Thank you for the opportunity to speak today. I am going to address the issue of regulation and its impact on productivity.
Any survey that I read – of bankers, insurers, or retail businesses in financial services – names regulatory burden as a top concern.
That’s even more so in Australia, the US and the UK than it is in here New Zealand.
Nonetheless, if the surveys are right, many of you think that the regulatory load – in the last two to three years – is too high.
Well, I spent 20 years at Merrill Lynch on the other side of the table in roles that focused on our interaction with regulators and the regulations they promulgated.
So, believe me, I understand your perspective.
I know all about Basel Three, Anti-Money Laundering and Sanctions rules – for example – and what burden they impose.
But the proposition I want to put to you today is that the regulatory load in New Zealand is perfectly manageable.
And, more importantly, it’s perfectly justifiable.
I see comment – thankfully mostly from outside of New Zealand – on the negative impact of the current regulatory environment.
Over in Europe they have the massive added complication of the layers of extra-territorial and cross-border regulation – arising out of the EU and US – around insurance, fund management and banking.
In Europe and the US, the regulation of financial services has become a political football and there is very little international consensus about regulatory settings – and the international banks feel this drag on their productivity very strongly.
More generally, in terms of whining from the international banks – let’s face it – that is largely a complaint about the impact of new regulation on P&L – to which I am pretty unsympathetic given current record profits in large portions of the banking industry.
That said, I do talk to management of the local banks and fund managers here, and I listen to the amount of time they are currently spending on “compliance” and I understand the short-term pain they are going through.
We will need to manage that down as the new legislation and requirements bed in.
Not surprisingly perhaps, I’d argue the current level of regulation in New Zealand is necessary.
It’s necessary if we want to build confidence in the operation of our markets and the players in it, and for the New Zealand economy to continue to grow at a sustainable rate.
And it’s necessary if we want to provide more choice.
That’s more choice for firms that are raising capital.
And more choice – in sound long-term investments – for investors and consumers.
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Almost all of the additional regulation that’s coming through now is a result – in some way or another – of the global financial crisis.
The GFC – and let me note in passing that the GFC isn’t over, it’s still with us in many ways – exposed the shortcomings of lending practices and basic risk management among the big banks, especially those on both sides of the Atlantic.
Or – to quote Warren Buffett – when the tide went out, it became apparent who was swimming naked.
The GFC has also exposed the shortcomings of regulation.
That was especially so with regard to regulation of the major European and US banks.
But it was also the case in other areas, including so-called shadow banking, in the special investment vehicles that were set-up to securitise mortgages, and in retail conduct.
The wave of mis-selling scandals in insurance and retail financial services in the UK and the collapse of governance, risk management and disclosure, evident in the finance companies in New Zealand shows an industry-wide problem with behaviour.
In all those areas – and to different degrees – regulation proved to be either inadequate, or aimed at the wrong regulatory targets.
Or both.
To stretch Warren Buffet’s analogy: the tide went out and we discovered that a lot of people were swimming naked.
But we also discovered that some of the lifeguards weren’t on duty, or that they were looking the wrong way.
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Every global event has its local echo.
And that’s the case in New Zealand.
The big bang of the GFC started on Wall Street, in New York, and, to a lesser extent, in the City of London.
But it reverberated across the globe.
In terms of bursting of asset bubbles, funding squeezes and collapses of inter-institution confidence, what we saw on Wall Street reverberated on Cuba Street and Queen Street as well.
Although our domestic banking sector remained strong through the GFC, allowing us to escape the most direct effects, New Zealand investor confidence took a further hit, coming in the midst of a series of finance company failures between 2006 and 2010.
The fall in business and investor confidence sped the demise of the finance company sector, with its extreme exposure to mezzanine property financing.
Let me review what happened in those firms.
Not because there is much dispute as to some of the things that went wrong, and definitely not because anyone here enjoys hearing about it, but because I think they illustrate the reasons why regulation – here in New Zealand and elsewhere in the world – is being revised and extended.
