Introduction

The Financial Services Royal Commission's Interim Report was tabled by the Government on 28 September 2018. It identifies a range of policy issues to emerge over the course of the first four rounds of hearings, that is in relation to: consumer lending (round 1); financial advice (round 2); loans to small and medium enterprises (SMEs) (round 3) and issues emerging in relation to experiences with financial services entities in regional and remote communities (round 4). Issues in relation to superannuation (round 5) and insurance (round 6) will be covered in the final report due by 1 February 2019. The deadline for submissions in response to the issues raised in the Interim Report is 26 October 2018.

Scope of the Interim Report

The Interim Report does not contain draft recommendations or refer entities to legal authorities. Rather, it identifies issues in relation to banking, loan intermediaries and the provision of financial advice, arising from the first four rounds of hearings, and 'poses a series of questions, directing attention to considerations that may bear upon what conclusions I [Commissioner Hayne] should reach, and what recommendations I should make...in response to the more particular issues identified in the Terms of Reference'. These issues are:

• the adequacy of the existing laws and policies to the provision of banking and related financial services;
• the adequacy of the internal systems of financial services entities;
• the adequacy of existing forms of industry self-regulation (including industry codes of conduct);
• the effectiveness and ability of regulators to identify and address misconduct;
• the effectiveness of mechanisms for redress for consumers;
• whether changes are needed (in relation to each of the first three points) to minimise the likelihood of misconduct in the future.

Context and timeline

• Timeline for submissions on the Interim Report: The Commission will accept submissions in response to issues raised in the Interim Report until 26 October. 
• Round 7 hearings: The seventh and final round of public hearings will focus on policy questions arising from the first six rounds of hearings (ie including superannuation and insurance, which are not addressed in the Interim Report). Hearings will take place between 19 November and 23 November.
• Final report: The final report is due to be submitted to the Governor General by 1 February 2019. The report will include the topics of the fifth (superannuation), sixth (insurance) and seventh round of hearings (policy questions arising in relation to the first four rounds of hearings).

Road map: The structure of the Interim Report

The Interim Report consists of three volumes.

Issues/common themes to emerge: Volume 1 outlines the issues to emerge in relation to each round of hearings (rounds 1-4), as well as providing background on the establishment of the Commission, the approach taken to the selection of case studies and work completed outside the hearings.

• Chapter 8 (Volume 1) identifies issues to emerge over the first four rounds of hearings in relation to existing regulation and the response of the regulators to the conduct identified in the report.
• Chapter 9 (Volume 1) considers the causes of the misconduct identified over the course of the first four rounds of hearings.
• Chapter 10 (Volume 1) sets out the policy questions to emerge in relation to each topic and identifies 'common threads and some more general questions'.

Case studies: Volume 2 of the report outlines the evidence in relation to each case study and identifies a number of instances in which entities may have breached the law, engaged in conduct that may have fallen below community standards and expectations, and/or potentially breached the Code of Banking Practice (Banking Code).

Appendices: Appendices to the report including (among other things) a list of submissions made to the Commission, a list of background papers and an outline of the public submissions received are set out in Volume 3.

Policy issues arising in relation to Round 6 hearings

Separately, the Commission has also released a document outlining the policy issues to emerge from round 6 hearings on the topic of Insurance. 
[Note: The policy issues to emerge in relation to the Round 6 hearings are outlined in a separate post in the 8 October issue of Governance News.]

Issues to emerge

Commissioner Hayne categorises the issues to emerge in relation to the first four rounds of hearings into the following categories:

• 'intermediaries – the confusion of roles and responsibilities
• customer needs – you "need" what we have to sell
• credit risk or unsuitable lending? Lending is not unsuitable if the consumer is unlikely to default
• processing errors – failure to deliver promised features of products sold'.

'Why did it happen?' and  'What can be done to avoid it happening again?' 

The report takes these questions as its starting point. More particularly the report asks these questions in relation to banks, loan intermediaries and financial advice, 'with a view to provoking informed debate about both questions'.

