A recurring theme in my last few CEO messages, is of iconic companies running amok, banks involved in large scale corrupt practices and auditors staying silent and giving unqualified audit reports whilst their clients paid scant attention to ethics and values. It is clear that such companies and banks considered compliance costs as just another business expense they would have to bear, but only if they get caught!
The interim report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry in Australia released in late September 2018 dramatically underlines my concerns that rampant misconduct is endemic as the costs of getting caught are minor compared to the super profits earned by indulging in fraudulent and dishonest acts or practices. This is a summary of the key findings in Australian Banking Royal Commission Interim Report, and a critique of it because the biggest rort has gone undetected.
The Rampant Misconduct in Banks – Why Did It Happen?
The Interim Report of the says the reason was “greed”, i.e. the pursuit of short-term profit at the expense of basic standards of honesty.
The report says that as the products and services offered by the banks and other financial institutions proliferated, “selling” became their focus of attention. Too often, the report says, it became the sole focus of attention.
The report goes on to say that:
“Banks searched for their ‘share of the customer’s wallet’. From the executive suite to the front line, staff were measured and rewarded by reference to profit and sales. When misconduct was revealed, it either went unpunished or the consequences did not meet the seriousness of what had been done”.
The report was also scathing about the conduct of the regulator, the Australian Securities and Investment Commission (ASIC), and the prudential regulator, Australian Prudential Regulation Authority (APRA). The report states that both these regulators rarely went to court to seek public denunciation of, and punishment for, misconduct.
“Much more often than not, when misconduct was revealed, little happened beyond apology from the entity, a drawn-out remediation program and protracted negotiation with ASIC of a media release, an infringement notice, or an enforceable undertaking that acknowledged no more than that ASIC had reasonable ‘concerns’ about the entity’s conduct. Infringement notices imposed penalties that were immaterial for the large banks. Enforceable undertakings might require a ‘community benefit payment’, but the amount was far less than the penalty that ASIC could properly have asked a court to impose.”
The report found that in the case of all in the industry, “Compliance” appeared to have been relegated to a cost of doing business; i.e. pay the small fine if caught.
“The case studies undertaken in the first round of hearings showed that there had been occasions when profit has been allowed to trump compliance with the law, and many more occasions where profit trumped doing the right thing by customers.”
This report has blown a hole in the excuse often used by senior bank executives and others that such bad behaviour is the work of “just a few rotten apples”.
Key Takeaways from the Report
The report found that the following behaviour falls below community standards and expectations:
- Consumer lending, which forms the majority of the banks’ business (with home lending a large percentage of that – at $1.6 trillion at the end of last year) was undertaken in the “pursuit of profit” rather in looking after the interests of their customers.
- All the major banks, and probably most smaller lenders, have been routinely breaching responsible lending laws when they approve home loans and car loans, and also credit cards.
- Greed was the root cause of bad behaviour in the financial advice industry, in which a ‘conversation’ with a customer was treated as an opportunity to sell the limited products and services that the entity has available to sell and, for that purpose, to gather some necessary information about the customer.
- Hundreds of millions of dollars that were charged in ‘fees for no service’ in the financial advice industry, and also bank fees were charged to dead people.
- Bribery rings with envelopes of cash used the banking system to launder money, with some banks ignoring reporting many such suspicious deposits.
- As small businesses are not currently covered by the responsible lending protections of the National Consumer Credit Act, they lacked both the bargaining power and resources, and also were relatively unsophisticated financial dealings and understanding. This made them easy prey for unscrupulous bank lenders.
- Entities engaged in agriculture lending ‘preferring pursuit of profit’ to all else – this had a “profound personal effects” on farmers when external events, including extreme weather, affected their profitability and ability to service their debts – with the bank often selling their land to recoup their money.
- Funeral insurers targeted Indigenous customers with low value products
- It was unclear how and when the banks should use discretion when charging overdraft and dishonour fees, which while small, can add up to significant amounts over time.
- The inaction of the corporate regulator ASIC and the prudential regulator APRA in reining in the bad behaviour was highlighted in the report.
- The report was also very critical of the financial planning organisations; i.e. the Financial Planning Association (FPA) and the Association of Financial Advisers (AFA) stating that “neither plays any significant role in maintaining or enforcing proper standards of conduct by financial advisers”.
A Brief Summary of Evidence
In the area of loans, the evidence detailed in the interim report showed that, more often than not, whilst each of Australia’s big banks (ANZ, CBA, NAB and Westpac) took some steps to verify the income of an applicant for a home loan, much more often than not none of them took any step to verify the applicant’s outgoings (expenses).
