Commissioner Kenneth Hayne and his staff have done a good job, and rightly, he now has an exalted place in Australian financial markets history. It's almost sacrilege to criticise, but either due to the limited time allowed, the mandate or his focus, the work was not perfect.
The lack of time was somewhat self-inflicted. Many months ago, as someone who watched maybe 100 hours of hearings, I became frustrated with the amount of time the Commission was spending on a few issues. I wrote this editorial on 10 August 2018:
"Okay, we get it, please move on. The Royal Commission is doing great work uncovering poor practices in financial services, but after nearly three days on superannuation, it had interviewed only one company. The witness list has 16 entities on it. We already know from Round 2 in April that there is a systematic problem with advice fees. I have listened to a dozen hours of the Commission this week and we have run around in circles with two MLC/NAB witnesses, and one has returned for more questions today on Day 4 ...
There's so much else it should address: performance reporting, fee calculations, rates paid on cash, valuations of unlisted assets, definition of 'defensive' assets (credit, property, alternatives), performance fees, active managers hugging the index, risk versus return, bid/offer prices, etc. And what about the dubious banking practices which have changed little in the 20 years since I wrote Naked Among Cannibals?
These issues will have more long-term impact on the vast majority of customer returns than charging fees for no advice or to dead people. I hope the Commission does not run out of time."
How Hayne rewrote the rules and achieved strong results
Hayne set new standards of enquiry which will lead the way for regulators. We knew something was unique from the moment the Commissioner aggressively pointed his finger at National Bank's counsel, Neil Young QC, who was questioning why his client needed to return the next day. Young had said, "On our instruction, her answer will be that she had no involvement in these matters." Hayne hit the roof.
"You will not give her her answer, Mr Young. You will not. Do you understand me?"
And barely a peep was heard from any QC for the rest of the year.
The Royal Commission struck gold with a simple approach. Prior to the commencement of hearings, financial institutions were given the opportunity to come clean with their past mistakes. Hundreds of pages of misdemeanors flooded into the Commission, and thereafter, the skilled QCs assisting Hayne played back the admissions before embarrassed executives. Rowena Orr's 'Let me show you a document' become a chilling phrase. Witnesses were forced to admit the sins of themselves, their companies and colleagues, and along the way, many did not survive. Sam Henderson, Terry McMaster, Chris Kelaher, Craig Mellor, Catherine Brenner, Andrew Hagger, the four majors, AMP, IOOF and many more became victims.
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Major issues missed by the Commission
Acknowledging the Royal Commission did a great job in shining light into dark corners, what did it miss, touch on or struggle with?
1. How banks price their products
Banks and other financial institutions offer a vast array of services. They are effectively the 'plumbing system' of the economy, especially in providing payment systems and intermediating between borrowers and lenders. Yet it is not difficult to find vital services which received little or no Commission attention.
Take the example of the way banks price their products. Why do the banks rollover the term deposits of existing customers at sub-market rates, forcing loyal customers to make a phone call to achieve a better rate? The vast majority can't be bothered or don't know the benefits, and what banks call 'retail inertia' makes a major contribution to interest margins. Why have credit card rates remained above 20%, when the poorest customers without the ability to pay off their cards each month suffer the most? Why do new customers receive lower mortgage rates than existing? Ross McEwan went to RBS in the UK after he missed the CBA CEO job to Ian Narev, and he said in 2014 that he found it,
"... absolutely abhorrent that you would give a new customer a better deal than someone who has been with you for 30 years."
I have written extensively on the subject of how banks price their products to protect profits, including in this article. For me, failing to address this was Hayne's biggest shortcoming, because it affects millions of Australians in their everyday banking. Instead, the Commission spent day after day on financial advice and issues such as 'charging fees to dead people' which impact a relatively small number of people.
2. Difficulty pinning down culture
The complex subject of 'culture' seems at the heart of the problem in banks, but like many before him, Hayne struggled to define and grasp it. The most common phrase in response to the Commission will be 'rebuilding trust', which is convenient because there's no real way to measure it.
In the Final Report, Commissioner Hayne said:
"Too little attention has been given to the evident connections between compensation, incentive and remuneration practices and regulatory, compliance and conduct risks."
But what to do about such a culture?
A significant problem is how to define community expectations. A leading law firm, Allens, told The Australian Financial Review that while Hayne was extremely well placed to opine on matters of the law, he had no special expertise in deciding a benchmark for community standards. Banks do not have one dominant type of culture, although Hayne said poor behaviour could be traced to the pursuit of profit over other purposes.
We have written more on culture here.
3. Accessing the financial advice that people need
It's well established that most people are unwilling to pay enough for financial advice to cover the cost of providing the full service. Many financial advice groups are thriving by servicing wealthy clients, willing to pay 1% or $20,000 a year for advice on a $2 million portfolio (and of course, much more). But charge 1% on $50,000 and $500 pays for two hours with a decent adviser, which is barely enough time to crank up the spreadsheet let alone have a decent conversation and produce the obligatory 70-page Statement of Advice.
The large banks addressed this problem by cross subsidising, selling their own products such as managed funds to help pay for advice. This led to the claims of not putting the clients' best interests first and favouring in-house products.
The end result of the criticism is banks stepping away from providing financial advice and fewer Australians having access to the services they need. Long-term planning and retirement incomes are likely to suffer as a result. Financial advisers do not only focus on investing, but they address aged care, social security entitlements, superannuation structures, estate planning ... on it goes. Is it better that the bank teller will send the bank client to the adviser in the office above the real estate agent, and hope the conflicts are less there?
