The 1000-page interim report of the Royal Commission into the Banking, Superannuation and Financial Services Industry, released on September 28, addressed the case studies highlighted in the first four rounds of Royal Commission hearings. These were consumer lending, financial advice, loans to small and medium enterprises and issues affecting Australians who live in remote and regional communities. It made a number of observations about the conduct examined. Commissioner Kenneth Hayne AC QC asked why it happened and sought to uncover what can be done to avoid it happening again.
“Too often, the answer seems to be greed — the pursuit of short-term profit at the expense of basic standards of honesty,” said Hayne. “The conduct that is at the heart of the Royal Commission’s work is inextricably connected with remuneration practices, with deficiencies in governance and risk management, and with the culture of the entities concerned. The inescapable fact seems to be that interest too often trumps duty. Too often, conflicts between interest and duty are ‘managed’ in a way that coincides with the interests of the party who owes some conflicting duty or has some conflicting interest.”
Given the conduct addressed in the report was contrary to existing financial services laws, Hayne said, two questions arise. First, why were the breaches as widespread as they were? And why would changing the law make any difference?
Hayne expressed a preference for simplification of the legal framework rather than additional regulation, noting that complexity can promote a “tick the box” approach to compliance and obscure the simple principles that should govern behaviour in the financial services industry.
“It should be considered recognising that there is every chance that adding a new layer of law and regulation would serve only to distract attention from the very simple ideas that must inform the conduct of financial services entities:
- Obey the law
- Do not mislead or deceive
- Be fair
- Provide services that are fit for purpose
- Deliver services with reasonable care and skill
- When acting for another, act in the best interests of that other.
These ideas are very simple. Their simplicity points firmly towards a need to simplify the existing law rather than add some new layer of regulation.”
What the Commissioner said
Most of the conduct identified and criticised in the report contravened existing norms of conduct (either existing laws or regulation, or promises made in industry codes or more directly to consumers).
Hayne put the banks’ remuneration practices at the centre of their poor conduct, writing in the interim report: “All the conduct identified and criticised in this report was conduct that provided a financial benefit to the individuals and entities concerned. The culture and conduct of the banks was driven by, and was reflected in, their remuneration practices and policies.”
Hayne appeared to discount the notion (suggested by Treasury in its earlier policy submission) that better disclosure of remuneration would make a difference, noting potentially conflicting interests of shareholders and customers. He criticised the Australian Prudential Regulation Authority (APRA) for having insufficient regard to the link between remuneration and conduct risk and observed that eliminating incentive-based payments for frontline staff will not necessarily affect the ways in which they are managed if their managers are rewarded by reference to sales or revenue and profit.
”That generally similar conduct occurred in all of the major entities suggests the conduct cannot be explained as a ‘few bad apples’... That characterisation serves to distance the entity from responsibility... It ignores the root causes of conduct.” Commissioner Kenneth Hayne AC QC
Issues for directors to consider
Directors say boards need to respond by firstly ensuring their remuneration is aligned with the culture they want to achieve.
“You reward people for doing the things that fit into the culture of the company. It doesn’t have to be all money. That can also be through comments and awards and their performance review,” says Eileen Doyle FAICD, a director of Oil Search, GPT Group, Boral, and Hunter Angels Trust, and a member of the AICD Corporate Governance Committee. “You reward people for complying with the risk appetite by not taking too much or too little risk because, if you don’t take the right amount of risk for your risk appetite, you’ll never get the returns that you expect.”
Hayne also noted that many incentives were paid to staff simply for doing their jobs, not for meeting targets — a point which Simon Longstaff AO, executive director of The Ethics Centre, says should prompt boards to examine the underlying assumptions on which many remuneration structures are based.
Longstaff asks if a board would ever hire a chief executive who in the job interview promised to only give of their best if they were paid a bonus — and would want a retention bonus to stay in the role for three years. “Yet that’s the logic, the psychology behind the way in which rem is structured at the moment for senior executives,” he says. “The same basic idea that people are not going to do things they ought to do unless they’re effectively bribed to do it has infected the rem structure and it’s distorted behaviour in ways we’ve seen play out in the Royal Commission.”
Longstaff says boards also need to set reasonable salaries then exercise discretion to pay bonuses only for superlative performance.
Ken Dean FAICD, chair of Mission Australia and a director of EnergyAustralia and Virgin Australia, says bonuses for good performance are appropriate, but for stretch performance, not just for meeting expectations that come with the job. “It’s a definition of what the performance means and it does get challenging,” he says. “That’s where boards have to be more vigilant to get those criteria right than has obviously been the case in some cases in the past.”
Dean says remuneration has become increasingly complex making it difficult to truly hold executives to account.