With regards to small businesses, the report states that the tension at the heart of small business lending is that small business owners desire access to credit, which requires the banks to take a risk, and that there are consequences for both the banks and small business owners when that risk does not pay off. However, the negotiations are always one-sided in that, both during the life of the loan and later, the bank had ‘all the power’ and the small business owner had ‘none’. In many cases banks protected themselves by asking for a guarantor. The report provided evidence of many instances where both the borrowers and their guarantors did not understand, and were not adequately informed about what steps the bank will take when bringing a loan in default to an end.
Although third party guarantors were described in the report as playing a “central and perhaps irreplaceable role” in securing funding, the report asks whether lenders should provide potential guarantors with more information about the loan and what could potentially happen should the new business fail. The report recognises, however, that a borrower defaulting on their loan does not necessarily mean, on its own, that the banker failed to comply with that duty. “When a loan is provided to allow the borrower to start a new enterprise, there will always be a risk that the business does not prosper and that the borrower may default.”
The current chief protection for small business borrowers is the Code of Banking Practice, which governs members of the voluntary industry group, the Australian Banking Association. Under the code, members are required to exercise the care and skill of a diligent and prudent banker when lending to consumer and businesses. In many cases, the evidence presented indicated that such did not happen.
In the case of agricultural loans, the report revealed stories of shattered dreams and the deep personal costs borne by business owners when things took a turn for the worse. A question at the centre of the submissions made by farmers is how borrowers and lenders in the sector deal with the consequences of unforeseen events beyond their control. According to the interim report:
“The answer that should be given in a particular case will seldom if ever be clear cut and obvious… the criticisms that can rightly be levelled at banks in their dealings with agricultural lending much more often than not find their roots in the bank’s failure to take all of the relevant considerations into account when deciding, in a particular case, whether to lend or what to do when the loan becomes distressed… there is no single or simple answer for the problems in agricultural lending highlighted in submissions to the banking royal commission.”
The report raises questions of how properties and agribusinesses are valued, and what should be done when valuations change, and whether default interest; i.e. higher interest charges that can add to the burden on borrowers in times of financial distress, should be charged to customers in drought-declared areas.
A central concern for many farmers who have lost their properties was the role of receivers and other external administrators, but this was not within the direct scope of the commission. However, the role of the banks in appointing receivers is noted in the report, which asks whether it should be only as a last resort.
In the financial planning and advice area, the report states that the financial advice industry ‘ignores basic standards of honesty’ and is ‘riddled with dishonesty and greed’. “Giving advice that does not serve the client’s interest, but profits the adviser, is equally dishonest,” the report states.
At the heart of such bad behaviour in the financial planning industry is a conflict in how advisors are remunerated. The report has a blunt view, “Sales staff can be rewarded by commission; advisers should not be.” The report goes on to say that “The root cause for what happened was greed — the greed of both licensees and advisers.”
Funeral insurers were singled out in the report for “predatory behaviour” and their products were identified as being of little value to consumers. An example of inappropriate selling by funeral insurers was the case of The Aboriginal Community Benefit Fund, a non-Indigenous organisation, that had nearly two-thirds of policyholders aged under 30, with around a third under 18.
The report asked whether banks could do more to improve access to their services in remote areas; and if funeral insurance was the type of product ASIC should target when it is given product intervention powers under legislation currently before Parliament.
The report also said that Indigenous customers in remote communities faced problems with access to basic accounts, informal overdrafts, dishonour fees and identification issues. It was recognised that Aboriginal and Torres Strait Islander people in remote communities may have limited access to conventional identification or inconsistencies across their documents, leading to difficulties in dealing with banks and super funds.
The report also found many roadblocks to Indigenous Australians accessing their own superannuation. The Financial Intelligence agency AUSTRAC already has guidelines to overcome this hurdle, but the report questioned whether they were being implemented on the frontline.
The Biggest Rort of Mortgage Interest Calculations Goes Undetected
Whilst there were many other examples in the interim report of behaviour falling below community standards and expectations, this is only the tip of a very big iceberg.
The biggest rort that appears to have gone undetected is the way banks use basic finance annuity equations to calculate monthly mortgage principal and interest repayments and the interest on deposits into offset accounts. The finance equations used to calculate the mortgage interest by banks are either erroneous, or are skewed to provide answers always in the bank’s favour at the expense of their customers.
I have collected many examples where a mortgagee’s monthly interest and principal repayment stated in his or her bank mortgage statement was different to that obtained by using that bank’s own loan calculator (available on the internet). In one case, the difference was $14.49 per month over 30 years. This amounted to a present value of $2,493.45 (in the bank’s favour) which is a substantial amount of money. In another case, the mortgagee elected to repay the interest and principal fortnightly. The bank simply halved the monthly rate and told the customer to pay this fortnightly. When this calculation error was pointed out to the bank – i.e. as the principal is being repaid at a faster rate, just halving the monthly rate is incorrect – the bank in question admitted that that it had changed the method of calculation only in February this year. This was probably due to the pressure being applied to banks by the Royal Commission.
