The Financial Markets (Conduct of Institutions) Amendment Act 2022 (CoFI) was passed into law in June 2022, as outlined in our recent article. CoFI creates a new conduct licensing regime for "financial institutions" (specifically, registered banks, licensed non-bank deposit takers and licensed insurers) that will be monitored and enforced by the Financial Markets Authority (FMA) and is expected to fully come into force in early 2025.
In summary, CoFI requires financial institutions to obtain a market services licence to "act as a financial institution”, prepare and comply with a fair conduct programme (in order to comply with the fair conduct principle) and comply with any restrictions on sales incentives. The "fair conduct principle" is a high-level principle to treat consumers fairly.
The new regime predominantly uses a principles-based approach to regulation, which the FMA has noted is a deliberate "move away from box-ticking compliance, towards a focus on outcomes". The intention of this approach is to make financial institutions proactively analyse their businesses and ensure that they prioritise fairness through the entire lifecycle of a product (from the product design stage to the point of sale, and throughout the customer relationship).
While New Zealand financial regulation has traditionally relied on a prescriptive approach more than other jurisdictions (such as Australia and the United Kingdom), there are several benefits to using a primarily principles-based regulatory regime that is supported, where appropriate, by a prescriptive approach to certain, limited aspects of that regulatory regime (such as regulating sales incentives under CoFI) to ensure good customer outcomes.
This article briefly summarises the CoFI regime and then explains:
- The benefits and drawbacks of both a principles-based and prescriptive approach to financial regulation and how thoughtful policy design can mitigate against any drawbacks
- What financial institutions and regulators can do to ensure the successful implementation of a principles-based approach to financial regulation such as the new CoFI regime.
What is the new CoFI regime?
CoFI is long awaited legislation that is the result of a conduct and culture review into banks and insurers from 2018 to 2019. The findings of this review spurred the Government's decision to create a conduct regime to "address the real risk of harm to customers".
The new regime has mostly been welcomed by the stakeholders and financial institutions that were subject to the review, with a recognition that legislation governing the conduct of financial institutions is aligned with international norms. For example, in a June 2021 public submission, the New Zealand Bankers Association (NZBA) noted that it "strongly supports the policy goals underpinning [CoFI]".
CoFI inserts a new subpart 6A into part 6 of the Financial Markets Conduct Act 2013 (FMCA) and requires financial institutions to be licensed in respect of their general conduct towards consumers. This licence will be a new type of market services licence with a similar licensing framework as that for other types of market services licences under the FMCA.
For a more detailed and technical overview of the legislative history of the new regime, the key provisions of CoFI, the standard conditions of the new financial institution market services licence and the various consultations that have been conducted in relation to this new regime, please see our recent article.
What are the benefits and drawbacks to a principles-based approach to financial regulation?
The core obligation under CoFI is a duty for financial institutions to establish, implement and maintain policies, processes, systems, and controls throughout their businesses to ensure they comply with the high level principle to treat consumers fairly and to then document these in a fair conduct programme (FCP). The FCP, along with the processes, systems, and controls that underpin it will be regularly reviewed by financial institutions.
The FMA has noted that its expectations for each FCP will be "proportionate to the institution’s size, strategy, culture, product range and customer mix". In practice, many financial institutions began this process of prioritising fairness throughout all aspects of their business several years ago following the 2018 to 2019 reviews (for example, by instituting conduct programmes).
In addition, it is likely that due to the more recent regulatory requirements under the Credit Contracts and Consumer Finance Act 2003 (CCCFA) and the FMCA, following amendments by the Financial Services Legislation Amendment Act 2019 (FSLAA), many financial institutions will already have adequate policies, processes, systems, and controls in place that prioritise fairness throughout the lifecycle of a product that will provide the foundations of a standalone FCP. However, this regime will also require smaller institutions, that may not currently apply the same rigour to incorporating fairness into all aspects of their business, to prioritise this fair conduct principle.
This principles-based approach to designing a FCP and complying with the fair conduct principle has, in our view, three key benefits that derive from the increased flexibility of this approach:
- Future proof – this approach can be applied to a range of current and future situations and, unlike a prescriptive approach, does not need to be amended to deal with new technologies, practices and business models
- Bespoke – it allows financial institutions to develop bespoke methods of compliance appropriate to their business, improving both efficiency and the effectiveness of the regulatory regime in delivering good customer outcomes
- Innovation – it allows financial institutions the ability to regularly review and update their FCPs, innovate new solutions to ensure customers are treated fairly (whether strategic or technological), and adapt their business while still achieving the aims of the regulatory regime and delivering good customer outcomes.
