After weeks of embarrassing and alarming revelations about dodgy financial dealings, Prime Minister Malcolm Turnbull admitted he made a political mistake by resisting calls to hold a royal commission into the banks.
It wasn't an apology, more an acknowledgment that the airing of dirty linen can serve a useful purpose. The biggest banks have been humiliated. The Commonwealth Bank, for instance, has admitted charging dead clients for financial services. And financial service company AMP’s fee-for-no-service confessions wiped $2.2 billion from its market value during the commission’s two-week financial advice hearing – its chief executive and chairwoman have both resigned.
When the royal commission was announced last November, Monash Professor of Finance, Kevin Davis, wondered whether its terms of reference would be too vague to be of practical use. But he now concedes that “sunlight is the best disinfectant”.
Many of the issues uncovered by the royal commission were already the subject of inquiries by the Australian Securities and Investments Commission (ASIC), and the Australian Prudential Regulation Authority (APRA), he says, but the public may have remained unaware of them. Official reports, evenly sternly worded ones, and enforceable undertakings lack the drama and interest of a cross-examination before a royal commission.
For instance, APRA’s final report into the Commonwealth Bank’s “governance, culture and accountability” was released on 1 May. The APRA inquiry was a response to a number of incidents over the previous decade that had damaged the bank’s reputation. These included breaches of money-laundering and anti-terrorism financing laws; fees for no service in financial advice; use of an outdated definition of heart attack in its CommInsure insurance products; and mis-selling of credit card insurance.
One breach dated back to 2008 and concerned the mis-selling of marginal loans to retail customers investing in financial products recommended by Storm Financial.
Storm Financial’s collapse caused losses of more than $3 billion, leaving about 3000 of its 14,000 client base destitute.
In 2012, the CBA announced it had made a resolution with ASIC to make up to an additional $136 million available to customers who invested through Storm Financial. The payments the CBA provided to customers, including the ASIC settlement, was around $270 million. ASIC’s Storm-related litigation finally ended in March this year – almost a decade after the initial collapse – when the Federal Court imposed civil penalties of $70,000 each on the company’s Townsville-based directors, Emmanuel and Julie Cassimatis.
In its final report on the Commonwealth Bank, APRA found that the bank’s “continued financial success [had] dulled the institution’s senses”.
The report also spoke of “overly complex and bureaucratic decision-making processes”, “unclear accountabilities” and a board that did not adequately oversee or challenge “emerging non-financial risks”.
The bank has agreed to implement APRA’s recommended reforms in a “timely manner”. APRA has also added $1 billion to the bank’s minimum capital requirement until the changes are completed to its satisfaction.
Moral purpose clouded
Professor Davis says the banks have lost a clear sense of moral purpose.
“Shareholder value has become the mantra, the guiding force at the top of organisations, and when you feed that down an organisation, shareholder value gets equated with the attitude that our objective is to make profits … or ‘How much can we get out of this deal?'. As opposed to saying, ‘Any transaction we’re engaged in, both parties should benefit’.”
The principle of mutual benefit is not new, and was well understood when AMP was formed in 1849 as a non-profit life insurance company and mutual society.
“There was no separate set of shareholders,” says Professor Davis. “And there was a good reason for that, because if you're taking out a long-term life insurance policy, you would like to think that the insurer is going to be around for 50 years without there being the risk of shareholders chasing short-run profit through risk-taking to your possible detriment.”
Stock exchanges used to be mutual organisations, too. Credit unions and building societies in Australia have retained the model, as have some European banks.
Market economies work best when transactions are “between people who have equal information”, he says.
“They will only enter the transaction if they believe they're both going to benefit from it. Whereas in the finance sector it’s typical that one person has all the information, and therefore you have a real risk of allowing transactions without any regulatory oversight, and that the person without the information – the customer, generally – will be the loser.”
The Storm Financial investment strategy, for instance, relied on the stock market always rising. Investors were encouraged to mortgage houses and to take out loans that they wouldn't be able to repay if the stock market fell – which it did in 2008, during the Global Financial Crisis. Although the big banks didn't devise Storm’s investment strategies, they allowed their customers to take out the loans.
“Shareholder value has become the mantra, the guiding force at the top of organisations, and when you feed that down an organisation, shareholder value gets equated with the attitude that our objective is to make profits."
Despite the royal commission’s revelations, Professor Davis says Australians are, generally speaking, satisfied with their banks.
By international standards, APRA is considered to be a tough regulator and has done a good job of ensuring that the money entrusted to Australian banks is in safe hands.
“But clearly with those big organisations, which are pretty good on balance, there's always the risk that some aspects of the business are going to lead to wrong behaviour. And the internal governance, reporting, remuneration and so on isn't set up in a way to weed that out and stop it in its tracks.”
Are the banks too big?
Professor Davis says one set of problems has emerged as the banks have set up additional services such as insurance and financial planning – a process he calls horizontal integration.
“They've trashed their reputations by going into all these other areas that they can’t control, but they're small compared to their core business,” he says. “The amounts involved are trivial compared to their actual profits. And the banks are already getting out of these things.”
Other issues have been caused by financial planners recommending financial products linked to particular companies – a process he calls vertical integration.
“That’s a problem, because you’ve got potentially wrong incentives, and it’s also to some extent anti-competitive in that whole advice space, because advisers get locked into this.”
Professor Davis participated in the Australian Financial System Inquiry led by David Murray. He said among the recommendations they made in 2014 was that customers be made aware of an adviser’s links to a particular company, be clearly informed about how the adviser is paid (to avoid hidden or trailing commissions), and that steps be taken to ensure that the products offered are safe and reliable.
The government accepted most of the recommendations, although their implementation and effects are still working their way through the system. The royal commission is now re-examining the terrain.
“A lot of bad stuff happens outside of the banking sector,” Professor Davis says. “There’s lots of crooks out there, basically. There is always another sucker. It’s easy to get into finance to try and scam people, because you're exchanging money for promises … There's always potentially more scope for scamming in the world of finance.”