Even if the banks use the correct equations, how they apply these equations when interest rates change is always in the bank’s favour. A common occurrence in all mortgages is that when interest rates go up, the change in mortgage interest payable is applied immediately; but when interest rates go down, these are only applied from the beginning of the next monthly cycle date of the loan.
There is evidence that such practices have been going on for at least the last 30-years, netting all banks many billions of dollars cumulatively. This is the real hidden bulk of the iceberg below the water-line, and hidden from the Royal Commission.
Incomprehensible Mortgage Loan Statements
The banks hide these sorts of rorts with incomprehensible mortgage loan statements that lack any semblance of transparency. These statements are extremely difficult for even a finance specialist to comprehend. In addition, a number of unexplained “interest corrections” or similar amounts appear constantly in the statements without any explanation. Each correction is of a small amount – but such corrections spread over all loan accounts at the bank could amount to many millions of dollars.
The Royal Commission’s interim report does allude to bank statements lacking transparency in charging overdraft and dishonour fees, which while small, can add up to significant amounts over time. The report also said that Indigenous customers in remote communities faced problems with access to basic accounts, informal overdrafts, dishonour fees and identification issues. However, even professors of finance in big cities will find it difficult to analyse these opaque statements.
To give us an idea of the magnitude of the problem, the Royal Commission to undertake a forensic audit of the interest and principal repayment calculations of a sample of Mortgage Loans, covering all banks. The ideal time to do such an audit is when the Bank is asked to provide a final discharge amount on the termination of a loan. If given access to bank records, a simple calculation by a finance expert will indicate if the discharge amount is correct, or if its substantially in the bank’s favour.
As the Royal Commission’s work has gone on, entities and regulators have increasingly sought to anticipate what will come out, or respond to what has been revealed. Here is a sample of a range of announcements.
Although the major banks have significantly tightened their home loan assessment procedures due to the findings of the Royal Commission, the report asks whether even these tougher processes still fail to satisfy the law. If the banks are still in breach, they will have to tighten access to credit even further, lowering their profits and potentially further negatively impacting an already declining housing market.
The banks will also stand exposed to potentially billions of dollars in regulatory and consumer lawsuits, especially if thousands of those home loans start going bad. Westpac has already agreed to a $35 million penalty to settle a responsible lending case with ASIC, but the interim report hints at far more to come.
“Preventing improper conduct (and promoting desirable conduct) is a central task of management, at every level in an entity – from the most junior supervisor to the most senior executives and the board.”
The report acknowledges that there has been reluctance on the part of small business owners to take up proposals for increased protections as they fear it could lead to less availability of credit and increased costs. Much to the relief of those aspiring to be small business entrepreneurs, the interim report suggests that the commissioner is not considering a lot of new lending restrictions, which some feared would make credit harder to come by.
On the contrary, in the case of financial advisors (who are most often mortgage brokers on commissions), the report is clear that as their current conduct ignores basic standards of honesty, they would require much more regulation and structure. In this regard, the Future of Financial Advice (FOFA) reforms introduced by the Australian Labor Party have come under scrutiny for their failure to outlaw many conflicted forms of payment. For example, grandfathered trailing commissions remain under FOFA. “How can these provisions be justified today?” the report asks.
The other big threat to the mortgage broking industry, is the questions being asked as to who brokers really work for, as they are paid by the lenders whose loans they sell. The best case for brokers, is if they are only asked to be more upfront with their customers about how they earn their income. In the worst case, the income the mortgage brokers rely on via commissions could be restricted or banned totally.
Other announcements in the report cover (a) new programs for refunds to, and remediation for, consumers affected by an entity’s conduct, (b) the abandonment of a number of dubious products or practices, (c) the sale of whole divisions of a business, (d) new and more intense regulatory focus on particular activities, and (e) the institution of enforcement proceedings of a kind seldom previously brought. There were even proposals of changes in industry structure and industry remuneration.
The report states that the law already requires entities to ‘do all things necessary to ensure’ that the services they are licensed to provide are provided ‘efficiently, honestly and fairly’. However, it is observed in the report that:
“Much more often than not, the conduct now condemned was contrary to law”. Passing some new law to say, again, ‘Do not do that’, would add an extra layer of legal complexity to an already complex regulatory regime. What would that gain?”
“Should the existing law be administered or enforced differently? Is different enforcement what is needed to have entities apply basic standards of fairness and honesty: by obeying the law; not misleading or deceiving; acting fairly; providing services that are fit for purpose; delivering services with reasonable care and skill; and, when acting for another, acting in the best interests of that other? The basic ideas are very simple. Should the law be simplified to reflect those ideas better?”
We will await the final report with much anticipation to see how these fundamental questions are answered.
Professor Janek Ratnatunga, CMA, CGBA
CEO, ICMA Australia
The opinions in this article reflect those of the author and not necessarily that of the organisation or its executive