Why Banking Scandals Will Continue

(Bloomberg) -- The best reality TV show in Australia right now is the televised hearings of the Royal Commission into Australian banks. The formal public inquiry, led by a retired judge with broad coercive powers, has uncovered a litany of wrongdoing including bribery and fraud rings, poor lending practices, and pervasive lying to regulators.

The most startling revelations relate to financial planning and wealth management. Banks have provided poor and inappropriate investment advice, charged fees without providing any additional services, siphoned fees from the estates of deceased clients, impersonated clients or forged their signatures on documents, and generally failed to act on legitimate client grievances.

At some level, the revelations simply confirm that Australian banks — once among the most profitable and trusted in the world, frequently cited as paragons of sound management — are no better than their U.S. and U.K. counterparts. Very similar practices came to light after the global financial crisis. Financial advisers, whose remuneration was linked to sales, ignored their fiduciary duties and failed to put the interests of their clients first. They succumbed to conflicts of interest, giving out "free" advice while being paid by sellers of investment products (including the banks where they were employed). Banks emphasized shareholder returns and profitability over client interests. Regulatory bodies were undermanned and politically constrained.

Just as their counterparts did then, Australian banks are resisting greater regulation. They argue that the industry only has to contend with a few rotten apples. Separating financial products and advice, they say, would require major restructuring. They warn that stringent regulation could shrink the supply of essential credit to the economy, not to mention harm the more than 14 million Australians invested in banks by damaging share prices and dividends.

On the other hand, light regulation hasn't exactly worked elsewhere. Wells Fargo recently paid a $1 billion fine to settle allegations of mis-selling financial products.

Nothing will change unless authorities recognize three fundamental facts about the way the system is set up now. First, the privatization of retirement savings has put too much power in the hands of unprepared citizens. In Australia as elsewhere, state and corporate pensions have been replaced, in full or part depending on the jurisdiction, by self-funded arrangements, usually encouraged by sometimes generous tax incentives.

The shift places the responsibility for planning, saving and investing on individuals. This assumes a level of financial knowledge and acumen, if only to be able to distinguish between good and bad advice. It's unlikely that most people, whatever their other expertise, possess these skills.

A lack of information creates moral hazard, placing savers who are managing significant sums of money at the mercy of financial advisers. The problem is compounded by the increasing complexity of investment choices, risks and rewards, and tax- and estate-planning considerations. Relying on the banks' fear of reputational damage to enforce good behavior has historically been a bad bet.

Second, ordinary investors are unwilling to pay for advice — or at least, to pay enough for the kind of service and expertise they require. Financial advisers are thus reluctant to move to a fee-for-advice model, as it may reduce earnings. Instead they rely on sellers of financial products to pay them upfront or through a trailing commission, in return for promoting their products.

Third, too many clients are unwilling to accept good advice. Many investors have an unrealistic expectation of returns and frequently underestimate risks, making investment choices which are inappropriate to their circumstances. This reflects not just their lack of financial sophistication but peer pressure, where neighbor Jones always seems to have higher returns. Stagnant incomes and rising living costs mean that higher returns are sought to compensate for inadequate savings rates. Ultimately, nothing can save an investor seeking to get rich quickly.

These issues are embedded in the design of the retirement saving systems increasingly mandated by governments around the world. Reverting back to a system of state or company pensions is impossible at this point. Imposing strict regulations would create a negative feedback loop, with banks facing higher costs then looking to recoup those costs surreptitiously from clients.

Regulators could think about treating financial institutions more like utilities, with an agreed rate of return on capital. Banks would only charge set fees and wouldn't be entitled to compensation from the manufacturers of financial products. This would reduce their ability to use linked advisers to sell profitable investment products, which has become central to increasing market share in the investment management business. But, of course, banks would resist. They may even stop offering financial-planning services and move into other, less-regulated areas. This is one problem without a neat, ratings-ready conclusion. 

To contact the author of this story: Satyajit Das at sdassydney@gmail.com.

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