Because it’s no accident that regulation is high on the agenda of governments around the world.
All change in public policy has a cause.
And the cause that’s driving regulation, at the moment, is largely the on-going results of the GFC and the wave of mis-selling and other market scandals that have surfaced since then.
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In the four years to mid-2010, about 45 of the Kiwi fincos collapsed.
These were companies that raised debt financing from the public, offering higher interest rates than banks and appearing to offer safety for investors’ capital through security over property developments.
It’s hard to say exactly how much investors lost in the fincos.
The Reserve Bank estimates the cost of the collapses – to 2011 – at $5.9 billion dollars, measured in outstanding liabilities at the time of the collapses. The RB estimates 171 thousand investors suffered losses.
There have been some recoveries – by liquidators and receivers – since 2011, which will have reduced the net losses to investors.
And we continue to fight tooth and nail to recover money for the victims of the wrong-doing.
We acknowledge however, that in many cases it is not enough and not quick enough.
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Of course, those estimates represent the financial cost.
The human cost came in people who lost their savings and assets.
Houses that were sold as families tried to recover.
Inheritances that won’t be passed on to another generation.
And a huge impact on trust and confidence that people would behave honestly, truthfully and look after other peoples’ money prudently, and that someone was watching over the industry.
All up, a big cost for a small society.
And a significant and long-lasting damage to our capital markets.
The regulatory shortcomings, in the fincos, were twofold.
Firstly, the regulation to which the fincos were subject was too general.
As debt-raising firms, they were subject to the Securities Act 1978.
But there was insufficient remit for on-going oversight – by regulators – of their balance sheets or risk arrangements.
That meant the fincos were able to take on large risks relative to their balance sheets which, in turn, exposed the investors to large risks.
The regulatory shortcomings meant there was insufficient intervention to mitigate or anticipate the prudential and contagion risks.
Secondly, the regulation that applied was – for the most part – aimed at the wrong regulatory target.
Mostly, it was regulation of the retail offers that the firms were making.
But, as I have noted, the risk – for the companies, the investors and, indeed, the risk for the country – was in high-risk balance sheets and also, in many of the fincos, serious shortcomings in company governance.
The fincos revealed other – less obvious – shortcomings in New Zealand financial services.
These shortcomings highlight, in turn, areas that need regulatory attention.
One area was financial advice.
Many of the people who bought debentures in the fincos shouldn’t have done so.
The finance companies were too high-risk given the investment profile of those investors and the risk premium being offered.
Many of those finance companies were hopelessly exposed either to a property price slump, rising interest rates or a funding squeeze.
We know that some of the retail investors bought the fincos based on professional advice.
We have seen that some of that advice didn’t take into account the needs of investors, didn’t explain the risks, and was incentivised by high direct and trailing commissions paid by the finance companies.
High-quality advice is partly a result of high-quality advisers working to high professional standards.
And it’s also a result of sound regulation that is applied carefully and consistently.
The regulation of advisers was found wanting in this instance ... although, we have to acknowledge that advisers – like many people in New Zealand – did not understand the full picture of risk in the fincos. In the vast majority of cases the advisers were acting honestly.
I am pleased to say – by the way – that financial advisers in New Zealand have recognised the need to raise their standards systematically.
Their response to regulation – in the wake of the GFC, the finance company saga, and Ross Asset Management – has been largely positive and focused on reframing the need to act in the interests of the customers.
I will say here what I have said a number of times – I believe that a confident and competent adviser population – of which a critical component must be independent advisers – is very positive for capital markets and therefore a productive economy.
I want to remind everyone (including me) that New Zealand was looking at its regulatory architecture before the finance company issues hit home – so the Financial Markets Conduct Act is not solely the result of that situation, just as the Financial Advisers Act reflected developing concerns that pre-dated Ross Asset Management.
