Notes for an address by David Murray to American Chamber of Commerce in Australia 20th June 2018
By their nature, Royal Commissions are hard hitting inquiries. Recall previous Commissions into natural disasters where the line of forensic investigation goes to the most heart wrenching incidents, for example people killed in their cars trying to escape from bushfires. Unless this is done, the Commission is unable to determine what standards or accepted procedures need to change – such as building standards or evacuation procedures. But in making recommendations it is not possible to eliminate all risk.
This Royal Commission is no different. While it is not dealing with loss of life it is dealing with the essential element underpinning the operation of the financial system, namely, trust and confidence.
It is clear there has been a breakdown of trust in financial services as a result of misconduct by institutions which has bought significant reputational damage to them and the system as a whole.
There are now some clear themes emerging from the proceedings of the Royal Commission. From a public perspective, the apparent extent of misconduct has received widespread coverage partly because of the approach the Commission has taken to self-confessions and selected case studies. In dealing with this, the Royal Commission will have to consider the incidence of mistakes and their severity as no aspect of commerce can be regulated to eliminate all risk.
What is clear, however, is that Australia already has a significant body of statute law dealing with misconduct. Recommendations of the Royal Commission will therefore have to take into account why the law was not obeyed or enforced.
This will require consideration of the law relating to commerce generally and to the finance sector in particular. Many of the Commission’s observations relate to general legal constraints on commerce such as deceptive and misleading conduct, goods of non-merchantable quality, anti-competitive behaviour, and conduct which is not careful, diligent, efficient, honest or fair.
In short, there seems no shortage of laws and the Financial System Inquiry in 2014 recommended a number of changes, many of which are still being implemented.
In making its final recommendations, the Royal Commission is required under its terms of reference to take into account the implications of any changes to laws for the economy, users of the system, competition and stability. In doing so the Commission might take into account:
• Whether the application of general commercial law should apply evenly to the financial sector and non-financial sectors of the economy;
• The special reasons for financial services regulation, namely; The avoidance of monopolistic competition; Managing the asymmetry of information where one party is unfairly advantaged with knowledge; Self-amplifying price spirals, which can lead to systemic failure and economic hardship.
• The roles and responsibilities of the regulatory agencies in enforcing the law; and
• Whether additional measures are required to encourage compliance by financial institutions.
Today I would like to suggest how the Commission might think about its recommendations in three areas, and provide some overarching principles for application of the law. Those areas, each of which address the interests of users of the system, are: Financial advice, Residential mortgage market and Culture.
Following the Future of Financial Advice reforms in 2012, the Financial Services Inquiry in 2014 made significant recommendations regarding the provision of financial advice.
The rationale for the FSI’s position was that the Wallis inquiry’s approach to transparency through product disclosure statements had not been sufficient to deal with the information asymmetry that works against the consumer in financial advice.
The FSI recommended a targeted and principles-based product design and distribution obligation, proactive product intervention powers, the disclosure of risks and fees to customers, powers to deal with remuneration structures and banning of advisers, and raising professional competencies. In addition, the FSI recommended better funding; increased powers and a capability review for ASIC.
Much of the evidence at the Royal Commission to date has already demonstrated the importance of these recommendations with respect to the best interest of consumers. Accordingly, the Commission will need to consider what further actions might be needed and/or whether the strengthening of the enforcement and compliance regime under the new arrangements will be sufficient. Clearly one issue is that of vertical integration, which the FSI did not consider to be a main concern.
Neither the United Kingdom nor United States have banned vertically integrated models. In the United Kingdom, legislation sought to increase transparency and fairness in the mid- to late-2000’s through the Retail Distribution Review (RDR).
In many ways, the RDR broadly achieved its aims for consumers of advice, as:
• Entry-level and continuing education standards of advisers increased;
• Consumers were sold a more balanced mix of products, with high commission products significantly reduced; and
• Greater transparency was created for consumers regarding whether the adviser was independent or aligned to a product manufacturer.
However, following the implementation of the RDR, an ‘advice gap’ emerged in the mass-market, where individuals were unable or unwilling to afford the upfront costs associated with advice.
There was also a large-scale exit of advisers from the industry, driven by independent advisers who could no longer profitably service the mass-market, and by large financial institutions withdrawing from mass-market advice.
