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Incentives at heart of Commission's findings

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.


Vinay Kolhatkar
October 02, 2018

Thank you, Ken. I have not read Kahneman's book, but I would be optimistic about human ability to stay objective. We rely on objectivity by judges, juries, bosses, colleagues, and even friends when they judge us.

Re insurance, the clearer and more comprehensive the policy is, the easier it is to assess claims. I am reminded of the movie where an insurance company denies a claim because it said "acts of God" were not covered in the policy, and the film's protagonist wins in court by arguing that earthquakes are caused by known physical and natural disturbances, and therefore, are not 'acts of God'.

Customer ratings, public feedback, tribunals, and of course, the threat of litigation, especially class action litigation, not to mention long-term stock price, would tend to keep insurance companies honest. Their management could have lower salaries and shares that vest after several years. Front-line salespeople could be assessed by independents posing as customers on the phone.

Incentives and monitoring is an area rich for research and betterment.

Vinay Kolhatkar
October 01, 2018

Thank you, Chris, this is true (that unaligned agents will not necessarily act in the client's best interest).

Yes, the experience is likely to be different but unaligned agents have varying commissions, and, as the saga about Flight Centre shows, even equal commissions do not solve the problem.

Integration is not a problem here because the travel agent is an agent of the principals, being airlines, hotels etc. and clients need to be well aware of this.

Thank you also for the e-bay suggestion. Large corporates like Telstra and the major banks have often not used client feedback well.

October 01, 2018

IF in the future you are refused a home mortgage, or are forced by your bank to refinance elsewhere, you get sick or suffer financial consequences due to having no life or disability insurance, and you cannot get access to a financial adviser and end up at Centrelink in retirement, just remember that this has been the inevitable outcome of the Labor Party and the Bank Royal Commission.

As this is now what life is like for many in the UK, which also fell victim to such foolish legislation.

So enjoy your life under Labor's version of trickle down economics, where under their model, hapless members of Industry Super funds enrich Union bosses. Nice work.

Chris Jankowski
October 01, 2018

The author says in his example:

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.

I would disagree with the author's conclusion. The independent travel agent, as described, still has incentives that are not aligned with the client:

1. Such agent is likely to sell product that gives him the highest commission. This is unlikely to be in the client's interest.
2. Obviously, they will try to minimize the resources they spend on preparing the deal. And the critical resource is their time. This behaviour may lead to proposing to clients whatever is on hand and most familiar. Not necessarily what would fit the needs of the clients best.

To resolve the first conflict of interest is easy in principle. The agent could refund all commissions and charge a separate fee for service. Note that truly independent financial advisers work this way. This is not easy in practice, as clients tend not to value services with such a fee attached and put straight in front of them.

To resolve the second conflict is harder. One way to do it would be to have a feedback based rating system similar to the one used by many on line e-commerce sites e.g. eBay for its sellers.

Vinay Kolhatkar
September 30, 2018

Hayne's report does acknowledge that banks and financial conglomerates are commercial entities with commercial imperatives, but also throws out there the sentiments that Garry Mackrell is quite rightly worried about.

Are there illustrations of where the tension between commercial imperatives and best interest obligations are well managed? I believe, yes. There will be exceptions everywhere. But many a law firm has been profitable, and they're required to represent their client's best interest.

A "Royal Commission" into virtually any industry would uncover wrongdoings.

But let's look at a simple example here. If real-estate agents get a flat fee such as 3%, they are motivated to not act in their principal’s interest. If a property is worth $900,000, the agent may get the appointment by saying he/she can get a million, and a few weeks later say the market has fallen so the seller’s expectations should as well. If the seller agrees, the agent has no incentive to try hard to get even $20,000 above the fair price of $900,000. Why? Because a sale at $900,000 results in a commission of $27,000 whereas $920,000 results in a commission of $27,600. Why work several extra weeks for another $600 (an extra $19,400 to the seller) when, in the same time for the same effort, another sale (with a $27,000 commission) can occur?

But if the agent received a zero commission for the first $800,000, then 10% for any amount up to $900,000, and 20% for any excess thereafter? The same agent will behave markedly different.

Setting aside the issue of whether banks are to be forced to have social obligations (I don't think they should), the answer to the question: Have financial conglomerates managed incentive structuring well? is, I believe, a No. Perhaps their remuneration consultants have been too busy defending the multi-million salaries and bonuses at the top or simply haven't been asked to analyse remuneration structures and incentives all the way down.

Incentive structuring across all levels is complex and hard to get right. How Berkshire Hathaway (Warren Buffett) does it for businesses it owns is a good start. Berkshire's very long-term price trajectory should be seen as one outcome of getting it right (or wrong). A lot more research is available and accessible. And it's arguable that not enough thought has gone into this at Australian financial organisations.

Ken Scott
September 30, 2018

I agree with the relevance of the truths demonstrated by "Freakonomics" & its successor.
Another set of truths that are re-shaping the way many of us approach decision-making are expressed in Daniel Kahneman's "Fast ans Slow Thinking". We are nowhere near as detached & objective as we pride ourselves on being. Our judgement is constantly distorted by previous experience and personal interest.
If we take these things seriously, we should expect, in a just society, to a have a full separation between the creation and selling of insurance policies, and the assessment and payment of claims.
Whilst the issuing and selling of policies seems appropriate to private enterprise, the assessment process should probably be undertaken by a statutory authority.
I would be interested to hear what you & others think of this notion.

Garry Mackrell
September 30, 2018

There has been a fair bit of commentary about fiduciary responsibilities.
Some seem to think a banker's responsibilities are, or should be, akin to those of a trustee in managing customers' investments.
They are not,nor should they be-the primary accountability of a banker under the Banking Act is the safety of the depositor.The safety of the banking system is of fundamental importance.
That means that a bank needs to take due care in not just lending money but all reasonable steps in ensuring the money that is lent is paid back/can be recovered and in structuring its loans,deposits and (high quality)liquid investment portfolio in appropriate maturities and diversification to avoid both liquidity and insolvency crises.That also infers that a bank needs to undertake these activities profitably through time.

There also seems to be a view by some that banks are some sort of public utility whose role is to underwrite an increasing number of social objectives that are seen to be desirable.
At the same time,as listed public companies they have legal obligations to grow shareholder wealth on a sustainable basis,competing for capital nationally and internationally.
Banks,like all businesses,have to sell to generate revenue.

If the conclusions reached are that bankers should not be incentivised to generate sales/revenue/profits and that they should not seek to develop adjacent or vertical revenue sources and with regulators placing additional capital constraints on expanding overseas and insisting that domestically, personal and business lending should only be supported by current hard financials ( not future potential or other judgments about willingness to repay),within frameworks of "social licences",then the best advice will be to sell your bank shares!


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