Looking back, New Zealand had a fragmented and patchy legislative framework which produced uneven regulatory results, driven in some cases by choice of corporate structure rather than required investor outcomes.
Generally it created a fuzzy regulatory picture.
I do hear issues around the number of government agencies operating in the financial services space, but the Financial Markets Conduct Act, and other legislation, has significantly clarified who does what and what it is that the FMA has responsibility for and what we don’t.
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The legislative response, to the GFC, and the role of the FMA is a critical part of the picture.
We have powers to regulate the conduct of firms and professionals – like the fincos – in retail and wholesale markets.
Plus we have oversight of the quality of disclosure of debt and equity offers in public markets.
The Reserve Bank now has regulatory oversight of non-bank deposit-takers, which includes finance companies and savings institutions.
These firms are also subject to prudential supervision by their trustees.
The Reserve Bank requires non-bank deposit takers to run formal risk management arrangements, and have a chairperson who is not an employee ... plus at least two independent directors.
The regulatory regime imposes a minimum capital adequacy ratio – of 10 percent – if the entity has no credit rating, and 8 percent if it does have a rating.
There are limits on exposure to the aggregate credit-risk of related parties - up to a maximum of 15 per cent of capital – and quantitative limits on liquidity risk in trust deeds.
All up, the regulatory regime in New Zealand – in the wake of the GFC and the finance companies – is closer to a comprehensive one.
That’s not only the regulatory regime as it applies to firms like the finance companies.
It’s the arrangements that apply from retail markets – where consumers are buying financial services – through wholesale markets and governance – and right through to capital-raising.
The regulation we are putting in place now – with your co-operation – recognises that we have to apply the right regulation in the right place at the right time.
There are now fewer places where firms can slip down, between the edges of regulation.
The rights of investors and consumers are recognised more directly.
The role of financial services professionals – as retailers, advisers, managers, and directors – are now recognised as having a direct impact on outcomes.
And we recognise that national welfare – in the form of an economy that raises capital, allocates it to productive uses, and anticipates risk that jeopardises growth – is partly dependent on quality regulation.
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I wanted to turn now to the broader subject of regulation, and what it provides for a society, including businesses, and how it contributes to productivity.
The starting point of any argument for regulation is the question:
- What are we trying to achieve over the long-run?
In the case of a markets and financial services regulator – like the FMA – the answer is threefold.
Firstly, we‘re here to assist in deepening New Zealand’s public capital markets so businesses have more capital-raising options and so that – eventually – there’s more capital available in net terms.
Secondly, we’re here to ensure confidence in the operation of our markets and the regulation of them – that includes confidence professional-to-professional and business-to-business.
Thirdly, we’re here to improve outcomes for investors and consumers, and to ensure that investors and consumers enjoy confidence in financial markets and professionals.
Those three roles are entirely consistent with a productive economy.
Indeed, I’d argue that they enhance business and contribute to growth.
In capital markets, the New Zealand Government has a stated objective of growing net productive capital by 90% – or two-hundred billion dollars of additional money – over 10 years.
Mostly for firms that export.
It’s an ambitious target.
Because when you compare New Zealand to other countries, the capital market here is shallow.
Australia’s equity market is many times bigger than ours. Indeed, as a proportion of GDP, Australia’s listed capital is almost three times that of New Zealand.
Applying a similar measure, US capital markets are four times that of New Zealand.
The FMA’s biggest role – in deepening markets – is to provide regulation that eliminates unnecessary hurdles and which also increases capital-raising options.
That includes providing regulation for the proposed new ‘stepping-stone capital market’ for small and medium-sized businesses.
We’re also providing the new arrangements that allow existing issuers to offer new debt and equity securities with fewer hurdles.
Plus, we’re licensing the new crowd-funding and peer-to-peer platforms.
So, all in all, we’ve got a much broader and more creative mandate – the new legislative approach allows greater opportunity to adapt and apply the rules to the circumstances – with a view to facilitating the development of our markets.