Why the conduct occurred

A culture of 'greed'

In response to the question of why the conduct occurred, Commissioner Hayne identifies ‘pursuit of profit’ or ‘greed’ as a ‘unifying cause’ of the issues identified. ‘Much if not all of the conduct identified in the first round of hearings can be traced to entities preferring pursuit of profit to pursuit of any other purpose' he writes. He adds, 'Too often, the answer [to why the conduct occurred] seems to be greed – the pursuit of short term profit at the expense of basic standards of honesty'. 

Commenting specifically in relation to banks, Commissioner Hayne writes that 'the banks have gone to the edge of what is permitted, and too often beyond that limit, in pursuit of profit. And they have gone beyond the limit because they can; and because they profit from the misconduct that is described in this report. Risk to reputation was ignored'.

Other causes identified

Other causes identified and discussed in the Interim Report include: conflict of interest and duty, remuneration structures, culture and governance, and the regulatory response.

• Remuneration structures as a driver of conduct: The Commissioner writes that 'conduct identified and criticised in this report was conduct that provided a financial benefit to the individuals and entities concerned. (If there were exceptions, they were immaterial.) The governance and risk management practices of the entities did not prevent the conduct. The culture and conduct of the banks was driven by, and was reflected in their remuneration practices and policies'.
• Cultural/governance deficiencies: Commissioner Hayne writes that the 'same or similar deficiencies of governance and risk culture' identified in APRA's report into CBA culture, appear (based on issues identified over the course of the first four round of hearings) to be present in other financial services entities. 'The conduct suggests that there has been insufficient attention given within those entities to regulatory and compliance risk. It suggests want of attention by those entities to reputational risk. Some of the conduct suggests want of proper governance in the entity'.
• Business Structures (vertical integration): Commissioner Hayne comments in relation to this issue: 'The inescapable fact seems to be that interest too often trumps duty. Too often conflicts between interest and duty are “managed” in a way that coincides with the interests of the party who owes some conflicting duty or has some conflicting interest'.
• Role of the Regulators: The report questions the effectiveness of the approach taken by both the Australian Securities and Investments Commission (ASIC) and the Australian Prudential Regulation Authority (APRA) in deterring and preventing the misconduct identified, and in enforcing compliance with existing laws. 'When misconduct was revealed, it either went unpunished or the consequences did not meet the seriousness of what had been done. The conduct regulator, ASIC, rarely went to court to seek public denunciation of and punishment for misconduct. The prudential regulator, APRA, never went to court' Commissioner Hayne writes. Though he emphasises that individual entities are ultimately responsible for their own conduct, he also identifies the approach taken by the regulators as a contributing factor in the misconduct: 'Too often entities had been treated in ways that would allow them to think that they, not ASIC, not the parliament, not the courts would decide when and how the law would be obeyed or the consequences of the breach remedied' he writes. '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'.

What should the response be?

Regulation and the regulators

Chapter 8 the Interim Report identifies issues to emerge over the first four rounds of hearings in relation to regulators and regulation with a focus on why the breaches were ‘so many and so widespread' and whether changing the law would ‘make any difference’.

In posing these questions, Commissioner Hayne emphasises that ultimately 'each financial services entity is responsible for its own conduct' and that 'the criticisms that are made of the ways that regulators have responded to this conduct must not be understood as diminishing in any way the culpability of the entities that engaged in the relevant conduct.'  However, he is also critical of both the effectiveness of the current approach taken by the regulators to enforcing compliance with the law, and the complexity of the existing law.

A need for ASIC to adopt a new approach to enforcement?

Commenting on ASIC’s enforcement approach, the Commissioner writes: 'When deciding what to do in response to misconduct, ASIC’s starting point appears to have been: How can this be resolved by agreement? This cannot be the starting point for a conduct regulator. When contravening conduct comes to its attention, the regulator must always ask whether it can make a case that there has been a breach and, if it can, then ask why it would not be in the public interest to bring proceedings to penalise the breach. Laws are to be obeyed. Penalties are prescribed for failure to obey the law because society expects and requires obedience to the law'.

