Reserve Bank’s new enforcement vision for 2022 onwards
How will it be put to work?
In March 2021, the Reserve Bank of New Zealand established a new Enforcement Department following a lengthy consultation process to settle upon some Enforcement Principles and Criteria to inform its approach.
The Department’s work is expected to begin in earnest in early 2022. This will result in closer scrutiny of entities that are regulated by the Reserve Bank and an increased number of regulatory prosecutions and other actions.
What has changed?
The creation of a new Enforcement Department indicates that the Reserve Bank intends to focus more upon its enforcement powers than it has done previously, and determine how it will use them in a more structured way. This began with work to develop an enforcement framework to guide the Enforcement Department’s activities. In October 2021, the Reserve Bank released a paper outlining proposed Enforcement Principles and Criteria and sought submissions from stakeholders. The Enforcement Principles and Criteria are expected to be released in early 2022.
The Reserve Bank exercises enforcement powers under various statutes which govern the financial sector, such as the Anti-Money Laundering and Countering Financing of Terrorism Act 2009, Reserve Bank of New Zealand Act 1989, Insurance (Prudential Supervision) Act 2010, Non-bank Deposit Takers Act 2013 and Financial Markets Infrastructures Act 2021. Soon, there will be two more: the Reserve Bank of New Zealand Act 2021, replacing the 1989 Act of the same name, and a new Deposit Takers Bill – an exposure draft that is currently being consulted on with the expectation it will come into force in 2023.
Until 2021, the Reserve Bank managed its enforcement work as part of its general operations, without a dedicated enforcement arm. Perhaps as a result of this, it has generally been less active in using its enforcement powers than the primary financial sector regulators, the Financial Markets Authority (FMA) and the Commerce Commission.
What will the Enforcement Department do?
The Enforcement Department will investigate breaches of regulatory requirements, provide input to supervisors on compliance matters, and recommend enforcement actions where appropriate. Though it is operationally separate from the Reserve Bank’s Supervision Department, it is expected that the two will cooperate in these functions in light of their shared membership in the broader Financial Stability Group.
The Enforcement Department’s activities will be guided by the enforcement framework. The Reserve Bank says this framework will be tied to three goals:
- incentivise and monitor prudent behaviour;
- promote confidence in compliance; and
- enforce compliance by holding institutions to account for non-compliance.
In addition, the Reserve Bank has formulated three high-level Enforcement Principles and four Enforcement Criteria that are intended to apply across all the areas that the Reserve Bank regulates. The three enforcement principles are high-level ideals that guide its enforcement strategy: risk-based, proportionate and transparent. The four criteria are specific considerations for use when deciding on the appropriate enforcement response in each case: seriousness of conduct, responsiveness, public trust and confidence, and efficacy.
Principles in practice
The Reserve Bank offers the following examples of how these high-level ideas are intended to guide the way it approaches enforcement in particular cases:
The Reserve Bank will focus its efforts and its enforcement resources to address conduct around issues that could have the potential to damage the financial system or the New Zealand economy significantly. Perhaps surprisingly, however, the example given is AML/CFT regulation, which is not obviously an issue that poses the greatest threat to the financial system or the economy (compared, for instance, to the need to ensure that deposit takers and insurers are undertaking only prudent exposures and have sufficient financial reserves).
The Reserve Bank will determine its enforcement response in a case after considering aggravating and mitigating factors, the broader compliance context and internal and external (i.e. cases with other regulators) precedent. It will seek to apply the regulatory tool that is appropriate for the nature and magnitude of the non-compliance, the particular entity and its general attitude to compliance, the risk posed by the non-compliant activity and the public interest.
The Reserve Bank will publish key guidance and enforcement outcomes unless there are exceptional circumstances that make it inappropriate to do so. Transparency also means engaging openly and honestly with regulated entities during investigations and not publishing allegations during the investigation phase unless it is appropriate to do so.
What do the Enforcement Criteria tell us?
The Reserve Bank has broken each of its four criteria down into factors that it will consider when making enforcement decisions.
Seriousness of conduct
- prevalence of non-compliance (i.e. whether the entity has a history of breaches);
- magnitude and impact (including whether a breach is technical or not and whether it presents systemic risk or shows up failings in a compliance programme – again AML/CFT is given as an example, which appears to signal a particular focus on that aspect of regulated entities’ conduct; and
- executive or operational knowledge (including whether the relevant conduct was known at a senior level, how long it persisted, and whether there was negligence or recklessness).