The general rules around “conduct” give us an umbrella under which to shelter some of this creativity.
Our second major role is to ensure professionals and businesses – in financial services – enjoy confidence in each other.
And that they enjoy a level-playing field in regulation.
That’s a result of the licensing and compliance that we provide for – among others – financial advisers, investment scheme managers, statutory supervisors, and derivatives-issuers.
So, for example, two financial advisers who are dealing with each other should enjoy the confidence that comes from recognising they are both subject to the same regulatory requirements, and that they are both subject to a code of conduct.
Finally, we’re here to ensure investors and consumers enjoy confidence in financial markets.
To this end, the Government has added to our powers in this regard, under the Financial Markets Conduct Act that’s being phased in now.
There is the good conduct provision in the Act – which I referred to earlier when I was discussing the fincos – that applies to anyone and everyone working in markets and financial services.
There are also new powers that enable the FMA to seek wide-ranging court orders over debt offers or registered schemes.
And our empowering Act – from 2011 – includes a provision that allows us to ‘stand in the shoes’ of an investor or customer, and take action against a firm, effectively exercising the rights at law that an investor or customer might have.
We also take a regulatory overview of entire sectors, including capital market infrastructure - basically the NZX – the Kiwisaver schemes, and the superannuation schemes.
We report upon all of them – publicly – every year.
Those seem to me to be unsurprising – and perfectly reasonable – regulatory powers in order to provide and deepen confidence among businesses, investors, and consumers.
More importantly, those powers are fully consistent with a competitive and productive economy.
Indeed, such powers enhance an economy.
The framework I’ve described recognises that regulation can assist markets – hence our role in deepening capital.
And it recognises that businesspeople, investors and consumers anticipate that the State will look after their interests by setting rules to which everyone subscribes and which are enforced when necessary.
I can’t see any regulatory overload in that.
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I wanted to turn to a final point.
And this is how regulation is applied.
This is really a question that occurs at agency level.
Indeed it’s largely an operational decision for managers in regulatory agencies, like the FMA.
Governments can set manageable regulatory loads.
But agencies can apply it in a way in which it becomes a system-wide burden.
Or not.
At Merrill Lynch we had operations in 43 countries outside of the US and that meant even more regulators than that.
I had cause to see a very varied approach to regulation. Not all of it especially pretty or thoughtful.
For our part – at the FMA – I want to reassure you that we are going out of our way to ensure we keep the transaction cost of regulation to a minimum.
Practically, that means we should not demand things that aren’t material or be prescriptive when there are different ways to get to the regulatory outcome, or demand information from the regulated population that we are never going to use.
We must always be alert to the detail - but not unrelentingly pedantic.
And where businesses are a few degrees off the mark, we’d prefer to help you get it 100% right, provided you are acting in good faith - rather than head straight into enforcement territory.
I see our role in offering support and guidance as core, and we’d rather help the industry achieve good outcomes than just parade a belt full of scalps to show how good we are at taking people to court.
I know that message will resonate – especially - with people who run smaller businesses – say in financial advice – which have fewer resources to dedicate to regulation.
Notwithstanding what I have said about our willingness to be facilitative, we do have high expectations of conduct by professionals and firms.
We will take action over wrong-doing and sloppiness.
We will act against misconduct.
We will act where people try to find cute ways that are designed to get around the law.
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Thank you for listening patiently.
I recognise the demands that regulation imposes on many of you, whether you run big firms, medium-sized ones, or smaller ones.
I also recognise that – as a regulator – we need your collaboration.
There’s not much we can achieve on our own.
We can only produce results – for business, investors, and for the country – where we can persuade you that regulation is in the
interests of something larger – namely, the national welfare.
Thank you - I am happy to take questions.
[1] Reserve Bank of New Zealand, ‘Report for the Minister of Finance on the Prudential Regime for Non-bank Deposit-takers’, New Zealand House of Representatives, September 2013.