In the long run, a more bespoke approach that requires a financial institution to think carefully about how fairness can be promoted in every aspect of its business is of more benefit to that institution than a box-ticking regulatory regime. It requires the financial institution to consider all aspects of their business, formally document their policies, processes, systems, and controls, and regularly review their business to ensure that their products continue to not only make commercial sense but also continue to deliver good customer outcomes. As a result, this principles-based approach is likely to result in improving customers' access to more suitable products and fair outcomes.
However, it is important to acknowledge that an overreliance on a principles-based approach may sometimes result in a lack of clarity or perceived gaps being created in the legislative regime. The lack of clarity can sometimes have a freezing effect that reduces customer access to products. For example, the FMA has noted that "there’s been a drop in over the counter sales of insurance at banks, perhaps in part because staff are worried about the consequences of getting the conversation wrong". The best designed principles-based regimes would address these concerns with clear mandates and signals that the regime is not "uncertain" or "incomplete", but is deliberately designed to give regulated entities permission to fill in those gaps themselves by tailoring their methods of compliance as best suited for their business.
Guidance is a helpful starting point for regulated entities to understand general expectations and possible compliance methods and to develop best practice. However, principles-based regulation can be quickly subverted if a regulator fills perceived gaps with prescriptive requirements. Concerns about uncertainty and gaps can be alleviated by giving regulated entities confidence in the regime, in particular by regulators giving them permission to create a compliance path that best suits their business, without being concerned that regulators will perceive their compliance plans as "wrong" and take action against them.
It is important to allow the benefits of a principles-based approach to occur, and ensure that financial institutions are given sufficient permission to ensure compliance with the legislative regime in the best way possible for their business. One of the most effective ways to achieve this is by regulators committing to taking a collaborative approach to working with the industry to develop best practices.
What are the benefits and drawbacks of a prescriptive approach to financial regulation?
Even within the context of a primarily principles-based regulatory regime, there are some limited instances in which the use of prescriptivism may be helpful. There is some nuance to determining when a prescriptive approach may be appropriate, and this can be informed by understanding the benefits and drawbacks of this approach. The advocates of a prescriptive approach to financial regulation generally note that this approach improves compliance with a regulatory regime due to two key reasons:
- Clarity – a clear delineation of obligations and a 'box-ticking approach' to complying with regulatory requirements can result in improved clarity for all stakeholders on what is required to comply with a regulatory regime and assists financial institutions that genuinely intend to comply with a regulatory regime, but would otherwise fail to comply due to an inadequate understanding of the principles based requirements
- Detection – advocates note that this clarity makes it easier for customers, financial institutions and regulators to detect instances of non-compliance with a regulatory regime.
However, the rigidity of a prescriptive regulatory regime can often result in financial institutions prioritising compliance and box-ticking over actual customer outcomes and for the obligation to become something that is only the concern of the compliance department of an institution rather than something that is proactively considered by all stakeholders in a business in order to deliver the best customer outcomes. This is not optimal for two key reasons:
- Unintended consequences – a failure to prioritise actual customer outcomes can result in several negative, unintended consequences. A recent example of this is the amendments made to the CCCFA (which predominantly governs consumer credit contracts) in December 2021 that were designed to protect vulnerable people from predatory lending, mostly from mobile traders and truck shops. A 2022 Government investigation concluded that these changes (especially those relating to affordability assessments) were "having some unintended impacts" such as borrowers "across all lending types" being declined for loans, being subject to "reductions in credit amounts" and facing "unnecessary or disproportionate inquiries" and that these unintended impacts were due to the "prescriptive nature of the CCCFA changes". Many critics have noted that a more principles-based approach to, for example, determining affordability and/or a restriction of prescriptivism to the limited types of lending that were the highest risk, would have likely avoided these unintended consequences. For a more detailed overview of these unintended consequences and changes please see our previous article
- Poor customer outcomes – often this approach is not only onerous on financial institutions but also results in the delivery of sub-optimal customer outcomes. As noted above, a primary focus on mere compliance may result in institutions being unwilling to go above and beyond what is required to optimise customer outcomes for fear of being penalised for not strictly complying with an approach that can be considered a safe harbour. For example, in a 2020 Australian ruling, the Australian Securities and Investments Commission (ASIC) brought proceedings against Westpac where it alleged that the bank failed to adequately take into account all of the prescriptive legal requirements (specifically a borrower's expenses) when assessing the affordability of a loan. Westpac appealed the ruling essentially arguing it was not in the customers' best interests to blindly comply with the law and won the appeal, with the Court affirming an outcomes-based approach was more suitable and allowing Westpac the flexibility to "do what it wants in the assessment process" as long as it does not "make unsuitable loans".
