rights of consumers are protected without placing disproportionate obligations on financial institutions.

Regulatory capital

Forward effect of new capital rules

The process which led to RBNZ’s decision last year to raise bank regulatory capital requirements was strongly contested, leading RBNZ to provide a seven-year window before the new regime was fully implemented. It has since delayed the start date to the seven-year countdown by one year, to 1 July 2021, and has signalled that it may consider further delays.

But we are already seeing changes in market behaviour in anticipation of the new rules. In particular, banks are:

• limiting their exposure to sectors with high capital requirements, such as farming, and
• raising prices and/or increasing cost provisions in facility agreements (which allow the lender to recover the cost of changes such as the capital decision of borrowers), the effect of which may limit the ability of some companies to grow – or even maintain – their position.

Regulatory capital is the amount of equity (and, to a limited extent, certain other capital types) a bank must hold, calculated as a percentage of its risk-weighted assets. The new rules will increase this from 10.5% to 16%, or 18% for the four largest banks in recognition of their systemic importance for the New Zealand banking system. The aim of the policy is to reduce the potential of a bank failing to a one in 200 year occurrence.

There will also be implications for banks’ capital instruments other than common equity. RBNZ amended the eligibility requirements for such instruments but has yet to publish the new criteria. There are concerns that instruments meeting these criteria may not be a suitable investment for retail clients and could be unfamiliar to offshore investors, making them hard to issue.

Overseas banks operating through a branch rather than a subsidiary structure in New Zealand may have an initial advantage as their capital requirements are set by their home regulators. However, such advantage is likely to be of limited duration as RBNZ requires foreign banks to act through a locally incorporated subsidiary once their New Zealand activities reach a certain size.

Increased supervisory activity

RBNZ has been increasingly active in its enforcement of banks’ prudential obligations. Recent published breaches included the use of unapproved models for calculation of risk-weighted assets and potential issues with director attestations.

Whether this signals an increased appetite by RBNZ to up its prudential supervision and take enforcement proceedings remains to be seen.

But the current Reserve Bank Act Review is likely to lead to the RBNZ having substantially more resources, including in the enforcement and crisis management areas, which may lead to increased activity in the future.

The Reserve Bank of New Zealand Bill, addressing RBNZ’s institutional governance, has been introduced into Parliament and Cabinet has made an in-principle decision to introduce a Deposit Takers Bill. We expect will overhaul the prudential regulation of banks, non-bank deposit takers and non-bank lending institutions – including new standards, licensing conditions, executive accountability provisions, and enforcement tools.

Consumer credit law reform

Lender responsibility has been at the forefront of Commerce Commission and media attention in recent years.

The Credit Contracts Legislation Amendment Act 2019 has a strong pro-consumer focus, including:

• strengthening the affordability and suitability tests
• imposing caps on the accumulation of interest and fees on ‘high-cost’ loans
• tightening requirements around disclosure and advertising
• creating personal obligations for directors and ‘senior managers’ to ensure compliance with the CCCFA, and
• equipping the Commission with new remedies and penalties for non-compliance.

We look, at each of these elements below. Some are not yet in force as the Act is being progressively implemented, from 1 June 2020 to 1 October 2021.

Affordability and suitability tests

Lenders must now make reasonable inquiries into the affordability and suitability of loans not only when entering the loan but whenever a material change is made to the loan, such as credit limit increases or unanticipated additional advances.

This reflects the Commission’s ongoing concern with the inappropriate provision of credit to consumers. Lenders which fail to satisfy this requirement before entering into an insurance contract or obtaining a guarantee, may be required by the courts to refund premiums and payments made under those guarantees.

Fees

The Commission has filed a number of proceedings in the past year against creditors charging fees the Commission considers to be unreasonable, and has successfully obtained compensation orders in several cases.

Lenders will be required to review a credit or default fee if they know, or ought reasonably to know, that there has been a change to their business or costs that is likely to affect the fee’s reasonableness.

To inform the Commission’s monitoring and enforcement approach, lenders will need to provide annual returns with data on their lending, although the detail and timing of these returns has yet to be developed.

The requirement to track and regularly review fees extends what was contemplated by the original bill put before Parliament, which was to have lenders prove to the Commission (if requested to do so) that fees were not unreasonable at the time they were set.