As the impacts of the RDR are felt, the UK government is considering amendments to the legislation in light of concerns that the market for financial advice is not working well for consumers, including recommendations to reduce the barriers to access financial advice through automated models and allowing consumers to pay for advice from pension balances.
In Australia, the advice industry requires professionalisation and financial advisers need to become financial advice practitioners. Reforms to this end are already in place, and time is needed to determine the outcomes of these existing reforms before additional regulation is considered.
A recent industry report suggested the implementation of the FASEA educational standards will lead to a decline of 6,500 advisers by 2024. Innovation in the industry is required to provide a workable solution to address this ‘advice gap’, for example with automated advice. Given the importance of good advice for consumers and the knowledge gap, it is hard to envisage a world without the need for face-to-face advice.
Australia will see an ageing population and increasing life expectancy over the coming years, increasing the population aged over 65 from 3.8m people today to 5.2m people by the end of the next decade. Retirement management is therefore becoming increasingly important: for more and more individuals who need to set themselves up for a comfortable life in retirement; and for the Government who will need to manage the economy through these challenging dynamics.
A robust financial advice system is necessary to help individuals chart a course through retirement and alleviate the taxpayer burden from longevity risk. This system must be a source of consistently sound financial guidance which can be accessed widely and relied upon.
Should legislation target vertically integrated business models, it risks the removal of the significant sources of support for financial advice that exist today.
Substantial consumer benefits can be derived from vertically integrated business models as a result of their scale and access to capital. They have resources that can fund the investments needed support large scale product and advice platforms, can support systematic and comprehensive customer remediation in the event of misconduct, and can develop compliance systems that will evolve with regulation.
The issue for the Royal Commission will be that increasing number of users of the financial system will not be able to acquire affordable financial advice. To deal with this it would be better to prohibit activities rather than business models. For example advisers should not receive product or distribution based fees but can adapt their remuneration to fees for professional advice once only or as a percent of an investment portfolio where the interest of the adviser and consumer are aligned.
Fundamentally the corollary of regulation for information asymmetry is the need to ensure that affordable advice is available.
The residential mortgage market
The issue with lending is the opposite. The difference between financial advice and lending is that information asymmetry works against the consumer in advice but for the consumer in lending.
Central banks have long known and written about this in the context that the knowledge gap (where the borrower invariably knows more about their circumstances and prospects than the lender) creates inefficiencies in the credit market which can distort the transmission of monetary policy.
Banks lower the overall risk of lending in the economy by managing the information asymmetry that exists between lenders and borrowers, and the moral hazard and adverse selection problems that arise from this asymmetry.
The idea that lenders should make reasonable inquiry of a borrower is fair in that it limits malpractice and serious mistakes where some people should never have borrowed. Where lending is clearly accompanied with advice, for example to leverage assets into further investment, then the advice regime should apply.
However for the credit market to work in the best interest of the economy, borrowers should be able to be held to the representations they make in their applications which form part of the loan contract. If they are not, or are able to use responsible lending laws and guidelines to avoid loan obligations, two consequences may follow:
• Firstly, moral hazard, in which the knowledge of potential debt avoidance encourages increased borrowing for higher risk assets with increased risk of asset bubbles and systemic risk in the economy - a similar outcome to the ‘hand back the keys’ rules in the US which compounded the GFC; and/or
• Secondly, A response by lenders in which they reprice and/or ration credit in which case the more creditworthy in the community can borrow and other others, particularly first home buyers must find loans at more onerous terms elsewhere
The FSI did not receive any substantive submissions on responsible lending law which had been in place since 2009. Clearly cases and precedents have begun to emerge since.
In the interest of an efficient and effective credit market the law should only apply to those situations where the borrower’s representations in applying for credit are clearly inconsistent, meaning that the lender must make some inquiry and judgement. However the law is framed, two other conditions should be met:
• The regulator should not set up prescriptive guidelines effectively determining the procedures by which the market creates credit; and
• Any agent or broker acting on behalf of borrowers should be liable for compliance and should stand with the borrower in any representations made in the loan contract.
This latter requirement would require mortgage brokers to carry insurance against claims, as others do in like situations in the financial sector.
For mortgage brokers this leaves the issue of transparency about for whom they act and the value proposition to their clients. It would be a retrograde step to deny borrowers the value of ‘shopping around’ afforded by brokers. But if they do not know the cost, they cannot make the trade-off. Accordingly any commissions should be disclosed by the broker and made visible by the lender in the loan statement, as happens with lenders mortgage insurance.
