There are lessons from Australia about the root causes of misconduct in providing consumer financial services. They are important for all countries, but especially those seeking to encourage financial inclusion through best practice consumer protection regimes.
But lessons from Australia? Doesn’t Australia have a highly regulated financial services sector and active regulators!? True but there are critical issues highlighted in the Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Finanical Services Industry (Interim Report). The Interim Report describes widespread misconduct and raises troubling concerns about the regulatory response.
The misconduct discussed in the Interim Report includes: charging incorrect fees or interest (including fees for no service and fees charged to dead consumers); irresponsible lending practices; mis-selling of add-on insurance; fraud by intermediaries such as mortgage brokers and financial advisers; inappropriate advice; use of prohibited “unfair terms”; and misleading advertising. And there is more!
So what drives misconduct in the financial sector? The aim here is to start to better understand its root causes so regulators and policy makers can do more to prevent it.
Factor No.1: Pursuit of profit (greed)
The most fundamental cause of misconduct appears to be greed:
“The Commission’s work, so far, has shown conduct by financial services entities that has brought public attention and condemnation. …
Why did it happen?
Too often the answer seems to be greed – the pursuit of short term profit at the expense of basic standards of honesty.” (emphasis added)
Source: Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Executive Summary.
Factor No. 2: Regulatory action is not a disincentive to misconduct
The Interim Report also stresses that an entity’s duty to shareholders entails a duty to pursue the long-term advantage of the entity (as well as short – term gain). This includes both obeying the law and doing what is required to preserve the entity’s reputation for behaving “efficiently, honestly and fairly”.
The Interim Report suggests that regulators focus too much on protracted, negotiated settlements and other out of court arrangements, with minimal consequenuces for the offender. So the punishment does not fit the crime. The alternative of seeking appropriate penalties through the courts is rarely followed. These arrangements may to some extent compensate consumers but do not provide any incentive for the financial services provider to avoid misconduct in the future. The likely result is that regulatory compliance, and any related penalties for non-compliance, is seen as a cost of doing business.
The following quotes illustrate the key points made in the Interim Report:
“When misconduct was revealed, it either went unpunished or the consequences did not meet the seriousness of what had been done. 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.” (emphasis added)
“When deciding what to do in response to misconduct, ASIC’s starting point appears to have been: How can this be resolved by agreement?
This cannot be the starting point for a conduct regulator. When contravening conduct comes to its attention, the regulator must always ask whether it can make a case that there has been a breach and, if it can, then ask why it would not be in the public interest to bring proceedings to penalise the breach. Laws are to be obeyed. Penalties are prescribed for failure to obey the law because society expects and requires obedience to the law.”
Source: Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Executive Summary, page xix (first para.) and page 277 (second and third paras.).
The really interesting question is why have regulators taken this approach? Lack of resources? Perhaps but the Royal Commission does not accept that the solution to scarce resources is to avoid all compulsory enforcement action. So regulatory capture by industry? The answer is not entirely clear but will no doubt be explored in the Final Report.
Factor No. 3: Perverse incentives in remuneration and commissions
The payment of sales – based remuneration and commissions to senior executives, staff and intermediaries is seen as especially problematic. Put simply, the concern is with payments which incentivise those to whom it is paid to act in their own interests rather than those of the consumer.
To quote the Interim Report:
“ … value- and volume-based remuneration for intermediaries in the home loan industry has been an important contributor to misconduct and conduct falling short of community standards and expectations and poor customer outcomes.”
Source: Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, page 61.
Should volume and value – based commissions be banned? This critical issue is raised in the Interim Report in the context of home loan intermediaries and financial advisors. However it is equally relevant to other third parties – including agents in developing financial markets dealing with vulnerable consumers.
Factor No. 4: Thinking “responsible lending” means assessing the lender’s credit risk, rather than the suitability of the credit for the consumer.
Many countries, and international good practice standards, require lenders to engage in “responsible lending” practices. In summary, the requirement is usually for the lender to assess the suitability of the credit for the consumer in question, having regard to their personal circumstances (such as their financial needs, objectives and situation). There may also be an obligation to verify the information that is provided by the consumer.
The Interim Report notes a number of important points in relation to Australia’s responsible lending laws, which may also be relevant elsewhere. Perhaps the most important cooncerns mistaking credit risk assessments for meeting responsible lending obligations:
“… Credit risk is an inquiry that prudent lenders have always made. The responsible lending provisions of the NCCP Act introduced new and additional requirements. They require more than the lender being satisfied that the loan is an acceptable credit risk.”
Source: Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, page 24.
So, responsible lending is not just about assessing credit risk for the lender. This is the case in at least Australia, and is likely to be so in other countries. Some other observations in the Interim Report may be of interest in this context (in summary) :
- Regard should be had to expenditure as well as income in assessing a consumer’s financial situation;
- A particular consumer’s financial situation will not be revealed by a general statistical benchmark on household expenditures;
- Verification of a consumer’s information “calls for more than taking the consumer at his or her word”; and
- A lender cannot avoid their responsible lending obligations by using a third party to make the necessary inquiries.
Factor No. 5: Vertical integration of financial service providers
The issue here is whether the vertical integration of product manufacture, sales and advice entites is likely to create a culture where mis-selling and poor advice flourish. For example, banks may acquire insurance, funds management and investment advice businesses. The Interim Report notes the potential for vertical integration to promote efficiencies, which could then be passed on to consumers with lower costs and ease of access to financial advice. However these structures may lead to the cross – selling of products to consumers which they may not want or need, as well as having adverse effects on compeititon.
“Vertical integration promises the virtue of efficiency, which is then passed on to consumers in the form of lower costs and greater access to financial advice. Customers may also enjoy the simplicity of dealing with just one institution. But the internal efficiency of the ‘one stop shop’ does not necessarily produce efficiency in outcomes for customers. The one-stop shop has an incentive to promote the owner’s products above others, even where they may not be ideal for the consumer.” (emphasis added)
Source: Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, pages 79 / 80 and footnote 25.
So should there be restrictions on vertical integration of financial service providers? That is the critical question.
What is the best way to deal with misconduct?
More laws? Simpler laws? The Interim Report does not suggest more laws are the answer and is seeking views on the issue. The following extract from the Executve Summary highlights their thinking (bearing in mind that licensed financial service providers in Australia are already required to do all things necessary to ensure that they provide financial services “efficiently, honestly and fairly”):
“What can be done to prevent the conduct happening again?
Passing some new law to say, again, ‘Do not do that’ would add an extra layer of legal complexity to an already complex regulatory regime. What would that gain?
The basic ideas are very simple. Should the law be simplified to reflect those ideas better?”
Source: Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Executive Summary, page xx.
More enforcement through the courts? The Interim Report does not specifically recomemnd such action but it would seem likely, given the comments about current regulatory practices, that the Final Report will make recommendations in this regard.
We await with interest the Final Report, which is due on 19 February 2019. For now the implications of the above misconduct issues, and possible solutions, are well worth reflecting on in all countries and especially those seeking to promote responsible financial inclusion.
Financial Inclusion – Regulatory Design
 I stress that these factors are my own interpretation of the Interim Report. Further, the Final Report of the Royal Commission (which is due on February 19, 2018) may suggest other factors, as well as making policy recommendations.
 Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, page 54 and following.
 Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, page 24 and 56.
 Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, page 286
 Source: Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, page 55.
 Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, page 24 and following
 Section 912A of the Corporations Act 2001 (Australia)