- cooperation with the Reserve Bank in addressing the breach, including whether it was promptly admitted and fully and willingly disclosed;
- the entity’s compliance history (which seems to duplicate the same point under the seriousness factor and could in our view be omitted from this one); and
- the entity’s conduct in resolving the breach, including any proactive and voluntary remedial action.
Public trust and confidence
- Public confidence – whether enforcement action will promote public confidence in the financial system. Interestingly, the Reserve Bank seems to be willing to acknowledge that some enforcement action may risk financial instability, such as a ‘run on the bank’ – a very welcome indication of necessary pragmatism.
- Deterrence value – whether enforcement action is likely to modify the behaviour of the entity and others.
- Consistency and fairness – whether the enforcement response is consistent with previous action by the Reserve Bank and other regulators.
- Promoting maintenance of the law – whether enforcement will promote regulatory objectives and policy objectives, as well as whether there is a need to clarify the law.
- Strength of evidence – the Reserve Bank will be pragmatic about its prospects of success on the evidence. In some cases there may be a tension as a regulated entity may cooperate in the hope of resolving an issue, but in doing so provide the Reserve Bank with the evidence it requires.
- Available legal defences – a fundamental and necessary consideration, because if a credible defence is available, no wrong has been committed, in which case the Reserve Bank has no business bringing enforcement proceedings.
- Supporting other regulators and working with them when regulatory areas overlap.
- Potential outcomes – the effect upon overall financial system stability (also a consideration under the public trust and confidence factor) and whether the proceeding is likely to result in a conviction, compensation or penalty – and also whether a warning or another lesser response is appropriate.
What effect will the consultation process have on the enforcement framework?
Generally, we view the draft Enforcement Principles and Criteria as appropriately pragmatic. Indeed, they closely resemble the equivalent frameworks adopted by the other New Zealand financial market regulators.
However, other regulators are more specific about their priorities. While the Reserve Bank says that its principles are intended to be high-level, it offers only one indication of a priority area: AML/CFT regulation.
The FMA, by comparison, is much more specific and recently issued a revised set of priorities in response to the effects of the COVID-19 pandemic, including supporting investors to make good decisions, responding to scams, monitoring treatment of customers in vulnerable circumstances and responding swiftly to market disruptions and significant events.
We expect stakeholders, especially those potentially subject to enforcement action by the Reserve Bank, to have communicated to the Reserve Bank that greater specificity would enable regulated entities to respond more effectively. If such submissions are received and taken on board by the Reserve Bank, this would hopefully result in greater detail as to the Enforcement Department’s areas of focus for 2022.
What should we expect from the Enforcement Department in 2022?
We expect to see more enforcement activity from the Reserve Bank in 2022, as a natural consequence of resources being invested to develop a dedicated enforcement arm. Based on the approach that the FMA took when it was set up, activity may be restrained at first, as the Enforcement Department develops its internal processes and identifies strategies for targeting priority areas.
Over time, we expect to observe a significant increase in enforcement action, as we have seen with the FMA. As the only issue specifically identified in the draft Enforcement Principles and Criteria, AML/CFT is likely to be a real focus (as it has been for the FMA), at least initially.
One issue to monitor is how the Reserve Bank manages the risk that enforcement action may have on trust and confidence in the financial system generally – an issue it acknowledged in the draft Enforcement Principles and Criteria. The Reserve Bank will be cautious of taking action that may trigger a collapse in public confidence in a systemically important financial institution or in the financial markets generally, possibly resulting in a calamitous outcome. This is not a factor that the FMA or the Commerce Commission are normally expected to take into account when regulating conduct.
The inherent conflict between enforcing conduct rules and preserving confidence in the financial system is one of the key reasons for the separation of conduct and prudential regulation under the “Twin Peaks” model as originally developed in Australia in the Wallis Report, and partially applied in New Zealand. This is reflected in the potential conflict between the Reserve Bank’s proposed principle of transparency (expressed in its intention to publish the outcomes of its investigations) and its criteria of public trust and confidence (which may be damaged by the same publication).
While we view the emphasis on public trust and confidence as important and consistent with the financial stability goals of the Reserve Bank, it highlights the inherent conflict referred to above and potential conflicts between the Reserve Bank’s response in particular cases and the responses of other financial services regulators. In our view, this issue should be considered and addressed by all of New Zealand’s financial services regulators, particularly if a rise in class actions (notwithstanding the completion of regulatory action) is on the horizon.
We expect to see more enforcement activity from the Reserve Bank in 2022, as a natural consequence of resources being invested to develop a dedicated enforcement arm.