Regulation - creaking or creeping?

Fallout from the Ross Asset Management continues to reverberate throughout the NZ financial services industry Recent revelations include a conversation warning a regulatory officer about the Ross Asset Management situation some time ago - a warning which was not acted upon, and which was all too accurate as it turns out.

The collapse of Ross Asset Management appears to have revealed a serious shortcoming in the regulatory framework and comments from some quarters to add more regulation to the existing framework are typical reactions when regulation is found wanting.

To be fair to these commentators, there appears to have been little review work carried out since the legislation was introduced, nor any 'report card' produced, or called for, on the performance of the regulations and the regulators.

However, adding regulations in an ad hoc manner in reaction to a specific situation has been known to give rise to regulatory creep in other territories. Now, evolving the effectiveness of a regulatory environments is perfectly logical - but doing so piecemeal in a reactive manner can deliver unexpected consequences.

The Ross Asset Management issue has been the biggest test of the regulatory regime so far, and I regret to record, that the regime has failed.

  • It has failed the investors in the collapsed entity;
  • It has failed the industry is was established to improve;
  • It has failed all those practitioners who subscribe to the standards set;
  • It has failed the NZ taxpayer;
  • It has failed to display sufficient resilience to cater for a relatively straightforward but serious breach .

While the FMA was heavily involved in conducting audit reviews into adviser practices which displayed no overt signs of breach - Ross Asset Management was plunging investors headlong into financial ruin, untroubled by anything as inconvenient as a regulatory authority.

Something about Nero, a fiddle, and Rome burning springs to mind!

The regulatory framework is truly creaking at the seams and may even be cracking at its foundations.

So rather than indulge in some regulatory creep by adding more ineffective measures to a structure which has already proved to be inadequate for the purposes it was established, I submit that a full review of the regulatory framework, the underlying concepts, the enforcement provisions, and the basic intent of the regime be undertaken.

That the industry needs regulation is not in question; but the industry needs effective regulation, and not a regime that fails at the first test to prevent losses on the scale experienced. The credentials presented by Ross Asset Management were insufficient proof of competence, honesty, and integrity.

There is also little to be gained by finger-pointing at those involved in framing and presenting the original regime. Submissions were called for at the time from all appropriate sources, and there appeared to be sufficient consensus that while not 100% perfect for everyone, there was at least a context for the establishment of an operational and workable regulatory framework.

However, there were - and still are - some areas where the context for the regime could stand review in the light of experience.

1. The segmentation by product complexity was, and remains, fundamentally flawed. An AFA could easily cause a wealthy, sophisticated, and 'eligible' investor to lose on an investment through inadequate or inappropriate advice. The consequences, depending upon the amounts involved of course, may be of little overall consequence to the client. A Financial Adviser, charged with arranging a share purchase scheme for a corporate entity can cause untold damage to families, companies, employment, and the wider community. Yet the standards set by way of examination, and proof of bona fides, are markedly more onerous for an adviser handling investment products.

2. There is a reasonable case for separating risk advisers from investment advisers. While there were many willing to criticise advisers for recommending finance company products prior to the collapse, I've seen figures of 60% - 70% quoted as the percentage of the totals invested which came directly from the public. Risk advisers were not the issue - even within the estimated 30% - 40% which was invested as a result of adviser recommendation. These advisers were in the investment camp. Does this suggest different standards of regulation for different classes of adviser? Of course it does! Life insurance and investment advice are now generally regarded as separate disciplines, if not separate industries.

3. The functions conducted by the investment adviser should be segmented. In this respect, references made to the U.K. regime where I spent 10 years as a practising insurance, investment, superannuation, and life insurance adviser, have some relevance. The original U.K. regime 'tiered' the advice from 'execution only' at the basic Level 1, to Level 6 which governed discretionary investment portfolio management services. In order to conduct business at Level 6 an adviser and/or the firm had to have a prescribed solvency margin with a mandatory liquidity ratio (6 months operating expenses, from memory), and be subject to a separate and more exacting audit than that required by the governing corporate legislation.

4. It is widely recognised that the QFE structure was a compromise introduced for the benefit of the banks and larger insurance companies. The wisdom of this concession in the light of the nefarious practices of the banks over Kiwisaver switching has proved false. Also, the howl of protest raised when changes to Kiwisaver distribution rules were recently promulgated, should provide the regulators with a clue that they're on the right track in eliminating certain shonky practices currently accommodated under the existing regime. The banking industry has always enjoyed a strong lobby in NZ, and appears to have the ear of the current governing party. But with one or two exceptions, the QFE structure has facilitated the generation of profits destined for offshore corporate banking entities, and has done nothing to benefit New Zealand consumers, investors, or taxpayers.

The NZ regulatory regime has been in existence long enough for a serious review of the stakeholders' experiences, and to assess the effectiveness of the regulatory framework in restoring confidence in NZ's capital and investment markets, as was intended at the outset.


The Laird