xxxviii) Impact Of Poor Culture

Need to understand impact poor culture. Some examples revolve around the major Australian banks, ie placing the desire of short-term profit above the interests of their customers. Another indicator of poor culture is the amount of effort (including brain power), time and money that the industry expends to resist sensible regulation.

There are 3 main drivers to human behaviour relative to the finance industry, ie

i) deterrent, eg probability of getting caught with appropriate punishments (NB some companies have become too comfortable with paying the fines for uncompetitive conduct; as a result, these elements no longer are deterrents)

ii) incentives like remuneration

iii) culture like doing the right thing by the customer

Prior to the GFC (2007), the Australian Royal Commission (2001) into the failure of the insurance group (HIH) found that the regulator had been passive and unprepared, was slow to react and could have done more to minimise the damage. Some key learnings included

- the banks need to build strength and maintain it in good times so they are better able to handle the next crisis
- the public has less trust in the finance system as a result of these failures and now there is a heightened community expectation of what should happen
- the need for a stronger regulatory framework
- history does repeat itself but people think otherwise, ie people miss impending crises as they think that this time is different from what happened before. This has been referred to as the "contagion effect"

The GFC identified
"...there were failings in the way institutions manage themselves, the way they govern themselves, their culture and the way they structured their incentive arrangements..."
Wayne Byres (Chairman, Australian Prudential Regulation Authority) as quoted by James Eyers, 2016

" institutions to ensure that they have the right systems, people and processes in place to monitor trading conduct and detect and address trading discrepancies in a timely manner..."

Cathie Armour, (2016), has quoted by Sally Ross, 2016

The financial system is the lifeblood of the economy. If it fails, the cost to the community is significant. The cost of bank supervision should be assessed against the cost of bailouts. Supervision is the most cost-effective way to achieve good prudential outcomes rather than writing lots of rules and regulations.

Since 2013 there have been many incidents of alleged misconduct in the Australian banking sector. Some examples

- 4 Corners (an Australian TV-based investigative reporting program) exposed bank's financial planners exploitation of clients, and alleged that bank-owned insurers fail to pay valid claims
- 3 of the top 4 Australian banks allegedly manipulating the bank swap rate (BBSW) - a key benchmark for interest rate,
- misaligned remuneration incentives
- a foreign exchange options and futures trader at Deutche Bank Australia made false entries between 2013 - 2016 that temporarily overstated the bank's revenue results by around A$ 50 m. (globally this bank is struggling as the US Dept of Justice is seeking a US 14 b. settlement on allegations of mis-selling mortgage-backed securities)
- a senior technology executive from the Commonwealth Bank of Australia has been found guilty of fraud in Australia and is now charged with fraud in the US over an alleged bribery scheme that enabled the bank's software contractor (ServiceMesh) to receive more than A$ 100 m. in bonuses by successfully lobbying internally to quickly award lucrative security software contracts. Several bank employees received "kickbacks" from the contractor.

Financial institutions claim they are here to serve the customer and the community, while the regulators are there to serve the community and make sure customers are protected preferably by a collaborative/cooperative approach between all players, rather than a policeman approach. Thus there is a tension between banks seeking to maximise short-term profits and regulators encouraging bigger equity capital buffers, ie a policy that reduces return on equity.

An example of where this approach has been effective was in December 2014. Continued low interest rates had encouraged the banks to sell mortgages to property investors. A new policy was introduced to curb loans to investors into real estate and this appears to have eventuated as planned.

Already conversations are starting to occur about how to measure and observe culture, and how to form a view about it in a more systematic way. This will require more than legislation and regulatory frameworks; it requires a change in culture, ie improving behaviour within the industry around governance and remuneration, and acting consistently with-in risk-management frameworks and strategies

With the Royal Commission into Australian Financial Institution (starting 2018) identifying many malpractices, there is a need to review the way these institutions work.

According to Leah Zell (a founder of Lizard Investors), the key to success of fund management (which is an example of people management) is composed of 2 elements, ie

i) culture

ii) compensation

This is enlarged into 4 components, ie

i) how you allocate responsibility

ii) how you identify authority

iii) how you hold people accountable

iv) how you reward them

NB It is important to control your emotions and realise that what might be upset you one day may have a totally different effect the next day!!!!

The best managed firms have a methodical and repeatable process(s) that is depersonalised.

"...small-cap equities are the last refuge of active management in a world increasingly dominated by exchange-traded funds and other index-tracking product run by algorithms and machines..."

Leah Zell (founder Lizard Investors) as quoted by Tony Boyd 2016a

In some industries like fund management, you need a certain ego to withstand the pressure. At the same time, the best people have learned to manage and contain their egos.

" is much more fun to work with fewer people. In that case your focus of competition of the world, whereas in the bigger shops there is a tendency for the politics to smaller shops it's much more important to get the right mix of people and right culture......of cooperation and a culture where you use the "I" word less frequently than "We" word..."

Leah Zell (founder Lizard Investors) as quoted by Tony Boyd 2016a

Also it is of interest to note that women are better fund managers and men. As they trade less frequently than men, and are more patient. They tend to manage less volatile portfolios and their returns tend to be steadier.

(sources: Tony Boyd 2016a; Sally Ross, 2016; John Kehoe, 2016; Anne Hyland, 2016a; James Eyers, 2016; Patrick Durkin, 2016a; Anne Hyland, 2016b)


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