Commenting on APRA's approach to enforcement, Commissioner Hayne writes that 'APRA is obliged to look at issues of governance and risk culture through the lens of financial  system stability. Understood in that light, APRA’s lack of action in response to the widespread occurrence of the conduct described in this report may, perhaps, be more readily understood'.

Policy questions identified

Particular policy questions identified in relation to these issues include the following.

• ‘How should APRA and ASIC respond to conduct and compliance risk?’
• ‘Should the regulatory architecture change?’
• ‘Are some tasks better detached from ASIC?’
• ‘Are some tasks better detached from APRA?’
• ‘What authority should take up any detached task?’
• ‘Should either or both of ASIC and APRA be subject to external review?’

Particular policy questions identified in relation to ASIC include the following.

• ‘Is ASIC’s remit too large? If it were to be reduced, who would take over those parts of the remit that are detached? Why would detachment be better?’
• ‘Is the regulatory regime too complex? Should there be radical simplification of the regulatory regime?’
• ‘Should ASIC’s enforcement priorities change? In particular, if there is a reasonable prospect of proving contravention, should ASIC institute proceedings unless it determines that it is in the public interest not to do so?’ 
• ‘If the recommendations of the Enforcement Review are implemented, will ASIC have enough and appropriate regulatory tools?’

Particular questions in relation to APRA include the following.

• ‘Are APRA’s regulatory practices satisfactory? If not, how should they be changed?’
• ‘Does the conduct identified and criticised in this report call for reconsideration of APRA’s prudential standards on governance?’
• ‘Having examined the governance, culture and accountability within the CBA group, what steps (if any) can APRA take in relation to those issues in other financial services entities?’

Further regulation?

Not necessarily a question of further regulation? Commissioner Hayne questions whether additional regulation is likely to be effective in addressing the issues identified. He writes: '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". 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?'  On this basis, he writes that 'I begin from the premise that no new layer of law or regulation should be added unless there is clearly identified advantage to be gained by doing that. And I begin from the further premise that very simple ideas must inform the conduct of financial services entities. Hence, the first question to be asked and answered is: Is the law governing financial services entities and their conduct too complicated?  Does it impede effective conduct risk management?  Does it impede effective regulatory enforcement?'.

'Different enforcement' of existing law and/or simplification of existing law? The report questions whether a 'different' approach to enforcement should be adopted: '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?'

A case for 'simplification'? Commissioner Hayne argues that there is 'a need to simply the existing law' to enable greater focus on 'the very simple ideas that must inform the conduct of financial services entities: Obey the law. Do not mislead or deceive. Be fair. Provide services that are fit for purpose. Deliver services with reasonable care and skill. When acting for another, act in the best interests of that other'. He goes on to say that 'The more complicated the law, the easier it is for compliance to be seen as asking ‘Can I do this?''

Policy questions

Policy questions identified in relation to these issues include the following.

• 'Are changes in law necessary? Should the financial services law be simplified?'
• 'Should carve outs and exceptions be reduced or eliminated? In particular, should  grandfathered commissions; point of sale exceptions to the NCCP Act; funeral insurance exceptions be reduced or eliminated?'

Remuneration 

Should the way in which bank staff are paid be re-thought?

• Is incentive remuneration necessary? The report questions the assumption that incentive remuneration (which the Commissioner notes is paid to most bank staff) is necessary. 'The unstated premise for so much of the debate about remuneration of both bank staff and intermediaries, that staff and intermediaries will not do their job properly and to the best of their ability without incentive payments, must be challenged. And in the case of intermediaries, arguments based in predictions of industry damage or collapse should be examined with special care' he writes.
• Why do staff require incentives? 'Why do staff (whether customer facing or not) need incentives to do their job unless the incentive is directed towards maximising revenue and profit? How can staff (especially customer facing staff) be encouraged to do the right thing (to ask ‘Should I’) except by the line manager observing, encouraging counselling and supporting the staff in that task? What is the point of allowing an incentive payment for doing the assigned task in a way that meets but does not exceed what is expected of that staff member?' the Commissioner writes.
• Should incentives be paid to executives?  Commissioner Hayne also questions whether bonuses should be paid to more senior staff/executives. 'If customer facing staff should not be paid incentives, why should their managers, or those who manage the managers? Why will altering the remuneration of front line staff effect a change in culture if more senior employees are rewarded for sales or revenue and profit?' he writes.

