The Australian taxpayer is currently funding the Royal Commission into Misconduct in the financial industry (or in more detail: Banking, Superannuation and Financial Services Industry). Lucky us.
We got screwed by these guys. Now we get to pay millions to find out what we already know:
This is not a ‘few bad apples’ problem.
This is a structural problem.
As I see it, there are (at least) two fundamental flaws in our financial system. They are not unique to finance. You could say they are fundamental flaws in the way we have applied capitalism. They’re just particularly obvious and destructive in finance.
The first flaw is kick-backs.
The second flaw is the responsibility of directors being to the organisation, not its customers or society as a whole.
Flaw 1: Kick-backs
How do lenders and insurance providers ensure that brokers and advisors recommend their products to clients when the competition is stiff?
They offer a commission – or kick-back – to the broker or advisor if the client signs up.
Brokers and advisors are supposed to tell you about these kick-backs. Some are fully transparent, giving you back the commission or sharing it with you. Some include that information in the small print of a 10-page contract.
Either way, a kick-back is a recipe for failing to do the best by the client.
To explain why, I’m going to put my engineer hat on and share some risk management theory with you.
How finance failed Risk Management 101
As a graduate engineer, I lived and breathed risk management. It’s a notoriously dry and monotonous area of work, which is why more experienced engineers offload it onto dewy-eyed newbies who haven’t had their soul crushed yet.
I learned to facilitate Process Hazard Analyses (PHA), Hazard and Operability Studies (HAZOP), Workplace Risk Assessment and Control (WRAC), Root Cause Analysis (RCA), Failure Modes and Effects Analysis (FMEA) and I got to apply them daily for years.
They all have two things in common:
- They reference the hierarchy of control for deciding the most effective way to reduce a given risk.
- When there is a chance that a human decision can affect the outcome, you assume the human failure rate is 100%.
So, how does the finance industry manage the risk of an advisor or broker giving their client bum advice so they can earn a better commission?
They introduce an administrative control – one of the least effective control methods possible – by making it a procedural requirement that they act in their client’s best interest.
Well done, finance industry. You just failed Risk Management 101.
What would be more effective?
On that hierarchy of control, the single most effective way to get rid of a risk is to eliminate it. Get rid of the possibility entirely.
In the finance industry, that means abolishing kick-backs.
Think about it this way: if there is no reward for recommending one product over another, brokers and advisors will not be tempted to do something …sub-optimal. They won’t be thinking: ‘If I can just sell one more Policy X or Loan Y, I’ll meet the target that earns me Bonus Z’. Bonus Z might be important to the broker or advisor – it might mean they can afford the school fees for example.
When you put an advisor or broker in the position of having to choose between the best product for their client but no bonus for them, or a decent product that will result in the best education for their child, what does risk management tell us?
They’ll go for the decent product, not the best one. Not all of them will, but someone will. 100% failure rate, remember?
It’s human nature.
“I would never do that!”
I’ve never met an advisor or broker who would admit they’d choose their kid’s school fees over a client’s best interests. In fact, they are shocked and appalled that any colleague of theirs would. Some will be incensed that I dare put this in print. Some will flatly deny it’s possible.
Of course it’s possible – that’s why we’ve got a Royal Commission now, and it’s why we had a Senate inquiry.
This. System. Does. Not. Work.
Flaw 2: Directors’ duties
Studying my certificate of governance was an eye-opener. For example, I had always wondered how the board members of companies that pollute hadn’t been sued into oblivion. The answer is in this tidy little sentence, paraphrased from the Corporations Act 2001 and outlining the responsibilities of company directors:
“…to act in good faith in the best interests of the company and for a proper purpose.”
Translation: the survival of the corporation is paramount.
Subtext: the corporation is more important than the customers as individuals or society as a while.
Think about the implications of this in a bank:
- Banks make their money by selling customers debt.
- More debt = more revenue = more sustainable company.
- If the directors don’t do their utmost to sell more debt, they are neglecting their duty to the company.
- If the neglect is proven in court, they can be personally sued.
With this in mind, consider the bank’s in-house lending specialist or financial advisor. They’ve got a target to sell more debt, because that’s how the bank makes its money. They may lose their job if they don’t meet their targets.
Is this an environment in which we can be assured of the best outcome for the client?
No, it is not, as evidenced by the appalling number of reported cases of shoddy financial advice from the Australian finance industry, which has led to hardship for (at least) hundreds of Australian families.
Again, this is not a few bad apples. This is a systemic problem and it won’t go away until we fix the problem.
Bring on the revolution
It is possible to engineer out the misconduct being examined in the Royal Commission: abolish commissions and make directors directly and proportionally accountable to the results experienced by the company’s clients.
The question is: will we have the guts to do it?
If the financial industry is serious about rebuilding trust as the ANZ CEO claims, this would be a good start.
Only time will tell.
Until then, please protect yourself. Act with the knowledge that conflicts of interest are possible because of our flawed system. Do not abdicate decision making, and refuse to be bullied or baffled by BS.
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Lacey Filipich is the co-founder and director of Money School. She helps parents raise financially savvy kids and helps adults get on top of their finances. Connect with her on LinkedIn and follow the Money School Facebook page to learn more.