Simon Papa argues proposed reforms to financial markets regulation rejects, without proper validation, decades of orthodoxy on market regulation and basic market concepts

By Simon Papa*

The Financial Markets Authority (FMA) has published a draft Guide called “Fair outcomes for consumers and markets.” The draft guide seeks that all providers of financial products and services regulated by FMA (who I’ll refer to as the “providers”) comply with “fair outcome” standards. A somewhat similar existing Guide (which seeks “good customer outcomes”) only applies to licensed providers. The FMA has invited submissions on the draft guide (the deadline is 1 March 2024).

If implemented as proposed, the Guide, together with the “Conduct of Financial Institutions” (CoFI) law coming into force in 2025, mark a very significant shift in how New Zealand regulates its financial markets.

As I explain in this article, these reforms include some important improvements to law but also largely reject the use of market mechanisms to regulate financial markets. My view is that, overall, these reforms are not an appropriate response to the issues identified and are not an adequate means to regulate a complex system like a market. So I think there’s a real risk that they won’t achieve their stated objectives and won’t be cost-effective.

Post-neoliberalism

CoFI and the Guide reflect a rejection of the market-led approach to market regulation that has prevailed in New Zealand since 1984.

Implementation of the CoFI law and the Guide will result in a return to direct market intervention by the State similar to the type that predominated prior to 1984. While the neo-liberal reforms introduced in the 1980s have been the subject of much criticism, the market-led approach to regulation and economic management they embody is often the most effective means to achieve social and economic goals.

Rather than relying on market mechanisms to achieve stated objectives, the CoFI law and Guide seek to regulate markets via the application of overarching “fairness” standards. The Guide requires the achievement of “fair outcomes” for consumers and markets, and the CoFI law requires banks and insurers to “treat customers fairly”.

The CoFI law and Guide will regulate (directly and indirectly), through the fairness standards, what financial products & services should be provided, as well as their core terms, how they are priced and who should be advising consumers about them. Currently the law does not generally regulate such matters. That’s because there is no obvious reason to think that legislators and regulators are generally better than market participants at efficiently allocating resources within markets.

A current example of direct regulation of the supply, and of the terms & conditions, of financial products is the regulation of consumer lending via the Credit Contracts and Consumer Finance Act (CCCFA) and the Reserve Bank’s powers to manage interest rates and control the supply of loans.

The Labour government’s tinkering with CCCFA in 2021 highlights the problem with intervening in the supply of financial products. Those changes led to a significant drop in lending and complaints that the law made it more difficult to lend to low risk borrowers. The CCCFA was hastily updated to try to remove some of the worst effects but there is still significant concern about whether this was enough. The National-led Government has said it will further liberalise the CCCFA.

You’re not rational

In my view neither CoFI nor the Guide recognise consumers as having an integral role in markets. That’s because distrust of consumer decision making is baked into these reforms. The responsible Minister at the time the CoFI law was being developed is quoted as saying that, in connection with the CoFI law and new financial advice law, “No matter how much you earn, generally New Zealanders aren't very good at managing their money”. That is a somewhat unfair generalisation but it exemplifies the thinking behind the CoFI reforms. Another example of this thinking is from the key official responsible for the CoFI reforms, who was quoted as saying:

“New Zealand’s journey represents a wider shift happening all over the world, where countries are moving away from regulation on the assumption of the “rational decision maker” - i.e., the idea that the customer will always choose what is right for them, so long as they are given the right information.… banks and insurers will instead need to prove that they have met a regulator-determined bar, and are actively engaged in ensuring that customers are treated fairly.”

The problem with this “journey” away from assuming that consumers are capable of making rational decisions is that that assumption underpins our entire market economy. The “fairness” standards at the core of the CoFI law and Guide attempt to introduce a new paradigm, in place of the assumption that consumers make rational decisions. Under that paradigm providers and the State are, to a significant degree, supposed to understand what consumers want and to direct them to make the right decisions. To support that FMA states that it needs to “[build] the FMA’s understanding of consumers’ perspectives and experiences across different demographics.”.

I have seen no validation of how that approach will result in better outcomes overall, be cost-effective or address the underlying causes of poor financial outcomes including inequality. I’m not suggesting that fairness isn’t something we should strive for but, as I note below, these “fairness” standards are being asked to do work that they’re not designed for.

A common failing of some regulations based on fairness is that they don’t appear to be designed to address the implications of moral hazard. That is, that people tend to take more risks if they believe they will be protected from consequences of those risks. I’m not advocating for financial products & services that are unsafe.

The issue is that the law and Guide do not acknowledge, or take into account, that consumers are market actors with agency and responsibility, and do not empower them to protect their own interests. For example, the Guide places significant focus on providers providing consumers with better information. But it doesn’t address ways in which consumers, as market participants, can be engaged to improve their financial literacy and ability to make effective financial decisions (but I acknowledge that there are separate initiatives to improve financial literacy). Nor does it address how consumers can be encouraged and supported to obtain appropriate advice.