Policy questions

Particular policy questions in relation to these issues include the following.

• 'What more should be done to implement the recommendations of the Sedgwick Review?'
• 'Should any bank employee dealing with a customer be rewarded (whether by commission or as part of an incentive remuneration scheme) for selling the client a product of the employer? That is, should any ‘customer facing employee’ be paid variable remuneration? '
• 'If the answer is either ‘no’ or ‘some should not’ what follows about incentive remuneration for managers or more senior executives? If more junior employees should not be remunerated in this way, why should their managers and senior executives?'
• 'Should other changes be made to the remuneration practices of banks? What would they be, and how could change be required?'

The BEAR (Banking Executive Accountability Regime)

• ‘Is the Banking Executive Accountability Regime (‘the BEAR’) relevant to the intersections between remuneration and culture more generally than in its application to particular senior executives?
• ‘Should the BEAR be altered?’
• ‘Should the BEAR be extended in application?’

Conflicts of interest arising from business structures (Vertical integration) 

Particular policy questions identified in relation to this issue include:

• 'Do the events that have happened suggest that manufacturers of financial products should not be permitted to provide, whether by employee or authorised representative, personal financial advice in relation to products of a kind it manufactures?'
• 'Do the events that have happened raise any issue about business structures?' 
• 'Do the events that have happened invite consideration of whether structural changes should now be made? More particularly, do they provoke examination of how and to what extent conflicts of interest and duty arising from the structure of the business can be managed?'

Other policy questions in relation to specific issues

Particular policy questions identified by the Commissioner in relation to each of the first four rounds of hearings, and the themes to emerge, are identified in Chapter 10, Volume 1 of the Interim Report. Some of the questions identified in relation intermediaries and in relation to responsible lending are below.

Roles and responsibilities of intermediaries

The Interim Report identifies a number of policy questions concerning the role of intermediaries (mortgage brokers, mortgage aggregators, introducers, financial advisers, authorised representatives of financial services licensees and representatives at point of sale of credit licensees). Policy questions identified in the report include the following (among others).

• ‘For whom do the different kinds of intermediary (mortgage brokers, mortgage aggregators, introducers, financial advisers, authorised representatives of Licensees, point of sale sellers of loans) act? For whom should each kind of intermediary act?’
• ‘If intermediaries act for the consumer of a financial service: What duty do they now owe the consumer? What duty should they owe?’
• ‘Who is responsible for each kind of intermediary’s defaults? Who should be responsible?’
• ‘How should intermediaries be remunerated?’
• ‘Are external dispute resolution mechanisms satisfactory?’
• ‘Should there be a mechanism for compensation of last resort?’

Responsible lending

• 'Should the test to be applied by the lender remain "not unsuitable"? How should the lender assess suitability? Should there be some different rule for some home loans?'
• 'Should the NCCP Act [National Consumer Credit Protection Act 2009 (Cth) (the NCCP Act)] apply to any business lending? In particular, should any of its provisions apply to: SMEs? agricultural businesses? some guarantors of some business loans?'
• 'To what business lending should the Banking Code of Practice apply? Is the definition of “small business” satisfactory?'
• 'Should lenders adopt different practices or procedures with respect to agricultural lending?'
• 'Are there classes of persons from whom lenders should not take guarantees; or should not take guarantees unless the person is given particular information or meets certain conditions?'
• 'How should lenders manage exit from a loan at the end of the loan’s term; if the borrower is in default?'

