rba philip lowe

There is an element of trust in all economic transactions. Without it, commerce can’t flourish. But the nature of trust in our society is changing. We can all think of recent examples where trust in our institutions and organisations has been severely tarnished. At the same time, changes in technology mean we are increasingly trusting the wisdom of the crowd on our preferred online platforms, rather than traditional institutions. Trust is now more likely to be distributed, rather than flow vertically from our institutions. Regardless of how that trust is earned and retained, we all have a strong interest in living in a high-trust society.

Trust in finance

Finance is all about trust. As the first line of the Banking and Finance Oath says: “Trust is the foundation of my profession”. I encourage everybody in the finance sector to live by it.

Australia’s banks have a strong record of being worthy of the trust placed in them to repay deposits. The last bank failure in Australia that resulted in a loss to depositors was almost 90 years ago — the Primary Producers Bank was wound up in 1931. It was a very small bank and depositors lost only a small fraction of their deposits.

This is a positive record few countries can match. This strength was apparent during the financial crisis and has served Australia well. Our banks are strongly capitalised and have considerable liquidity buffers. On the whole, they have managed credit risk effectively, reporting few problem loans by global standards. This means we can have a high level of trust in the ability of Australia’s banks to repay depositors. Indeed, our strong and stable banking system is one of the Australian economy’s strengths.

It is in other areas where trust has been strained. It is clear that the behaviours highlighted by the banking Royal Commission have dented the community’s trust in parts of our financial sector. The case studies used by the Royal Commission have put the spotlight on three important issues:

  • The inadequate way in which banks have dealt with conflict of interest issues
  • The way poorly designed incentive systems can distort behaviour — promoting a sales culture at the expense of a service culture, and promoting the short term at the expense of the long term
  • The fact that the consequences for not doing the right thing have, in some cases, been too light.

Strengthening trust in our financial institutions requires all three to be addressed.

Central to this task is creating a strong culture of service within Australia’s financial institutions. Too often our financial institutions prioritised sales over service. Correcting this starts with the system of internal reward established by board and management. The vast bulk of the people who work for Australia’s financial institutions want to do the right thing, to serve their customers as best they can. But, like everybody else, they respond to the incentives they face. If they are rewarded on sales or short-term objectives, it should not come as a great surprise that’s what they prioritise. So establishing the right incentives is key.

One of the things that influences incentives is the consequences and penalties that apply when something goes wrong. Strong penalties can play an important role in incentivising good behaviour, and this is an area we should be looking at. But we do need to get the balance right as there can be unintended consequences. It is worth making a distinction between the penalties that apply for poor conduct and those that apply for making loans that ultimately cannot be repaid.

On conduct issues, we should set our expectations and standards high, and if they are not met the penalties should be firm.

On lending, matters are more complex. Even when banks lend responsibly, a percentage of borrowers will end up in financial strife and be unable to meet their obligations. We need banks to be prepared to make loans in the full expectation that some borrowers will not be able to pay them back. Banks need to take risk and manage it well. If they become afraid to lend simply because of the consequences of making a loan that goes bad, our economy will suffer. A balance needs to be struck.

More broadly, having clear lines of accountability can help build trust. The Banking Executive Accountability Regime (BEAR) is helpful here. This regime is, however, largely limited to authorised deposit-taking institutions and prudential matters. It is worth thinking about how the same focus on accountability can be applied to a broader range of financial services and to conduct issues. We should not lose sight of the fact that their boards and management are ultimately responsible for the choices that banks make. It is unrealistic to expect that an appropriate culture can be created through regulation and penalties. Creating the right culture is a core responsibility of boards and management.

Changes now taking place within the financial sector should, over time, help restore trust, although it is likely to be a gradual process. The Royal Commission will have recommendations that should assist with this. One thing that would help is for financial institutions to have a long-term focus and reflect that in their internal incentives. Managing to short-term targets might boost the share price for a while, but this short-termism can weaken the long-term franchise value of the bank.

Franchise value is more likely to be maximised if financial institutions have a long-term perspective, treat customers well, reward loyalty rather than take advantage of it, and invest in systems and technology to deliver world-class financial services. Doing this would not only be good for bank shareholders, but also for the broader community.

Trust that living standards will improve

On many accounts, the Australian economy has performed very well over recent times. Over the past year it has grown by close to 3.5 per cent, inflation has been low and stable at around two per cent, employment has grown quite strongly and we are getting closer to full employment. Business conditions are positive and government finances have improved. There is a lot of investment in infrastructure and the number of job vacancies is at a record high. Overall, it is quite a positive picture. Yet not everybody shares this positive assessment.

Average hourly earnings in Australia, adjusted for inflation, have changed over time. Over the period 1995–2012, we saw a substantial lift in real hourly earnings; on average, real wages increased by almost two per cent per year. This occurred alongside inflation averaging around the midpoint of the two to three per cent target range and strong growth in corporate profits. Since 2012, it has been a different story with little change in average real hourly earnings. Any wage increases have been broadly matched by inflation.

This is having significant effects. On the positive side, flat real wages have supported the substantial gains in employment. At the same time, flat real wages are diminishing our sense of shared prosperity. The lack of real wage growth is one reason some in our community question whether they are benefiting from our economic success.

A similar thing has happened across most advanced economies, where despite unemployment rates being the lowest in many decades, too many citizens have diminished trust in the idea that the policies that have underpinned growth over the past 30 years are working for them. They feel more uncertain about the future and in some countries are also having to deal with high housing prices.

The diminished trust in the idea that living standards will continue to improve is a major economic, social and political issue. It underlies some of the political changes we are seeing around the world. It is also making it harder to implement needed economic reform. It is in our collective interest that this trust is restored.

This is a challenging task, but not an impossible one. Part of the solution is for the labour market to tighten further and for this to lead to a pick-up in household income growth. The current setting of monetary policy is encouraging this. As the labour market has tightened in Australia over the past year, there has been a modest lift in wages growth, further confirmed with the publication of the wage-price index. The RBA also continues to hear reports of larger wage rises in areas where there is strong demand for labour and workers are in short supply.

From a longer-term perspective, another part of the solution is to boost our productivity. The factors contributing to flat real wages for many workers are complex, but many of them are linked to globalisation and technology. The best way of dealing with this is not to ignore these forces, but to do what we can to capitalise on them. This means government and business having a sharp focus on the question of how we can best flourish in this world of global markets and continuing improvements in technology.

An important part of the answer must be investment in education, skills, research and development. We need to be thinking long-term. Realistically, more investment in human capital will not make much difference to real wages this year or next, but over the next decade or two, it is crucial to raising real wages and living standards. Increasingly, our prosperity rests on the ideas we have and how we can take advantage of them — how we can capitalise on new technologies. This means that having a strong culture of innovation in our businesses is important. With the right investments, Australians can enjoy high and rising real wages in a highly competitive, technically sophisticated world.

There are other elements to lifting productivity: the design of our tax system, the quality and pricing of our infrastructure and the strength of competition in our markets. The key point is that raising productivity and ensuring a strong economy will, over time, help deal with the diminished trust people have in the idea that real living standards will improve. We all have a strong interest in that trust being restored.

Trust in the central bank

One of Australia’s strengths is that we have strong and stable public institutions. We can sometimes take this for granted. But strong public institutions are one of the foundations upon which our economic prosperity is built. They help support the public’s trust in the development and implementation of economic policy, and in the fair and effective administration of laws and regulation. They can also help society balance some of the difficult trade-offs we sometimes face.

This is an edited version of a speech to the CEDA annual dinner in November 2018.