Misconduct in the Australian financial industry – what can New Zealand boards learn?

The long awaited Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry has dominated Trans-Tasman headlines this week. It is over a thousand pages long and includes 76 recommendations for reform. But what does it mean for boards in New Zealand? We highlight below key governance related findings and comments from Commissioner Kenneth Hayne AC QC that are relevant to all boards and directors in New Zealand.

Boards are responsible for misconduct

Upfront, the Royal Commission categorically states “that the primary responsibility for misconduct in the financial services industry lies with the entities concerned and those who managed and controlled those entities: their boards and senior management”.

Culture and the board

The board’s role in overseeing organisational culture and conduct has been central to the Royal Commission and it concludes that “culture can – and must – be assessed” by entities:

“Governance refers to the entirety of structures and processes by which an entity is run. By shaping how the business is run, governance shapes culture. The systems, controls and risk management processes of the business affect its culture. … It embraces not only how, and by whom, decisions are made, but also the values or norms that the processes of governance are intended to effect. Hence, it is rightly said that the ‘tone’ of the entity is, and must be, set at the top. But that tone must also be echoed from the bottom and reinforced at every level of the entity’s management and supervision; it must always ‘sound from above’. And a culture that fosters poor leadership, poor decision-making or poor behaviour will undermine the governance framework of the entity”.

Receiving the right information

The Commission focuses on connections between failings in governance and the occurrence of misconduct. Key criticisms were that boards of financial services entities often did not receive the right information about emerging non-financial risks and did not do enough with the information they did receive to oversee and challenge management in relation to such risks. It highlights that:

“Boards must have the right information in order to discharge their functions. In particular, boards must have the right information in order to challenge management on important issues including issues about breaches of law and standards of conduct, and issues that may give rise to poor outcomes for customers. … it is the quality, not the quantity, of information that must increase. Often, improving the quality of information given to boards will require giving directors less material and more information. … But boards and management must keep considering how to present information about the right issues, in the right way”.

Greater oversight of non-financial risks

The Commission found that when financial services entities considered risk and risk management, they failed to prioritise non-financial risks as well as financial risks. This left their frameworks for the management of non-financial risks underdeveloped.

“Entities must give sufficient attention, and devote sufficient resources, to the effective management of non-financial risks”.

Holding management to account

A core role of the board is to hold management to account and the Commission emphasised this:

“Boards must also use the information that they have to hold management to account. Boards cannot, and must not, involve themselves in the day-to-day management of the corporation … The task of the board is overall superintendence of the company, not its day-to-day management. But an integral part of that task is being able and willing to challenge management on key issues, and doing that whenever necessary”.

Remuneration and incentives

Remuneration and incentives (particularly variable remuneration programs) tell staff what entities reward, and it is evident that poor remuneration and incentive programs in the financial services industry has led to poor customer outcomes. A number of remuneration related recommendations have been put forward by the Commission including that entities ensure they regularly assess the effectiveness of their remuneration system in encouraging sound management of non-financial risks, and reducing the risk of misconduct. It is a timely reminder for boards to review remuneration policies and practices to ensure they are fit for purpose.

Accountability is critical

Accountability is central to corporate governance and the Commission found that often “it was unclear who within a financial services entity was accountable for what. Without clear lines of accountability, consequences were not applied, and outstanding issues were left unresolved”.

Director duties and shareholder and stakeholder interests

The Commission is highly critical of financial services entities that put the pursuit of profit above all else (including the interests of their customers and compliance with the law). In the context of discussing the board’s accountability to shareholders, the Commission considers the nature and extent of director duties:

“Directors must exercise their powers and discharge their duties in good faith in the best interests of the corporation, and for a proper purpose. That is, it is the corporation that is the focus of their duties. And that demands consideration of more than the financial returns that will be available to shareholders in any particular period. Financial returns to shareholders (or ‘value’ to shareholders) will always be an important consideration but it is not the only matter to be considered”.

In relation to stakeholder interests, the Commission notes:

“In the longer term, the interests of all stakeholders associated with the entity converge … Regardless of the period of reference, the best interests of a company cannot be reduced to a binary choice. And financial services entities are no different. Pursuit of the best interests of a financial services entity is a more complicated task than choosing between the interests of shareholders and the interests of customers”.

Questions for boards

Relevant to boards, the Commission reiterates questions from the Australian Prudential Regulation Authority’s 2018 report into the Commonwealth Bank of Australia:

• Is there adequate oversight and challenge by the board and its gatekeeper committees of emerging non‑financial risks?
• Is it clear who is accountable for risks and how they are to be held accountable?
• Are issues, incidents and risks identified quickly, referred up the management chain, and then managed and resolved urgently?
• Is enough attention being given to compliance? Is it working in practice? Or is it just ‘box-ticking’?
• Do compensation, incentive or remuneration practices recognise and penalise poor conduct? How does the remuneration framework apply when there are poor risk outcomes or there are poor customer outcomes? Do senior managers and above feel the sting?

What’s next for New Zealand?

It is uncertain the extent to which the recommendations for reform in Australia will have a flow on effect in New Zealand. However, the Government (after receiving reports on conduct and culture in our banking and insurance industry) has signalled that it will fast track customer protection measures across the financial sector.