This approach poses a dilemma for lenders. At present, residential mortgage loans are priced on the basis of a standard variable rate less discount (if applicable). As an established market practice this has left the industry vulnerable to the allegation of gouging when interest rates change due to the slower repricing of the ‘back-book’ which has been of concern to the Productivity Commission and others.
This pricing methodology varies from more established practice for other variable rate lending, which is typically priced from a base rate (for cost of funds and volume and other costs) plus a margin for risk for the individual loan. Under this approach it is much easier to add third-party costs, making all of the loan costs more transparent to the borrower and overcoming the ‘front-book’ / ‘back-book’ problem.
For the industry to move to this requires a first mover – a very tricky decision. It is therefore open to the Commission to recommend some form of reference to the ACCC to allow industry practice to change.
These suggestions on responsible lending, mortgage broking and loan pricing address the Commission’s mandate with respect to system users, competition, efficiency and productivity in the largest part of Australia’s credit market. Against the backdrop of high house prices and household indebtedness, this is an area for very careful consideration.
As to the relative roles and responsibilities of regulators, the systemic dangers of moving from caveat emptor to caveat venditor in the lending market suggest that oversight of any responsible lending legislation should be with APRA.
Whereas further legislative changes have and could be made in financial advice and mortgage lending, the question arises whether changes to the law can be effective in changing culture.
APRA’s report on culture at CBA has received widespread attention in Australia and elsewhere, and will be an important consideration for the Royal Commission.
The definition of culture is critical together with the way in which an effective culture is engendered in an organisation.
Culture is the set of beliefs of those working in or with an organisation about behaviours which are acceptable and unacceptable. There are three mechanisms or tools available to leaders to develop effective culture:
• The systems of the organisation, its policies, rules, procedures, controls, etc;
• Behaviour of leaders themselves which reinforce or reduce the effectiveness of those systems – in military terms ‘what you walk past you condone’; and
• The signals and symbols transmitted in the organisation which affect beliefs about the systems;
So using this approach, what has gone wrong?
As discussed earlier, the proceedings at the Royal Commission seem to suggest there is no shortage of laws. So are they are unclear, not enforced, unenforceable or considered unimportant? We shall have to wait and see what the Commission finds because culture is relevant in each case. For example the law may be clear but not properly enforced, in which case the industry believes it is unimportant. Alternatively institutions may believe that any enforcement matter bought by the regulator can always be managed without material consequences.
Regulatory supervisory frameworks and surveillance approaches are intended to restore consumer trust and market integrity by enforcing a common understanding of minimum requirements, expected behaviour, and the consequences of failure.
However, regulation alone cannot drive a change in behaviour as it can result in a convergence of leadership models and organisational structures, and this limits diversity and competition.
Organisational behaviour is an intangible asset that is cultivated uniquely by each institution. This makes it hard to set prescriptive guidance and comprehensive minimum standards for all organisations.
Accordingly, it is impossible to regulate for culture, but APRA’s report suggests that a systems-based approach to culture is very valuable in supporting the prudential supervision framework. Trust will not be restored until institutions revisit existing governance frameworks that may be inhibiting cultural reform.
If the reasons why we regulate the financial system are to protect the users of the system, it makes no sense to adopt legislation which encourages financial inter-mediation to develop materially outside the financial sector.
Given the potential for moral hazard risk to create systemic risk in the financial sector and the economy, caution is needed in allowing contract law to drift from the principle of caveat emptor to caveat venditor. Nevertheless there needs to be protection for consumers given information asymmetry. Further, robust competition is more likely to exist when regulation, particularly around culture does not become a de-facto prescription for business models.
As the Commission turns its attention to the potential recommendations that will be based on its findings, some principles for consideration might be:
• General commercial law, notably the law of contract should not be different for the financial sector than the rest of the economy;
• The law should not drift too far from caveat emptor to caveat venditor;
• Information asymmetry requires that there should be some protection afforded to users of financial advice but not so much for borrowers; and
• Conduct regulation for culture would be ineffective, but the prudential supervision model can benefit from a systems-based approach to examination of culture in individual institutions.
From this point on the Royal Commission has to the potential to help the industry rebuild trust with the community. For this to happen, the industry’s dealings with Commission need to be focused on the special role of the sector for end users and the need to embrace more rigorous compliance with and enforcement of the law.