The Royal Commission has prompted a rethink on bonuses. Jillian Segal FAICD, a director of Rabobank Australia & New Zealand, UNSW Deputy Chancellor and former director of NAB, says directors need to rethink the entire remuneration system. She advocates a flat incentive scheme where bonuses are paid as part of a pool with individual incentives based on profit. She feels companies need a game changer to turn around the whole system from a focus on profit to what is the right behaviour. “The only way to change it is to say: ‘No links to profit whatsoever’, says Segal. “To either have no bonuses at all and have a structure where people get paid to do a job and get raises when doing the job — and, if the rating falls below a certain thing, they won’t be in the job, or ratings will relate to promotions. Or you have a bonus pool, but it is only related to non-financial measures.”
Governance and risk management
What the Commissioner said
“The governance and risk management practices of the entities did not prevent the conduct occurring. The central question posed by the chain of events that has been described is whether other financial services entities have the same or similar deficiencies of governance and risk culture the panel identified in relation to CBA. As this report records, other entities have engaged in conduct of the kinds that led APRA to conduct its inquiry into CBA. The conduct suggests that there has been insufficient attention given within those entities to regulatory and compliance risk. It suggests want of attention by those entities to reputational risk. Some of the conduct suggests want of proper governance in the entity.”
Issues for directors to consider
Eileen Doyle says as much as companies set up systems and policies to drive the right behaviour, the difficulty is in ensuring these are deployed all the way down through the organisation.
“Directors need to drill down into particular areas,” Doyle says. “They can say, for instance: ‘We’re going to do a deep dive into this particular area, and I just don’t want to talk about the high level of the system. I want you to show me how it works all the way down to the shop floor effectively or the person at the branch so that I can understand how you deploy it, how you deploy that particular area’.”
Simon Longstaff says directors need to understand that their responsibility is to forensically interrogate all of the other systems, policies and structures that might be driving behaviour inconsistent with the desired culture, as outlined in the mission statements and ethical framework.
“In the well-governed organisation, there has to be some criteria against which to determine whether a decision is a good decision or a bad decision, whether it’s the right thing to do or the wrong thing to do, and that’s what the ethical framework provides,” says Longstaff.
“Then you’ve got to be able to go back and look at your policies, practices, systems and structures, and ask of them — as a whole and in each particular instance — what message does that send in relation to our espoused ethical commitments. Does it reinforce what we want? Or does it undermine it?”
Ken Dean says many organisations’ understanding of risk — particularly in the finance sector — has become overly focused on financial risks, which he says is understandable because (go to p56) (from p54) they are readily quantifiable. This belief in the numbers has impeded directors from thinking about what drives people’s behaviour and the “non-financial risk”.
“What do people get incentivised to do not just through remuneration, but through the culture of the organisation and ‘the way things happen around here’ to manage?” Hayne asked. “What things do people focus on?”
Risk management is being more often managed and mediated by the legal profession, says Dean, who adds that it is a logical consequence of the Royal Commission. However, it places too much focus on the consequences of failure rather than dealing with the issues wholeheartedly and stopping the problem in the first place.
Dean says he is an advocate of “management by walking around” and the interim report highlighted that directors and non-executive directors need to be more active and be seen in the organisation; not just in official board visits when “the silver’s been polished”, but to get into the organisation to and talk to enough people to get a feel for the way the organisation is going.
What the Commissioner said
Much of the misconduct was caused by culture, said Hayne, but added: “Changing culture in the Australian banks may not be easy and may take time. It cannot be assumed that entities will embrace change willingly or immediately. It cannot be assumed that entities will make desirable changes at all levels of the organisation. Good culture and proper governance cannot be implemented by passing a law. Culture and governance are affected by rules, systems and practices, but in the end they depend upon people applying the right standards and doing their jobs properly.”
Issues for directors to consider
One message in the interim report for directors is to try to break the culture of focusing on profit and look more to the long-term health of the organisation, with a focus on treating customers fairly, says Jillian Segal.
“You can’t just write culture in words,” she says. “Culture is the way things are done in an organisation and what is seen as the accepted behaviour and responding to situations. It has to be how people behave in all sorts of situations — whether it’s a situation of how you’re dealing with a complaint, how you’re dealing in selling a product or how you’re dealing in many other interactions with customers.”
While in small organisations it’s possible to create the right culture through the leadership and people, this is much harder in big businesses, which typically don’t have just a single culture. Like Hayne, Segal sees remuneration as the biggest lever directors have.
Ken Dean says it is impossible to set culture and instead directors need to model good culture. He puts the onus on individual directors and says there is a need to be visible in modelling good conduct in every aspect of their lives, including personal lives, because people are also judged by this standard.
“If you can’t take home the decisions you’re responsible for and part of around a board table — and have your kids examine them, there’s something desperately wrong,” he says.
Directors need to listen to range of litmus tests to determine culture — not just internal feedback such as formal staff surveys, but customer complaint lines and feedback, reports from the ombudsman and other regulators — and dig into some of the detail.
Boards also need to test and measure culture. Along with director visits and deep dives, there is also a range of analytic measurement tools available to directors.
