In a speech delivered on 20 November, the Governor of the Reserve Bank, Phillip Lowe, talked about trust and the financial system. The speech included his view on the application of incentives.

Dr Lowe referred to the case studies in the Royal Commission that have put the spotlight on three important issues:

• the inadequate way in which banks have dealt with conflict of interest issues;
• the way that poorly-designed incentive systems can distort behaviour – promoting a sales culture at the expense of a service culture, and promoting short-term at the expense of the long-term; and
• the fact that the consequences for not doing the right thing have, in some cases, been too light.

Dr Lowe believes that strengthening trust in financial institutions requires all three issues to be addressed.

Correcting the prioritisation of sales over service starts with the system of internal reward established by the board and management. The vast bulk of the people who work for Australia’s financial institutions want to do the right thing, and they want to serve their customers as best they can. But, like everybody else, they respond to the incentives they face. If they are rewarded on sales or short-term objectives, it should not come as a great surprise that they prioritise sales. So, establishing the right incentives is key.

It is important here to pause and consider Dr Lowe’s statement. He is not saying sales incentives per se are inappropriate (which is what some of the banks say in their submissions to the Royal Commission after the Interim Report). He is saying that the incentives prioritised sales over service.

It is also clear to us that the incentives were not incentives to break the law. They were simply incentives to obtain sales. The incentive framework was lacking adequate monitoring and negative rewards for breaking the law.

Dr Lowe recognises this important aspect of incentive design. He said that one of the features that influences incentives (read ‘behaviour’) is the consequences and penalties that apply when something goes wrong. Strong penalties can play an important role in incentivising good behaviour, and this is an area companies should be looking at. But, it is necessary to get the balance right as there can be unintended consequences.

Dr Lowe’s speech was nuanced.

He made a distinction between the penalties that apply for poor conduct and those that apply for making loans that ultimately cannot be repaid.

• On conduct issues, expectations and standards should be set at a high level, and if they are not met, the penalties should be firm.
• On lending, matters are more complex. Even when banks lend responsibly, a percentage of borrowers will end up in financial strife and be unable to meet their obligations. The community need banks to be prepared to make loans in the full expectation that some borrowers will not be able to pay them back. Banks need to take risk and manage that risk well. If they become afraid to lend simply because of the consequences of making a loan that goes bad, the economy will suffer. So, a balance needs to be struck.

Dr Lowe said that it would help for financial institutions to have a long-term focus, and to reflect that in their incentive framework. Managing to short-term targets might boost the share price for a while, but this short-termism can weaken the long-term franchise value of the bank.

As Guerdon Associates’ submission to the Royal Commission noted (see HERE), it may take regulation to break the impasse between the short-term influence of investor and proxy adviser guidelines on executive remuneration and the need for incentive frameworks aligned with the longer term.

See Dr Lowe’s speech HERE

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