The Financial Markets Authority (FMA) is turning its attention to the risks our low, but about to be tightened, interest rate environment poses.
It warns low interest rates and volatile equity markets have seen more complex financial products emerge to meet the demands of investors seeking higher yields.
“We see possible harm to consumers, as complex products and the risk-return dynamics involved are more difficult to understand,” the FMA says in its Strategic Risk Outlook 2017.
Released on Wednesday, the document identifies the existing and emerging risks threatening the fairness, efficiency and transparency of our financial markets, and details how the FMA will respond to these. Its last Outlook was published in 2014.
Complex and risky products
The FMA says complex products often have unclear disclosure documents, making them susceptible to being mis-sold to investors who don’t fully understand what they’re getting into.
“For example banks’ increased use of sub-ordinated unsecured debt instruments to meet their regulatory capital requirements has led to concerns in several jurisdictions over whether these instruments are suitable for retail customers,” it says.
“More broadly, if investors are classified (or classify themselves) as ‘wholesale investors’ in order to gain access to certain products but lack requisite knowledge, this also brings increased risk, as wholesale investors do not have the same protections, such as disclosure, as retail investors.
“Similarly, retail investors may not fully understand the inherent risks in non-mainstream property-related offers (syndicated or other indirect investment structures) in New Zealand.
“We have also noticed an increase in foreign exchange and binary option trading providers who target New Zealand investors to trade through their platforms.
“While the products are not necessarily complex, they often use leverage, with the suggested higher returns never materialising, and investors not fully understanding the risks of loss. In some cases, the businesses are just operating investment scams.”
The FMA has committed to keep monitoring these products and how they’re sold.
Changing market conditions
The regulator also recognises the risks posed by looming interest rate rises.
“The extent and pace of this change may challenge many investors’ investment plans,” it says.
“One example is conservative and balanced KiwiSaver funds which often include a high proportion of long-term bonds that carry some risk. Bond issuers may not repay the money, especially in an environment of rising interest rates. What’s more when interest rates rise, the bonds decrease in value, providing negative returns over the short term.
“Default funds, specifically, tend to have a higher proportion of investments in long-term bonds so, when interest rates rise and bond values fall, there is a risk that those funds will experience negative returns. This could lower the overall confidence in KiwiSaver and drives ill-considered switching.”
The FMA plans to keep working with default KiwiSaver providers to ensure investors have confidence in their long-term investments and KiwiSaver members improve their financial capability.
Reliance on technology and dodgy foreign companies
Unrelated to interest rates, but also a “developing theme” on the FMA’s radar are the risks associated with people being increasingly reliant on technology-driven products and services.
“These include: increased exposure to complex products for retail investors, data security vulnerabilities, and a time lag between their release and effective regulation to manage risk.”
It maintains its regulatory settings are “flexible enough to embrace innovation”, noting how quickly it acted to implement licensing of peer-to-peer lending and equity crowd-funding.
Nonetheless, it says: “Balancing the reduction of risk with innovation and improved efficiency in the sector is the challenge that we and other international regulators currently face.”
The FMA also raises its concerns over the number of companies included in the Financial Service Providers Register, that don’t have much to do with New Zealand, but want to be seen to be regulated in New Zealand, as this makes them appear more legitimate.
“We want to prevent offshore businesses form using, or damaging, New Zealand’s good financial reputation and effective regulation.”
The FMA will keep working with other authorities and “take enforcement action” where necessary in this space.
Other drivers of risk
The FMA also identifies the following drivers of risk:
- Low investor capability and gaps in investment knowledge.
- New regulation, which may cause financial service providers to be uncertain about what’s expected from them.
- The concentration of the New Zealand market, which can “amplify existing market frictions, conflicts of interest and information asymmetries”. There are also challenges being a small market adopting overseas regimes like that around anti-money laundering.
- The international movement, which has seen the government pass on the risks and responsibilities of funding retirement, to individuals. Retirees might not have provided for as much as they need and there’s a risk they’ll be mis-sold products.
- Younger, tech-savvy investors bypassing traditional investment models. Financial service providers need to adapt accordingly.
- Cultural diversity, which can result in changing business norms and migrants not understanding the law , the financial products and services on offer and their consumer rights.
- Poor company culture and employee incentives that can lead to mis-selling and unclear product design.
- Information asymmetry, where people have uneven access to, and ability to understand, important information.
- Conflicts of interest inherent to certain business models, which are intensified in a small market like New Zealand. This relates to the way retail sales staff are incentivised, as well as the conduct in wholesale markets.
- New technology and globalisation of financial services are creating new business models, which regulators may struggle to keep up with.
FMA’s plan of action
Pulling everything together, FMA CEO Rob Everett says: “Since the Financial Markets Conduct Act came into full effect in December 2016, and with confirmation of our funding, we now have certainty over our mandate and resources, which means we can take a longer term view of our strategic planning.”
He says the FMA will remain focussed on the seven key areas it's been working on:
- Conflicted conduct
The FMA says it will use its review into churn in the life insurance sector as a benchmark for similar reviews into sales practices and incentives in the future.
- Capital market growth and integrity
“We have worked to improve our relationships with market participants and their advisers. We now want to extend this approach to investment banks,” the FMA says.
“We have begun to look at wholesale activity and its impact of retail investors. For example, we have begun engaging with NZX, banks and other trading businesses to clarify the boundaries of acceptable wholesale trading practices and behaviour.”
- Investor decision-making
The FMA plans to continue working with issuers to improve the quality of disclosure documents. It will move towards a more “risk-based and thematic monitoring” of disclosure documents.
- Sales and advice
The FMA says it will apply what it’s learnt about the advice KiwiSaver investors need, to the way it regulates all managed investment schemes.
- Effective frontline regulators
- FMA effectiveness and efficiency
- Governance and culture