Too few of us realise it, but we should thank God (and my new best friend, Peter Costello) for our independent central bank. Prime ministers and treasurers seem to say little that’s not point scoring, and Treasury is now highly politicised, but we can always rely on Reserve Bank governors to be frank about what’s happening in the economy and what should be happening.
Last week the latest of our straight-shooting governors, Dr Philip Lowe, offered his conclusions on the shocking revelations of the banking royal commission. His wise words are worth recounting at length, to be sure you don’t miss them.
As Lowe reminds us, finance is all about trust. The first line of the voluntary “banking and finance oath” (which more bankers should now be taking) says “trust is the foundation of my profession”.
Australian banks have a strong record of being worthy of the trust that is placed in them to repay deposits, but in other areas trust has been strained.
The royal commission has highlighted three issues where work is needed to restore the public’s trust. First, Lowe says, “the inadequate way in which banks have dealt with conflict of interest issues”.
Second, “the way that poorly designed incentive systems can distort behaviour – promoting a sales culture at the expense of a service culture, and promoting the short term at the expense of the long term”.
Third, “the fact that the consequences for not doing the right thing have, in some cases, been too light”.
Central to fixing these breaches of trust is creating a strong culture of service within our financial institutions, Lowe says. This starts with correcting the system of internal reward established by the board and management.
“The vast bulk of the people who work for Australia’s financial institutions do want to do the right thing, and they do want to serve their customers as best they can. But, like everybody else, they respond to the incentives they face.
“If they are rewarded on sales or short-term objectives, it should not come as a great surprise that that’s what they prioritise.”
In the minds of economists, incentives can be negative (sticks) as well as positive (carrots). “One of the things that influences incentives is the consequences and penalties that apply when something goes wrong.
“Strong penalties can play an important role in incentivising good behaviour, and this is an area we should be looking it.”
But it’s worth distinguishing between the penalties that apply for poor conduct and those that apply for granting loans that can’t be repaid, Lowe says. “On conduct issues, we should set our expectations and standards high, and if they are not met the penalties should be firm.”
With bank lending, however, it’s trickier. “Even when banks lend responsibly, a percentage of borrowers will end up in financial strife and be unable to meet their obligations.
“We need banks to be prepared to make loans in the full expectation that some borrowers will not be able to pay them back."
Get this: “Banks need to take risk and manage that risk well. If they become afraid to lend simply because of the consequences of making a loan that goes bad, our economy will suffer.”
So it does seem true that Lowe fears the banks will overreact to the punishment and tighter regulation imposed on them following the royal commission’s findings, and that this could lead to them crimping economic growth.
(Just how concerned Lowe is about this is something the media can only speculate about. Top econocrats will always be sotto voce, for fear a loud shout of warning may be self-fulfilling. The media trumpet dire predictions because they don’t imagine anyone will take them seriously.)
Back on the public’s trust, having clear lines of accountability can help. But “we should not lose sight of the fact that it is the banks’ boards and management that are ultimately responsible for the choices that banks make. Creating the right culture is a core responsibility of boards and management.”
One thing that would help, Lowe says, “is for financial institutions to a have a long-term focus and reflect that in their internal incentives. Managing to short-term targets might boost the share price for a while, but this short-termism can weaken the long-term franchise value of the bank.
“I would argue that the franchise value is more likely to be maximised if our financial institutions have a long-term perspective, treat their customers well, reward loyalty rather than take advantage of it, and invest in systems and technology that deliver world-class financial services . . .
“Doing this would not only be good for bank shareholders, but also for the broader community.” Well said.