To leverage the benefits of a prescriptive approach to financial regulation and mitigate the risks of this approach, its use would be ideally limited to areas of a regulatory regime that would best benefit from the improved clarity and where it is unlikely to cause a chilling effect that stops institutions from innovating and optimising for the best customer outcomes.
For example, the CoFI regime will use a prescriptive approach to prohibiting sales incentives based on volume or value targets. This approach was supported by the NZBA, which set out that a principles-based prohibition on sales incentives may result in unintended consequences, uncertainty for financial institutions and potentially capture "incentives that can be used to reward good customer outcomes". This limited and targeted use of a prescriptive approach is a good example of the types of instances in which a prescriptive approach can be useful and complimentary to a primarily principles-based approach.
What can regulators do to ensure a successful implementation of a principles-based regulatory regime?
It is clear that a primarily principles-based approach to financial regulation can result in flexible, future proofed, and innovative approaches to compliance that financial institutions can tailor to their own business. This approach also mitigates many of the harms of a prescriptive approach by allowing financial institutions to prioritise customer outcomes.
However, regulators have an important role to play in order to ease stakeholders' concerns about the uncertainty caused by a potentially less clear regulatory regime. Regulators can do this in three key ways:
- Consistency – applying a consistent principles-based approach to several different regulatory regimes allows financial institutions to develop market best practice and confidence navigating a principles-based regulatory regime
- Collaboration – proactively consulting and engaging with key stakeholders (such as financial institutions) to work through any areas of potential non-compliance that may result from a more principles-based approach, both during the design of a regulatory regime and during a transitional period following the regime coming into force, rather than taking a punitive approach while the industry is navigating a new regulatory regime
- Guidance – developing and publishing guidance (following public consultation), rather than by applying prescriptive and rigid regulations, to clarify matters in the first instance.
Under this framework, we commend the FMA's approach to applying a principles-based approach to financial regulation.
Clare Bolingford, the Director of Banking and Insurance at the FMA, at the annual Financial Markets Law Conference in July this year stated that the primarily principles-based regulatory approach to CoFI would be “broadly similar” to that used for New Zealand's new financial advice regulatory regime and also similar to the approach taken by the FMA towards the regulation of mandatory climate related financial disclosures (see our previous article for more information on this regime). We have hope that this consistency and expansion of a principles-based approach to financial regulation will improve the sophistication of financial institutions and the confidence that these institutions have in proactively applying these principles to their business.
Samantha Barrass, the Chief Executive Officer of the FMA, at the Financial Services Council Conference in September this year stated that "regulators around the world are increasingly recognising that regulations and rules are a means to achieve fair outcomes for consumers and markets, rather than an end in themselves" and that the FMA's approach is "not about catching firms out" but, rather, it’s about working with the regulated entities "to build trust in the delivery of outcomes that work for consumers". This collaborative and outcomes-focussed approach has been consistent with the FMA's actual approach to the new financial advice regulatory regime.
Lastly, the FMA has been proactive in both communicating when it will prepare guidance and preparing guidance to assist entities with obligations under a principles-based regime. For example, the FMA signalled that it would prepare a CoFI licence application guide and an information sheet for preparing FCPs in late 2022-early 2023, and it just issued such guidance.
CoFI is a primarily principles-based regulatory regime that has, so far and in our view, thoughtfully used prescriptivism in limited instances where appropriate. We are hopeful that this principles-based approach to CoFI will result in the best outcomes for customers and improve the sophistication of the financial institutions in New Zealand when it comes to prioritising fairness.
The increased confidence and sophistication that will likely result from the FMA's implementation of this principles-based regime will also likely improve corporate governance standards amongst financial institutions as it incentivises the entire business to consider fairness in its product decisions rather than simply outsourcing compliance to a compliance department. Ultimately, this should result in the delivery of more suitable products and fairer customer outcomes.
We applaud this move towards a more modern and progressive approach to financial regulation and encourage financial institutions to embrace the opportunities that this approach offers.