Westpac's New Zealand subsidiary has been ordered to increase the amount of capital it holds after the bank failed to comply with local governance standards.
The Reserve Bank of New Zealand on Wednesday said Westpac NZ had used unapproved capital models since 2008.
The RBNZ said a report uncovered serious shortcomings and non-compliance failures in relation to Westpac NZ's status as an "internal models bank" - a lender that uses its own estimates to measure risk.
"Operating as an internal models bank is a privilege that requires high standards and comes with considerable responsibilities," RBNZ deputy governor Geoff Bascand said.
"Westpac has not met our expectations in this regard."
The RBNZ has given Westpac 18 months to remedy the issues and increased its minimum capital levels until it has done so.
Westpac NZ's minimum common equity Tier 1 capital ratio will be lifted to 6.5 per cent from 4.5 per cent, with its total capital ratio increasing to 10 per cent from 8.0 per cent.
The RBNZ said it took into account that Westpac NZ had not deliberately sought to reduce its regulatory capital, and that it appeared to have remained well above its required regulatory capital levels.
"We believe the regulatory action is appropriate given the seriousness of Westpac's non-compliance and the need to protect the integrity of the capital regime," Mr Bascand said.
Westpac shares on the ASX were 0.5 per cent lower at $31.96 at 1415 AEDT, making it the worst performing of the big four Australian banks.
Westpac said in a statement it had already begun to address the issues.