The Amendment Act also introduces caps on the amounts and types of interest and the fees imposed on ‘high-cost’ loans.¹

Advertising and disclosure

The Commission has enforced a number of breaches of disclosure obligations in recent years – coming to settlement agreements, or imposing hefty fines where the disclosure was perceived to be particularly detrimental to borrowers.

The Act will require lenders to take ‘reasonable steps’ to assist borrowers to make an informed decision (and to be reasonably aware of the full implications) about entering into an agreement in whichever language the loan product was advertised. The actual substance of advertising will be prescribed by regulations to take effect on 1 October 2021.

Personal duties

From 1 October 2021, senior managers and directors, will be bound by an overriding personal obligation to exercise due diligence to ensure that the creditor complies with the CCCFA.

A ‘senior manager’ is any person occupying a non-director role which allows them to exercise significant influence over the management or administration of the lender.

‘Due diligence’ includes taking steps to ensure that the creditor requires its staff to follow procedures that are designed to ensure CCCFA-compliance and has in place systems for identifying and rectifying deficiencies in compliance processes.

Enforcement

The Commission’s enforcement powers have been expanded, such that:

• non-compliance with lender responsibility principles now attracts pecuniary penalties of up to $600,000 for an organisation and $200,000 for an individual, and
• a court may make orders for a consumer credit contract to be amended to allow for the affordable repayment of any unpaid debt if certain breaches of the CCCFA have occurred.

Last year, the Commission filed 13 separate proceedings for CCCFA breaches, the majority of which related to failures to comply with the responsible lending requirements. That number will likely increase under the new Act.

Fair Trading Act changes

The Fair Trading Amendment Bill was introduced on 17 December 2019 and was due for report back by the select committee on 12 August this year. Its progress has been disrupted by the 2020 general election but we expect it will be picked up by the new Parliament, whatever the election result. It seeks to add an “unconscionable conduct” prohibition to the FTA and to strengthen the FTA’s unfair commercial practices provisions.

Unconscionable conduct

Unconscionable conduct is serious misconduct that goes far beyond being commercially necessary or appropriate. The prohibition will protect consumers and businesses across the formation of a contract, the terms of a contract and the way a contract is enforced.

The Ministry of Business, Innovation and Employment (MBIE) says the provision is modelled on Australian law and is intended to act as a ‘safety net’ in cases of particularly serious or egregious conduct not captured under the FTA. The Australian legislation requires a relatively high threshold before a breach can be proven and an inequality of bargaining power.

The Australian courts have found that conduct is unconscionable if it is ‘against conscience by reference to the norms of society’, and that such norms can include acting honestly, fairly and without deception or unfair pressure.

The New Zealand Bill does not define unconscionable conduct but provides a list of factors that a court should take into consideration.

Unfair commercial practices

Under the FTA, the unfair terms in standard form contracts provisions are available only to individuals. The Bill extends the protection to business contracts with an actual or expected total annual value below $250,000. This is targeted to SMEs, which account for as much as 97% of all New Zealand businesses, according to a 2016 MBIE estimate.

Banks will need to review any standard form agreements which are entered into with consumers and businesses for amounts below $250,000 in value to check for any terms that could be considered unfair.

Penalties

The unconscionable conduct and unfair commercial practices offences created by the Bill attract maximum penalties of $600,000 for bodies corporate and $200,000 for individuals.

The Bill retains the current enforcement model for unfair contract terms – meaning that it is not an offence to include an unfair contract term and that civil remedies are available only if the Commerce Commission wins a court declaration that the term is unfair. However change may be on the way as:

• the Commission argued in its submission to the Bill that private rights of action, as already applied to unconscionable conduct, should be extended to unfair commercial practices, and
• MBIE has indicated that the enforcement regime will be strengthened as part of a broader review of the FTA to ensure that the incentives are strong enough to achieve the policy objective.

Financial markets conduct reforms

New Zealand conduct and culture review

Flowing from the Hayne Royal Commission in Australia, the RBNZ and the FMA undertook a bank conduct and culture review in New Zealand, which identified five key areas for improvement.

