Forget fixing corporate culture: here are four ways to curb misconduct

If I hear about culture, leadership or trust one more time I think I’m going to tear my hair out.

New ASIC chairman James Shipton has promised tougher action.

If I hear about culture, leadership or trust one more time I think I’m going to tear my hair out. The royal commission into financial misconduct has unleashed a barrage of calls for better, stronger and more resilient leadership and culture at the nation’s major financial institutions.

The new chief of the corporate regulator, James Shipton, gave a speech on Thursday emblematic of this trend, suggesting the “trust deficit” in finance could be improved by “rebuilding culture from deep within”, more “sustained engagement” and “active stewardship of assets by investors”, alongside “more intensive and dedicated supervision”.

“It’s time for Australia’s financial services sector to remember its purpose,” he declared, in words unlikely to ruffle a feather anywhere.

As round three of the commission kicks off next week, expect more attacks on the regulators, especially the Australian Securities & Investments Commission, and financial firms for incompetence and excessive focus on financial returns at customers’ expense.

But practical recommendations that could curb misconduct are harder to find. If nothing changes, nothing changes. The only way outcomes will change is if the incentives regulators and individuals working in financial services face change.

In journalism if you stuff up badly you get sacked or sued and struggle to find a job with another media organisation. That’s a pretty good incentive for journalists to be correct and fair. There’s a tight link between input and output. In financial services the upside is more prominent: successful risk-taking leads to huge bonuses while wrongdoing leads only to the sack (which doesn’t matter much if previous bonuses have been large enough). What small penalties are levied typically fall on the shareholders rather than employees.

In any case, in the vast finance sector it’s easier to pop up somewhere else. This is the phenomenon Professor John Kay, whom Mr Shipton cited in his speech, argues leads to excessive risk-taking and misconduct in financial services. Recent US research showed one in 13 financial planners had misconduct records, for instance.

Rather than calls for more vigilance and sobriety, which is unlikely to make any difference to anyone’s actual behaviour, here are four ideas that would improve outcomes.

● First, why not give regulatory staff bonuses for successful prosecutions of corporate crime? The bonus culture has led to a highly attuned focus on making money in the private sector, so let’s align incentives in the same way at ASIC.

The “more intensive and dedicated supervision” Mr Shipton promised would be more likely if staff had the prospect of sizeable personal rewards. Last year ASIC paid bonuses to 1258 staff, ranging from $3242 on average for its junior workers to $18,405 on average for the top brass, according to its annual report. It’s unlikely these sums — minuscule fractions of what’s normal for top bankers — are enough as incentives.

Such bonuses for individual regulators would help neutralise the natural incentive of regulators not to rock the boat. Indeed, regulation tends to benefit incumbent firms by raising the barriers to entry for potential competitors.

Nobel Prize-winning University of Chicago economist George Stigler explained “regulatory capture” in his famous 1971 article.

“Regulation is acquired by the industry and is designed and operated primarily for its benefit,” he observed. For anyone puzzled, consider how it could be that a sector regulated by thousands of PhDs could have been so immensely profitable but economically destructive over past decade.

● Second, financial regulators should be barred from working for financial institutions in the future. This might require sizeable increases in pay for regulators (because the prospect of making a lot more in the future is part of their “package”). But it would remove any compunction regulators might have against rocking the boat for personal career reasons.

● Third, and most importantly, rules should encourage whistleblowers to come forward. How can we expect public servants sitting in office towers, however well-meaning, to enforce the law inside financial firms, day to day? It should be financially worthwhile to dob in colleagues who are breaking the rules. Large institutions often have their own processes for dealing with whistleblowers, but these rarely reward the whistler and at best result in dismissal of staff, who can simply pop up elsewhere.

● Finally, pay structures in banks appear to be leading to sub-optimal outcomes that erode public support for banks, distracting management from broader considerations.

Bonuses tend to be paid regardless of performance. For instance, it emerged in the royal commission that NAB’s chief customer officer had his bonus (in addition to salary) docked $60,000, reducing it to $960,000. Banking and financial services are licensed, highly regulated businesses — not a free market in any meaningful sense.

Capping or micromanaging pay structures or levels, however, is likely to produce perverse incentives, such as boosting fixed salaries. Instead, the government could follow US President Donald Trump’s lead and make it more expensive for companies to pay outlandish remuneration. The US tax reform ended tax deductibility for remuneration of directors of companies in excess of $US1 million, in effect making it more costly for large corporations to pay such sums.

People are always welcome to start their own businesses if they can earn more.