The Financial Services Royal Commission released its much-anticipated Interim Report on 28 September. Volume 1 (of 3 volumes) itself, at over 115,000 words, would fill around 400 pages in a paperback book.
There is a heavy emphasis on how the industry created the wrong incentives. The most illuminating paragraph in a sea of damnation occurs on page 301, Chapter 9 (Entities: Causes of misconduct, sub-heading, ‘Culture, governance and remuneration’):
“All the conduct identified and criticised in this report was conduct that provided a financial benefit to the individuals and entities concerned. If there are exceptions, they are immaterial. For individuals, the conduct resulted in being paid more. For entities, the conduct resulted in greater profit.”
And, further:
“The conduct that is at the heart of the Commission’s work is inextricably connected with remuneration practices, with deficiencies in governance and risk management and with the culture of the entities concerned ... And every piece of conduct that has been contrary to law is a case where the existing governance structures and practices of the entity and its risk management practices have not prevented that unlawful conduct.”
The Commissioner states an intersection between psychology and finance thus:
“An employee will treat as important what the employee believes that the employer generally, or the employee’s supervisors and peers, treat as important. When the employee and others in the organisation, including the employee’s supervisors and peers, are remunerated according to how much product they sell, or how much revenue or profit they contribute to the entity, sales or revenue and profit are treated as the goal to pursue. How the goal is pursued is treated as a matter of lesser importance.”
In other words, human beings are hard-wired to respond to incentives.
The wrong incentives can corrupt the most revered of professions
In 2009, economist Steve Levitt teamed up with Stephen Dubner, a journalist, to show that economics is, at root, the study of incentives - how people get what they want or need, especially when other people want or need the same thing. ‘Freakonomics’ (and its successor, ‘Superfreakonomics’) explored, among other things, the inner workings of a crack gang, the truth about sumo wrestling and the secrets of the Ku Klux Klan. Laced with dry humour and fascinating anecdotes, the lessons apply to all areas of life, including and especially commercial ventures.
The essence of the methodology is that data on outcomes reveals actual preferences much better than surveys, which demonstrate only expressed preferences. Even in blind surveys, people hardly respond with “Yes, I will behave dishonestly to gain more for me.”
Levitt's study of sumo wrestling is a good example of incentives gone wrong. In addition to Freakonomics, he co-authored a paper asserting that corruption existed in sumo, a revered, centuries-old professional sport, steeped in Japanese tradition. Levitt argued that the scoring system incentivised throwing matches at certain points in the tournament.
The Japanese Sumo Association (JSA) was shocked of course. How dare these Americans insinuate that sumo is corrupt? But in 2011, the JSA conceded after conducting its own investigation that match fixing was indeed widespread. It expelled 23 wrestlers and cancelled that year’s Grand Tournament in Osaka, the first time of such occurrence since 1946.
What was the problem with sumo incentives? When Levitt was asked whether he expected tennis players to throw matches the way sumo wrestlers had done, his response was:
“There is something absent from tennis that is present in sumo wrestling: a highly non-linear incentive scheme. The eighth win in a sumo tournament is worth far more than a sixth, a seventh, a ninth, or a tenth win. As such, the sumo wrestlers themselves can see strong gains from trade. In tennis, however, the only apparent incentive at work is bribes related to gambling. The lack of incentive for tennis players to trade wins has to mean that endemic cheating is far less likely.”
Vertical integration under fire
The word 'remuneration' occurs over 200 times in the Interim Report. 'Greed' only occurs nine times, 'dishonesty' only five times, despite what the report calls the recurrence of two themes, being greed and dishonesty. The report correctly forecasts that:
“Eliminating incentive-based payments for front line 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. The behaviour that the manager will applaud and encourage is behaviour that yields sales or revenue and profit. The behaviour that is applauded and encouraged sets the standards to be met and forms the culture that will permeate at least that part of the entity’s business.”
Hayne is setting expectations, but what outcomes should we expect? It's not difficult to find examples in other industries similar to the vertical integration in financial advice that Hayne criticises.
Suppose we visit a travel agent. Let’s say, the same company that owns the travel agency also owns a specific airline, a large hotel chain, a tour operator, and a travel insurer.
As a consumer, should we expect our experience and outcomes to be different as compared to visiting an agency which receives similar commissions from most airlines, many hotel chains, tour operators, and travel insurers?
The short answer is yes. The former is a vertically-integrated travel conglomerate which no doubt has incentives to use in-house products. The latter has no incentive other than finding the best deal for the client.
The question Hayne asks is whether such vertical integration should be allowed to continue in financial services. It is almost the bedrock on which our system has developed. For example, the Reserve Bank of Australia said this back in 1996 when the trend toward conglomeration in finance accelerated in the nineties:
“Financial conglomerates are becoming an increasingly important feature of the Australian financial system. A conglomerate is essentially a number of financial institutions under common ownership or control and operating in more than one of the main financial sectors of banking, insurance, funds management and securities.
“Over the past decade, technological and regulatory changes have encouraged many institutions to expand their activities beyond traditional areas of operation. Some life offices, for example, now have bank or building society subsidiaries. Banks have responded to competition from funds managers by establishing life office and other funds management subsidiaries which have been increasing their share of the funds management sector.”
This was a worldwide trend. In 1999, the US Congress passed legislation to permit bank affiliations with all sorts of financial enterprises. However, in 2002, Brookings Institution, a high-profile research agency, reported that:
“Investors do not necessarily welcome financial firms’ drive to become conglomerates or financial supermarkets … stock prices of (non-financial) multi-product firms generally sell at some discount relative to firms with more narrowly drawn product or service lines.”
Their report suggested that company performance in financial services is unrelated to size. The answer they receive to the question, “Are economies of scale and scope so compelling that the future must inevitably belong to the largest financial conglomerates?” was a firm 'no'. Perhaps the breaking up of Australian vertically-integrated businesses will create value rather than destroy it.
And this is even before we factor in the benefits arising from the correct application of fiduciary duties of bankers, trustees, financial planners and financial advisers toward their clients.
Struggle to reconcile fiduciary duty and cross selling
Perfecting a governance system that adequately addressed fiduciary duties while cross selling wasn’t thought through, and it may well be too hard. With the sale of their wealth arms or their insurance businesses, many Australian conglomerates have already conceded this by their revealed preferences even though the expressed preferences are customer apologies and ‘this time, we will do it right’.
Trimming the entities down won’t solve the problem, but it should make it easier to structure incentives correctly. Kenneth Hayne, however, is on a different path:
“The unstated premise for so much of the debate about remuneration of both bank staff and intermediaries, that staff and intermediaries will not do their job properly and to the best of their ability without incentive payments, must be challenged.”
Hayne is not providing answers in this Interim Report but asking numerous searching questions. Sceptical of more laws solving the problem, he is prepared to throw everything out there for questioning, from added regulatory and legal scrutiny to business structures, and even trying to solve the holy grail of how to ensure financial service employees act in the best interests of the client.
Vinay Kolhatkar is Assistant Editor at Cuffelinks.