How more intrusive regulation and cultural change can save Australia’s banks

Australia’s Royal Commission into Financial Services has revealed widespread malfeasance among big banks and other financial service providers, and cast a spotlight onto regulators for failing to act sooner.

The Royal Commission has heard allegations of bribery and forged documents,  and failure to verify customers living expenses before lending them money. AMP has admitted to lying to regulators, and the Commonwealth Bank and NAB have admitted to charging fees to dead clients, or without providing a service.

Australia is not unique in having issues in its financial sector – but it may have a lot to learn from the Netherlands which saw issues of misconduct in the wake of the Global Financial Crisis (GFC) in 2008.

Dr Femke de Vries is a Special Professor of Regulatory Enforcement at the University of Groningen. She is also a former Secretary-Director at DNB (the central bank of the Netherlands), and a former board member of the Authority for Financial Markets, the two organisations which regulate the country’s financial sector.

She says the Dutch response to its financial scandals was a major change in the structure and philosophy of regulation, with a new emphasis on more ‘intrusive’ regulation and preventing future misconduct.

Dr de Vries will be in Australia in December for the ANZSOG/National Regulators Community of Practice annual Regulators Forum in Melbourne. The forum will focus on the importance of culture in regulation, and what measures regulators can use to build more positive cultures. This will be particularly relevant to Australia, where 2018 has seen toxic cultures exposed in charities, sporting clubs, franchise chains and areas from health services to hospitality.

She says that institutional culture should be a big part of the focus of regulation, because there can be different parts of organisations which develop norms far removed from those of the broader society.

“Psychological research says that the behaviour of human beings is often strongly influenced by social norms within a group or institution, so it is important to pay attention to them,” she said.

“We can always punish and replace wrongdoers but they will return unless we replace the system.

“Unethical behaviour can also be steered or encouraged by reward systems, like bonuses, or by targets for employees. Leaders can often create or oversee a system where it is only possible to meet targets through unethical behaviour, and it becomes routine to put profit before the customer’s interest.

“While legislation is important in financial services, it cannot prescribe what is in the customer’s interest in every situation. Institutions need to have an insight into what the intent of the legislation is and to act on it.”

More intrusive regulation to prevent misconduct

Dr de Vries said the Netherlands had reshaped its regulatory system and was influenced by a landmark International Monetary Fund report into financial regulation in the wake of the GFC which recommended five criteria for regulatory supervision: intrusive, sceptical, proactive, adaptive and conclusive.

Dutch regulators decided to focus on being intrusive and proactive. They have attempted not just to regulate for current behaviour, but to identify future problems and potential sources of unethical behaviour.

Dr Femke de Vries

For example, the legislators have introduced product approval and review processes, of every new product that a financial institution introduces. These are done by the institution from the point-of-view of different customers over the life cycle of the product.

“This should create a strong compliance culture within the bank, who can challenge the commercial interests of the bank,” Dr de Vries said.

Regulators started looking for areas that might have future problems: analysing cultures and systems of targets and rewards. They moved beyond hiring lawyers and financial experts and brought in psychologists who could recognise the potential problem areas.

“We are also asking questions about the market as a whole: How big is the market? Can everyone make these profits ethically? Can these business models actually work if they put customer interest first?”

Avoiding regulatory capture

As well as trying to change the culture of regulation, they have also changed its structure, creating a special unit which is removed from day-to-day regulation but is able to quickly investigate individual institutions when required.

Dr de Vries says this was because enforcement is a very specific competence within regulation. It was also done to avoid regulatory capture “and for cases where regulators who supervise organisations regularly, become too satisfied with slow improvement”.

The Netherlands has also strengthened tests on board members, and the ability to revoke board members ‘fit and proper’ person test, if serious malfeasance occurred on their watch – a serious sanction which could also stop their ability to serve on other boards.

Some regulators in Australia have floated the idea of embedding regulators within banks but Dr de Vries says this approach may not be the right solution, given its potential for even greater capture of regulators by banks.

“The important thing is that regulation must be intrusive, and that regulators are able to ask for the right information and are able to question what seems to be common knowledge and common actions of banks. They also need to ensure that they are willing to take action,” she said.

The Australian Royal Commission has revealed widespread misconduct, which Dr de Vries said made it difficult to regulate.

“It definitely makes it harder to point to good examples. And it means you have to make more thorough changes to the way you regulate,” she said.

“When these issues are widespread you can’t take the axe to every staff member, you need to look at culture and leadership. You need to make sure organisations have their own checks and balances, then regulate them intrusively on the choices they make.”

The 2018 ANZSOG/ Regulators Community of Practice annual Regulators Forum at Melbourne’s Federation Square on Thursday 6 December. Register for the forum here.