The unclear mix of a sales culture with provision of financial advice confused the best interest duty of advisers for their clients. The revelations at the Royal Commission have further undermined public confidence in financial advisers, and are no doubt partly responsible for the outflow from retail funds to industry funds. But most industry funds have modest advice businesses, often focussed on limited or 'scaled' advice given the difficult economics of servicing members with low balances.
4. Fund commissions remain in certain sectors
Hayne has come down hard on commissions paid by product manufacturers to financial advisers, recommending a banning. But what about commissions by another name, such as paid by new issuers in Initial Public Offerings (IPOs) on the ASX? Commonly, the issuer will pay the lead broker and other brokers a 1% or more selling fee. Some brokers then offer this to financial advisers to sell the IPO to their clients, and while some advisers may reimburse it to clients, many do not. Why is a financial adviser prohibited from accepting a commission from a fund manager for an unlisted fund under the Future of Financial Advice rules and now Hayne's recommendations, when a Listed Investment Company from the same manager indirectly pays the adviser a fee?
5. Underestimating the competitive role of mortgage brokers
According to a Momentum Intelligence survey of 5,782 borrowers, 79% were not concerned that brokers are paid commissions by banks. The report, called Consumer Access to Mortgages, found 96% of people who use or intend to use a mortgage broker would be unwilling to pay the average upfront commission of $2,000 that banks pay to settle a mortgage. There was a perception among those surveyed (who may not represent the entire population) that brokers source the best loans and deliver the widest choice. Of course, the Royal Commission and some bank CEOs have offered different examples of brokers acting in their own best interests with poorly-structured incentive schemes.
If the service were not available, a competitive force would be removed with borrowers dealing directly with the banks with the biggest branch networks. A KPMG survey says mortgage brokers have helped reduce net interest margins of the banks by up to 20% in the last 10 years through increased competition.
In the interests of full disclosure, it should be noted that Momentum Intelligence is part of a media group that publishes titles aimed at mortgage brokers and real estate professionals. Nevertheless, with brokers now commanding a market share of mortgage origination of over 50%, it's easy to see how a ban on payments by banks to mortgage brokers will increase the power of the big banks.
In the Final Report, mortgage brokers will be subjected to a best interests duty and a ban on trail commissions from July 2020. Many brokers argue they provide a significant ongoing service, but Hayne rejected this, saying:
"The chief value of trail commissions to the recipient, to put it bluntly, is that they are money for nothing."
In the only exception to agreeing to implement all 76 recommendations, Josh Frydenberg said the Government would delay its decision on Hayne's call for upfront commissions to be banned and replaced by a customer-paid fee.
In response to the Final Report, Peter White, the Finance Brokers Association of Australia Managing Director, said,
"If a user-pays model was implemented, we know that most borrowers wouldn't pay, and banks would make more money and standards would drop further. It's very disappointing that the Royal Commission wants to destroy some 20,000 small businesses for the monetary gain of the big banks, and we trust the government will see clearly on this and continue to work extensively with our industry to improve consumer outcomes."
6. Industry funds escape detailed scrutiny
If the Productivity Commission recommendation on choosing the 10 'Best in Class' superannuation funds as defaults is adopted, industry funds are likely to dominate and their success will be further consolidated. Retail funds will struggle to compete. As the dominant institutional provider of retirement savings, Hayne should have explored some of the criticisms levelled at them more.
Instead, we are left wondering if the claims of competitors such as retail funds have merit. Examples include the methods used to value unlisted assets, which carry a higher weight in industry fund portfolios than in retail funds. The role of union members as directors of the boards of industry funds and the extent to which their board fees are paid to their unions and ultimately to assist the Labor Party, was overlooked. There was some scrutiny of entertaining at major events and industry funds spending millions a year on The New Daily publication, but the not-for-profit sector enjoyed the Royal Commission.
7. Financial advisers have a right to charge 'fees to dead people'
It's a great headline and the type of phrase people can easily recall, and on the surface, it sounds terrible to charge 'fees to dead people'. But the profession (the legal people at the Commission) arguing financial advisers should not victimise dead people is the same profession that often charges 'fees to dead people'. When a lawyer handles the will of a dead person and helps to administer the estate, do they do so with a feeling of sadness and benevolence and not charge fees? Of course they don't, it's a major part of many legal practices.
Financial advisers often have considerable work involved with an estate. Accounts remain open until probate, the process of proving and registering the will of a deceased person with the Supreme Court. When a person dies, many people are involved with their estate, and the executor of the will administers the estate and handles the disposal of assets and debts. Is the financial adviser the only one who is not supposed to be paid?
8. Lack of financial literacy taught in schools
At the heart of many issues uncovered by the Royal Commission is a community with poor overall financial literacy. Many people do not know which superannuation fund they are in, its cost and features, they pay for insurance they don't need or can't claim on and hold multiple accounts with duplicate fees. They carry credit card debt costing 20% and buy properties off-the-plan from spruikers.
Okay, this was a 'misconduct' Commission, but with both the Government and Opposition promising to implement recommendations, it was an opportunity to direct funds to education and help better-informed people make educated decisions and reduce the misconduct opportunities in future.
Finally, back to the earlier point, what about ...
... performance reporting, fee calculations, rates paid on cash, definition of ‘defensive’ assets (credit, property, alternatives), performance fees, active managers hugging the index, risk versus return, bid/offer prices, etc.
Feel free to add any comments on other issues the Royal Commission could have addressed.
Graham Hand is Managing Editor of Cuffelinks.