New Zealand's financial sector set for a shake-up

David Craig, Partner and Jonathan Norman, Solicitor | July 2006

Introduction

A notable feature of the New Zealand financial sector over the past few years has been the rise to prominence of non-bank financial institutions.  Predominantly funded through high-yield unsecured debentures, often held by "Mum and Dad" investors, these financiers have enjoyed a large slice of the retail investment market.  However, the recent collapse of two large players in the industry, Provincial Finance Limited and National Finance 2000 Limited, has focused the attention of retail investors on the inherent risks of this type of investment. 

Anecdotal evidence has also implicated unethical investment advisers, who encouraged their clients to invest large proportions of their portfolios with these companies, while earning substantial fees on the transactions.  Calls for reform have increasingly come from within the industry, where reputable financiers and advisers fear they are being increasingly tarred with the same brush as their less reputable competitors. 

Against this background, it is timely that a discussion document on the role of financial intermediaries has recently been released.[1]  This document forms part of a wider review of regulation across the whole sector.  It proposes significant reforms to the operation of financial intermediaries and how they are regulated.  This article outlines some of the proposed amendments, assesses their likely impact and looks at the likely effect of the changes for consumers.

Role of financial intermediaries

Financial intermediaries are seen as playing an important role in addressing information asymmetries in the retail investment market.  Ideally, they lead to the operation of an efficient market where investors can make informed decisions about products and services that match their needs. 

However, this presupposes that financial intermediaries consistently provide accurate advice to their clients.  As the discussion document identifies, there are currently only informal incentives (such as the potential loss of reputation) placed on financial intermediaries to credibly vouch for the quality of information that they provide.  Aside from general consumer protection legislation, there is little formal censure that can be applied to financial intermediaries. 

The main issues addressed in the discussion document are ensuring adequate disclosure by financial intermediaries and ensuring that financial intermediaries can be held accountable for the advice that they give.

Model for disclosure by financial intermediaries

The discussion document proposes a three-tiered classification for financial intermediaries.  Each level of intermediary would have different disclosure requirements commensurate with the type and level of advice it provides.  The classifications are:

• information only:  an individual or business who provides only factual information about a product (e.g., a sharebroker providing share prices to a client);
  
  
• product marketer:  an individual or business who markets financial products (e.g., a bank officer offering a term deposit to a customer); and
  
  
• high level intermediary:  an individual or business who advises a member of the public on the suitability of financial advice or financial products (e.g., personal financial advisers).

A fourth classification, execution only, was also suggested to deal with those individuals or businesses who do not provide advice, but handle money or property to purchase financial products.

As would be expected, there is an ascending requirement for disclosure for each class of financial intermediary.  Levels of disclosure are intended to match the degree of reliance that would be placed on advice from the relevant class of financial intermediary by a consumer.  Specifically:

• information only intermediaries would have to disclose the fees and remuneration options that they gain from selling a particular product; 
  
  
• product marketers would have extended requirements, including detailed disclosure of:
  
  
  • the exact remuneration received by the intermediary and the return received by the investor;
    
    
  • the types of products about which the intermediary gives advice;
    
    
  • the exact role being taken by the intermediary, including a statement of the intermediary’s various interests; and
    
    
  • the personal circumstances of the intermediary, including relevant convictions; 
    
    
• high level intermediaries would have the additional requirements of disclosing their experience, qualification, membership of any professional bodies and the nature and scope of any professional indemnity insurance.

The co-regulatory model

In order to enhance standards, and provide accountability to consumers, a co-regulatory model for regulation has been suggested.  This would involve approved professional bodies acting as the front-line supervisor, backed by the Securities Commission.  The Commission would monitor both the market and these bodies to ensure that there is public accountability and that the objectives of the reform are being met.

A major role for professional bodies will be setting competency standards for its members.  Competency standards will not be set in legislation.  Rather, the body will be free to place obligations on intermediaries to comply with approved professional body rules, which will set the competency standards.  Conduct standards will also be applied.  Professional bodies will also be responsible for administering formal discipline and dispute resolution services - both functions that have been missing from the industry previously.  It is suggested that the approved body would be responsible for lower level issues, with the Securities Commission undertaking higher level, or more serious, claims and breaches.

Discussion

While these suggestions are definitely positive for the sector as a whole, concerns have been raised about the practical application of the classification of intermediaries, and the role of approved bodies.  It has been suggested that the line between product marketer and high level intermediary is a thin one at best.  High level intermediaries will undoubtedly come under a great deal of scrutiny, as they are seen as providing the greatest risk to consumers if their behaviour is unethical or incompetent.  The discussion document states that they will have greater obligations placed on them by statute.  It would defeat the purpose of the legislation if intermediaries chose to remain as product marketers, while developing a close relationship with a high level intermediary, merely to avoid the highest level of disclosure and regulation.

It is also encouraging that professional bodies representing the different intermediaries will be established.  Giving these bodies a dispute resolution and discipline function indicates that attempts are being made to formalise the industry as a whole.  However, it is crucial that these bodies are accessible to the public, and operate in an independent manner, so that consumers feel comfortable raising their grievances.  The bodies must show objectivity in dealing with complaints against members to ensure there is confidence in the system.

Despite all this, there remains the risk that increased disclosure may not lead to increased investor awareness and better investment decisions being made.  Many investors may be unable to appreciate or evaluate complex financial information.  There is the risk that "Mum and Dad" investors will be swamped with information, most of which they will ignore.  While increased disclosure may have the objective of decreasing information asymmetries, for it to be useful, the information must be in a form that can be understood.  Focusing disclosure on key areas, rather than a broad spectrum approach, may be more effective.