Price regulation reanimated

A fair outcome standard in the Guide is that “Consumers should receive fair value for money”. FMA has already implemented this with the retail managed funds sector (by law KiwiSaver scheme fees cannot be “unreasonable”). FMA describes “fair value for money” as “fairness to consumers in pricing and equity in exchange of value”. FMA has stated that the CoFI law gives it the ability to intervene in pricing.

New Zealand has a specialist regulator, the Commerce Commission, which is responsible for the regulation of competition, and of prices in specific industries. So it is not even obvious that FMA should or can involve itself in pricing via such a broad standard.

History is littered with examples of misguided and counterproductive attempts to regulate market prices. FMA has not provided any cogent validation of why intervention in pricing is justified or how it will be effective. FMA does have a role with respect to prices including to promote price transparency and comparability. As an example, regulations that have provided for comparability of managed fund fees have played a significant role in identifying and removing unduly high fees.

Market mechanisms demoted

Not only do the recent reforms reflect an unduly sceptical view of the ability of markets to deliver appropriate products & services, they fail to apply market mechanisms to efficiently address actual and perceived market failures. The use of market mechanisms to do so was one of the core tenets of the neo-liberal reforms implemented in the 1980s. Carbon markets are a current example of the application of market mechanisms to achieve desired outcomes most efficiently.

In the case of financial markets, information asymmetry (that is, one party to a transaction has more information than another) is often cited as a key example of a market failure justifying regulation.

Markets themselves develop solutions (though imperfect) to address such asymmetry. An obvious example of such a solution is the independent financial advice sector, which acts as an intermediary between consumers and providers. The financial advice sector is now fully regulated and provides many consumers with advice and support on buying and managing mortgages, insurance and investments. Despite that, my experience is that Government officials appear sceptical of the independent advice sector and do not acknowledge, or adequately support, the important market role it undertakes. I think that’s in part because officials think, strangely, that large institutions are more trustworthy than the more diverse independent advice sector.

That appears to explain the strange outcome that, under the CoFI law, banks and insurers are required to oversee the activities of independent and regulated financial advice providers that advise on their products. FMA’s Guide doesn’t even mention financial advisers except to highlight a 2018 report that criticised the conduct of a relatively small group of financial advisers with respect to advice on replacement life insurance.

Rather, the Guide promotes providers as the predominant conduit for the provision of information and advice to consumers.

A market is a complex system with many interacting parts. However, neither the CoFI law nor the Guide acknowledge or support the other participants who play important roles in improving market outcomes. They include industry associations, budget advisers and aggregator sites. For example, there are no aggregator sites in New Zealand for car or house insurance because there is no regulation that requires the necessary pricing data to be shared with aggregators. While aggregator sites aren’t always perfect they’re a powerful market mechanism that help to increase transparency and competition.

Yet, as one example, FMA has continued to champion “fair pricing” via direct engagement with providers, rather than considering how market mechanisms can be used to provide for better price competition.

What are the benefits of the reforms?

As with most regulatory measures championed by regulators, the fair outcomes Guide is promoted as achieving multiple objectives at the same time. The Guide states:

“We consider that an outcomes-focused approach will encourage more engagement and dynamism in our financial markets – supporting an economy that New Zealanders have confidence to invest in, and is attractive to overseas capital, new ideas, and innovation. A focus on the fair outcomes and new ways of thinking required to support them should create more choice for consumers, and more competition and innovation in our financial markets, products & services. It will create a culture and environment for doing business in which people want to participate.”

The Guide represents an ambitious and well-intended attempt by FMA to fundamentally reframe and extend the already vast body of existing law regulating financial market conduct, in order to instigate a cultural revolution within the financial sector. But a concern is that there isn’t evidence of a policy development process of the type usually used to develop standards of similar breadth and ambition. There is not even a nominal cost/benefit analysis for the Guide. The Guide states that it is in line with “international best practice” but that’s not a validation. We don’t know whether other jurisdictions have got this right either (the global financial crisis arose because of international best practice at the time).

Implementing the CoFI law is imposing, and implementing the Guide will impose, high costs on providers and indirectly on consumers. FMA itself is nearly doubling in size to regulate the CoFI regime (most of the associated costs are being recouped from providers). My concern is that the “fair outcomes” standards are not adequate to achieve their multiple stated objectives and will impose costs that will exceed the value of the benefits.

A risk is that the primary beneficiaries of law based on fairness standards will be the laptop class (including lawyers), as ever more people are engaged by thousands of individual providers to try to work out how they (to quote FMA in the Guide) “take ownership of the outcomes and consider how their leadership, management, governance and operations all work together to deliver them in a way that is most appropriate and effective within their business context”.