Eileen Doyle points to voice analytics, which analyse staff communications and can determine where culture isn’t being followed and who the key influencers among the staff are. Directors should try to get a feel for the tension between cooperation and challenge in their organisation. “At the end of the day, if everybody cooperates and is nice to each other, and nobody challenges somebody because they’re not following the culture, it probably won’t work,” she says.
A big question for directors is how they operationalise the values embodied within the mission statements, the codes of conduct, the best practice policies, and so on, says Andrew Godwin, an associate professor at Melbourne Law School. He notes the irony that the last decade has seen significant growth in these sorts of documents yet many are very aspirational and don’t have a lot of detail in terms of how they can be operationalised.
Again, part of the answer is remuneration and the importance of assigning a value to examples of people doing the right thing and rewarding good exemplars. “We need to reward people for doing the right thing by customers,” Godwin says. “We need to reward people also for doing the right thing by the company in terms of maintaining and enhancing its long-term reputation.”
He adds that underlying many of the comments in the interim report is the expectation that directors need to take a more long-term view to satisfy their duties to act in the best interest of the company.
”We behaved our way into this mess, we have to behave our way out of it.” Australian Banking Association CEO Anna Bligh AC
What the Commissioner said
Hayne stated that neither the Australian Securities and Investments Commission (ASIC) nor the Australian Prudential Regulation Authority (APRA) had marked or enforced the bounds of permissible behaviour set by the law in a way that would prevent the conduct that came to light during the hearings.
Hayne criticised ASIC’s approach to regulation, noting that in responding to misconduct, the starting point for a conduct regulator should not be to ask: “How can this be resolved by agreement?”
“When misconduct was revealed, it either went unpunished or the consequences did not meet the seriousness of what had been done,” Hayne said. “The conduct regulator, ASIC, rarely went to court to seek public denunciation of and punishment for misconduct. The prudential regulator, APRA, never went to court. Much more often than not, when misconduct was revealed, little happened beyond an apology from the entity, a drawn-out remediation program and protracted negotiation with ASIC of a media release, an infringement notice or an enforceable undertaking that acknowledged no more than that ASIC had reasonable ‘concerns’ about the entity’s conduct.”
Hayne expressed a preference for simplification rather than additional regulation, suggesting that the more complicated the law, the more likely compliance will become a “tick the box” matter. He pointed to the issues including the size of ASIC’s remit and an entrenched culture of negotiating outcomes rather than insisting on public denunciation and punishment. While critical of the approach of the regulators (particularly ASIC), he noted that criticisms of the regulators must not be understood as diminishing the culpability of entities that engaged in the relevant conduct.
For ASIC, the report will raise expectations from government and the community more broadly that it will take a more litigious approach to enforcement, rather than favouring negotiated outcomes (such as enforceable undertakings). Such a shift was already underway with the recent appointment of a new deputy chair, Daniel Crennan QC, and increased funding for regulatory enforcement.
For APRA, there will be pressure to adopt a stronger focus on the link between misconduct and remuneration, and to ensure that it has a clear view of governance and risk culture in financial institutions, especially the four major banks and AMP, following on from the APRA prudential inquiry into CBA.
Issues for directors to consider
Andrew Godwin says regulators ASIC and APRA have themselves come under increased scrutiny in the Royal Commission. “What banks and financial institutions and directors and executives generally need to do is be prepared for an increase in the expectations that the regulators have of the regulated entities,” says Godwin.
He adds that there may be increased reporting requirements and more severe auditing requirements — and less accommodation and flexibility on the part of the regulators — as they seek to demonstrate that they are following up compliance and best practice within the industry, and show that they are taking the appropriate steps in relation to enforcement.
Commissioner Hayne has made a significant number of conclusions, including that some of Australia’s largest financial institutions may have breached the law, failed to meet community standards and expectations, and potentially breached various iterations of the Code of Banking Practice. Preliminary findings made in relation to case studies below are:
Consumer lending : Findings were made that certain matters may have amounted to misconduct, including breaches of legal obligations and conduct, which fell below community standards and expectations, by NAB, CBA, Aussie Home Loans, ANZ, Westpac and Citibank.
Financial advice: There may have been a number of breaches of the law and several instances of conduct that fell below community standards and expectations, along with breaches of the Code of Banking Practice, in relation to AMP, CBA, Westpac, ANZ, NAB, Henderson Maxwell and Dover.
SMEs: Misconduct may have occurred in relation to Westpac, CBA, Suncorp, ANZ, Bank of Queensland, NAB, Bankwest and Bank of Melbourne.
Agricultural lending: ANZ, Rabobank Bankwest, NAB, Rural Bank and CBA may have engaged in conduct, which failed to meet community expectations and standards and, in some cases, may have breached the law or Code of Banking Practice.
Remote communities: Commissioner Hayne observed that it was open to find that the Aboriginal Community Benefit Fund and Select may have breached several laws and fallen below community standards and expectations. In addition, ANZ may have failed to meet community expectations and possibly breached the Code of Banking Practice.
Read AICD’s summary of the interim report at aicd.com.au/summary