Response to the release of the Interim Report

• Treasurer Josh Frydenberg released a statement welcoming the release of the report and commenting that it, and the hearings to date, 'make clear that some financial institutions have fallen far short of treating Australians honestly and fairly'. He went on to outline the reforms already in on foot to 'reform the financial sector' adding that 'there is clearly more work to be done'. He went on to say that the government looks forward to receiving the Commission's final report by 1 February 2018 and 'acting on its recommendations'.
• Australian Banking Association (ABA): In a short statement, the ABA said: 'Today’s release of the Interim Report of the Royal Commission into Financial Services, Insurance and Superannuation, marks a day of shame for Australia’s banks. There are no excuses for the behaviour that has been exposed by the Royal Commission.  Banks accept responsibility for their failures and right now they are working day and night to make things right for their customers'. The statement adds that  'We will fix these problems and make them right without delay, to earn back the trust of the Australian public'.
• Governance Institute: Acting CEO Meegan George said that the 'The findings of the Interim Report raise issues of major concern — particularly greed — the pursuit of short term profit at the expense of ethical behaviour…The CEO and board of directors are key to influencing and improving good corporate culture. They need to put the voice of the customer first, not just the customer's wallet.'  Ms George went on to call for a ‘wide-ranging conversation on the clarity of the role of the board versus the executive and how organisations are held to account for unethical behaviour'.  Commenting on the issue of the possible change in enforcement approach/simplification of legal requirements suggested in the report, Ms George said: 'The report also raises crucial questions on whether the law should be administered or enforced differently…Governance Institute considers the Corporations Act as important economic infrastructure and we support reforms to modernise and simplify it — particularly those provisions impacting on customers and retail investors'.
• Australian Institute of Company Directors (AICD): In a statement, the AICD said that the 'revelations and testimony Revelations in testimony at the Commission about misconduct have been confronting and disturbing.'  The statement goes on to say that the AICD 'is committed to leading the governance community' in responding to the report 'I am confident the 43,000 strong membership of the AICD is committed to meeting the highest standards of governance. As part of that commitment, the messages of the Interim Report are ones we must hear. The misconduct revealed by the Royal Commission has contributed to the historically low levels of trust in our institutions. The task of restoring that trust is one that the AICD community will play a vital part in'.
• NAB: In a statement, CEO Andrew Thorburn said 'For us at NAB, where we have made mistakes or done the wrong thing, we will own them and fix them. It is difficult to face the statement of ‘profits before people’, but this is exactly what we need to confront. Banking was built on putting people first and earning the trust of customers. We must return to these principles once again, rather than continuing to be short term managers.'
• Westpac: In a statement, Westpac CEO Brian Hartzer said: 'The Royal Commission has identified many examples of misconduct across the industry. I apologise to any customers who have been impacted by mistakes that we have made'. The statement outlines the steps Westpac has already implemented and notes that 'we still have more work to do'.
• CBA:  In response to the Interim Report Commonwealth Bank of Australia CEO Matt Comyn said: 'The Royal Commission’s Interim Report released today is confronting and rightly critical of our industry and our bank. We have seen too many examples of unacceptable behaviour and unacceptable customer outcomes. The Commission has highlighted the need for significant changes, particularly to systems, processes and culture. I am committed to making sure that we learn from the failures detailed in this report to fix what went wrong and put things right for our customers. We have already made a number of changes and will make more to meet the community’s expectations and earn trust. The vast majority of our people do the right thing by their customers every day. They have also been let down'. Mr Comyn added that CBA will provide a submission to the Commission on the issues raised.
• AMP: In response to the report, AMP acting CEO Mike Wilkins issued a statement acknowledging the release of the Interim Report and noting that 'under the direction of new leadership, AMP has reset our business to accelerate positive changes in culture, governance, regulatory reporting and performance' and outlines some steps being taken. The statement adds 'We know we have more to do and we are committed to doing it'.