New Zealand has a large and vibrant financial sector that provides a wide array of financial products & services to millions of customers, in most cases diligently and honestly. There are obvious areas for improvement. Parts of the CoFI law and Guide are appropriate for the purpose of supporting providers to make those improvements. But there is a real risk that, when the reforms are considered as a whole, the benefits to be achieved won’t be commensurate with the high costs arising from trying wring out improvements via a regulatory model that relies on providers and the State applying all-encompassing fairness standards. I’ve highlighted some market-based solutions that could be implemented as an alternative, in some areas, and that would support markets to operate more efficiently and fairly.

What does being fair mean and is it an appropriate legal standard?

The law has for a centuries recognised “fairness” and some other moral principles as legal standards. However, the use of such standards has operated within fairly tight constraints and often in areas of where moral considerations are paramount, for example in family matters.

The problem with “fairness” as a legal standard is that it is a moral principle and so inherently subjective. Yet FMA’s Guide states at the outset that “We all know what is fair when we see it”. This echoes the often quoted legal test espoused by Justice Potter Stewart in the United States Supreme Court in a 1964 judgment about whether a motion picture (the French film The Lovers- Les Amants) was “obscene.” Justice Stewart said he wouldn’t define obscenity and rather stated that “I know it when I see it….” (Justice Stewart concluded that the film wasn’t obscene).

The reason that that part of the judgment is often quoted is that it highlights what is obvious to most people, which is “I know it when I see it” falls fundamentally short as a legal standard. It follows that it is not appropriate to base the core legal standards for the regulation of markets on moral principles, as they are usually hard to define and views on them differ. As an example of the issue is the following question- Is it “fair” that, if I fail to insure my house, the State steps in to protect me when it’s damaged (the State and councils are doing that in some areas currently)?

Maybe, maybe not (moral hazard is relevant-see above). But it’s certain that not everyone will have the same view on that and that there is not a single “correct” answer.

To be fair to FMA, the Guide seeks to clarify what the various “fair outcome” standards in the Guide mean. But in many areas that hardly helps, as the concept is not defined any more clearly. For example, with respect to the proposed “fair value for money” fair outcome standard, FMA states “Value needs to be considered from many dimensions. … Different approaches to different groups can be justified but they must be fair.” It’s good to have that clarified.

New Zealand has fairness standards in other areas of commercial law including unfair contract term law. In the case of unfair contract term law, the core subject matter of a contract, and the upfront price, are excluded from the scope of the law. That’s because that would involve regulating the nature of the products & services themselves, and their prices.

Those matters were previously assumed to be best left to the markets, not the law or regulators. Likewise, to date financial markets law has generally regulated matters peripheral to the financial products & services themselves, such as disclosure, governance, management capability, business infrastructure and misleading conduct.

So the key change introduced by the CoFI law and Guide is the direct regulation of financial products & services, including regulation of the types products & services to be provided, their core terms and their prices.

The Financial Markets Conduct Act, the primary law FMA is responsible for, itself recognises fairness by noting that a primary purpose of that law is to “promote and facilitate the development of fair, efficient, and transparent financial markets.” But in that context “fairness” is serving as a high-level principle that is applicable to the regulation of markets as a whole. In contrast, in the CoFI law and Guide “fairness” standards are being used as the primary tool for direct regulation of financial products & services. Also, efficiency and transparency are barely mentioned in FMA’s Guide.

Taking those factors into account, I don’t consider that “fairness” as a concept can do the heavy lifting required of it as the primary tool for regulating, for example, what products and/or services a provider should provide, and their core terms and their prices.

Everybody wants to rule the world

FMA notes in the Guide its aversion to detailed rules- it is concerned that they result in “tick box” approaches to compliance. That’s certainly a risk. But the existence of detailed rules is not an aberration - they can be a effective means to provide for efficient and fair outcomes. And outcomes- based standards are not always effective. A key cause of the leaky building crisis that arose in the 1990s and early 2000s was a move from building standards based on detailed rules to an outcomes-based approach.

The reality in my experience is that, where abstract legal standards are involved, de facto standardised market rules (based on those standards) develop in any case. That’s not necessarily a failure but reflects that it can be inefficient to expect each business to individually derive meaning from abstract standards and to apply that meaning on a bespoke basis to their own operations.

Governments (and legislators) often appear to assume that markets will respond to regulatory changes in the way they intend them to. Labour blamed lenders for the issues that arose from changes to the CCCFA in 2021, claiming that lenders were being too conservative in their interpretation of the updated law. I’m not commenting on whether that’s correct.

Rather, this highlights that it is optimistic to assume that most of the thousands of providers (many fairly small businesses) will be able to implement fundamental changes to their businesses, in ways intended, by applying the subjective fairness standards.