• Governance: Greater ownership and accountability required of Boards in order to measure conduct and culture risks and issues.
• Identification of issues: Issues need to be quickly identified in order for remediation to be accelerated; to achieve this, the overall process needs to be prioritised and given adequate resources.
• Strengthen process and controls: The frameworks for prevention, detection and management of conduct and culture issues need to be reviewed and strengthened.
• Staff reporting channels: Staff need to be trained (and refreshed) on best practice conduct and culture practices. Banks need to have effective mechanisms for employees to report any misconduct, such as whistleblowing.
• Incentives: Incentives linked to sales measure need to be removed, and incentive structures for all levels of staff need to be reviewed. The structures need to be designed in order to promote good customer outcomes.

The FMA in its Supervision Insights publication for 2020, released on 24 September, found that this is still very much a work in progress.

FMA Chief Executive Rob Everett said in his introduction that, while there had been “a lot of very good progress” in adopting a more customer centric focus “too often this still feels like an afterthought – something that is tacked on rather than at the heart of governance and culture”.

Financial Markets (Conduct of Institutions) Amendment Bill

The Financial Markets (Conduct of Institutions) Bill was introduced to Parliament in December 2019 and (like the FTA Amendment Bill) was due to be reported back on 12 August 2020 but has been held up by the general election.

The Bill is drafted as a “framework”, with the intention that details will be provided in corresponding regulations. It creates a new conduct licensing regime and a ‘fair conduct’ principle, requiring financial institutions (or intermediaries) to “treat customers fairly, including by paying regard to their interests”.

For further details please refer to our Brief Counsel.

Executive accountability regime

MBIE is exploring the creation of an executive accountability (EA) regime in New Zealand, with a Treasury report last year indicating preliminary interest from Finance Minister Grant Robertson.

EA frameworks focus on the individual accountability of senior managers, to prevent collective decision-making from being a shield, and are intended to:

• constrain excessive credit and market risk-taking
• mitigate retail and wholesale misconduct risks, with an emphasis on culture and reviewing remuneration models, and
• hold individual senior managers to account, by explicitly setting out clear management and responsibility maps, and taking disciplinary actions when regulatory breaches or failures occur.

They are gaining traction around the world, driven in part by the difficulty after the global financial crisis in tracing accountability back to senior executives. Australia has established the banking executive accountability regime (BEAR), the UK has a senior managers and certification regime, and similar arrangements are under active consideration in Ireland and Singapore.

EA regimes extend beyond obligation-driven duties to broader governance and culture responsibilities. Typically they do not contain sanctions but rely on existing laws, and encourage effective engagement with prudential and conduct regulators.

This can make them difficult and expensive to implement, which could be a significant barrier to adoption in New Zealand.

The Australian Prudential Regulation Authority (APRA) commented to the RBNZ review team on the high implementation cost of BEAR both for APRA and for the banks. As BEAR is still in its infancy, it is difficult to determine whether it will justify these costs by producing a marked improvement in customer outcomes.

COVID-19

The Australian Federal Treasurer announced on 8 May 2020 that all phases of implementing the recommendations from the Hayne Royal Commission would be deferred by six months. ASIC (the Australian Securities and Investments Commission) has reprioritised its workload away from reform and toward investigating COVID-related breaches, with a particular focus on significant consumer harm and market integrity risks. And APRA has suspended the issue of new licences and extended the BEAR notification period for accountability statements.

In New Zealand, the RBNZ Phase 2 review submission deadline, the new financial advice regime, and the accompanying new Code of Professional Conduct for Financial Advice have all been delayed for a minimum of six months. And the election has brought Parliament to a standstill.

These delays and the disruption created by COVID-19 will be exacerbating already tight resource constraints within both the RBNZ and FMA and may have compromised their ability to keep the reform momentum going.

This may give the banks some extra lead time to internally re-evaluate and reform their conduct in line with draft principles and proposals, ahead of the formalised regulations. The prudent course will be to continue to drive the change programme forward, rather than taking the opportunity to apply the brake.

1 ‘High cost’ loans are: (a) those with an annual interest rate of 50% or more; (b) where the weighted average annual interest rate applied to the unpaid balance is 50% or more on any day during the life of the agreement; or (c) where the total interest charged is 50% or more on an unpaid balance upon a default or exceeded credit limit (the latter limb having been included at the Bill’s second reading).