A significant concern also is that legal standards based on “fairness” undermine the rule of law. The rule of law requires that the law should be knowable so that we can all comply with it. That isn’t the case when legal tests become so vague (for example, “I know it when I see it”) that no one can reasonably determine what they mean in advance.

Fairly legal

FMA states that the Guide is not intended to create new law. Although limited parts of the Guide reflect existing law (including the CoFI law) most of the fair outcome standards are not supported by existing law. A rule of law consideration that arises is that FMA states in the Guide that:

“[The fair outcome standards] will Guide the FMA’s approach to exercising its regulatory powers and responsibilities, including our approach to monitoring and supervision [and] will be the starting point for decision-making at the FMA. In particular, for our supervisory approach, we will use them as the basis for how we frame our discussions with and assessments of providers.”

FMA’s approach is fine, as FMA is able to promote higher standards than the law itself mandates. And it can encourage providers to meet them. But a core constitutional principle is that (in nearly all cases) the Government cannot pass laws, only Parliament can (although a lot of rule-making is delegated to Government and its agencies including via powers to issue regulations, exemptions and designations).

So a concern is that FMA, in reframing its entire mission, resources and focus around non-laws, is in fact treating the fair outcome standards as enforceable legal obligations. Use of State power, including through targeted monitoring and auditing, for the purpose of seeking to compel compliance with non-laws is common in some countries but it would be a concern if that occurs in New Zealand.

What about innovation?

Greater innovation is one of a number of stated benefits of FMA’s fair outcome standards. However references to innovation in the Guide are fleeting. The fair outcome in the Guide of “Markets enable sustainable innovation and growth” is not a whole-hearted endorsement of innovation. It doesn’t refer to crypto-assets and other key recent market innovations. It’s unclear what “sustainable” is intended to mean. FMA has shown little interest in crypto-assets or their regulation.

During the 2021 Select Committee hearings on crypto-assets FMA did not offer recommendations for their effective regulation when asked to do so and was quoted as saying that they are “somewhat outside [FMA’s] field of expertise.”

The Guide states that seeking to meet diverse customer needs will drive market innovations but it also says that increasing digitisation “risks excluding those who do not or cannot use certain forms of technology”. That is fairly typical of the Guide - it promotes the achievement of conflicting goals with no way for determining which should be prioritised. In any case, FMA provides no cogent evidence that issues with respect to financial inclusion arise because providers are failing to provide appropriate products & services.

It is disappointing that the Guide doesn’t place greater emphasis on innovation as a key mechanism for delivering improved outcomes for consumers. The imposition of regulation often (but not always) stifles innovation rather than increasing it. Multiple providers have stated that the waves of new financial markets regulations that have been implemented over the last few years have taken up resources and management time that would otherwise have been focused on other areas including innovation.

Also, additional regulation often makes it more difficult for new entrants (who are often more innovative) to enter markets. I’m not suggesting that existing regulations are not appropriate (most are) or that new regulations should not be introduced to address specific issues.

But the point comes where ever increasing regulation, no matter how well-intentioned, starts to impose costs (including through the stifling of innovation) that outweigh the value of any benefits they achieve.

Back to the future

Prior to the 2023 general election the National Party said it would repeal the CoFI law. It has not mentioned that since the election but repeal is technically part of the coalition agreement. In submissions on the draft CoFI law I opposed the law. That’s not because it doesn’t include some good provisions- it does. Rather, a key concern is that there is a real risk that the high costs of implementation of (and of ongoing compliance with and administration of) the law will outweigh the value of the benefits to be achieved (a risk acknowledged in the Government’s own regulatory impact statement for the CoFI law).

Also, in the development of the CoFI law, market mechanisms, which could have been applied to achieve the law’s objectives more efficiently, were rejected out of hand. Similar concerns arise with respect to the Guide. Some aspects of these reforms are appropriate and will likely be effective.

However, I don’t support the overall approach of the reforms. As noted, they reject, without proper validation, decades of orthodoxy with respect to market regulation and basic market concepts. I think that, in their vaulting ambition, there’s a real risk that the reforms won’t substantively achieve their stated goals or achieve them at a reasonable cost.

In my view CoFI should at least be revisited and reformulated, with a focus on using it to remedy specific gaps in law (where that is justified) and to support the use of market mechanisms to achieve objectives, in place of all-encompassing standards based on moral principles.

The Guide largely works as a series of aspirational, but non-binding, goals for providers rather than as the central organising principle upon which FMA will regulate the financial markets. I think that the Guide should place greater emphasis on recognising and empowering a wider group of market participants, including consumers and advisers, with the goal of enhancing and strengthening markets as complex systems. It should also place unambiguous emphasis on innovation as a key means to improve consumer outcomes.

*Simon Papa is a commercial lawyer with 20 years’ experience and director of Cygnus Law. Cygnus Law is a boutique law firm that specialises in advising businesses in the financial services sector.