Royal commission puts entire Australian regulatory system under the microscope

The "invisible defendant" throughout the Australian royal commission into financial services has been the regulatory model itself. How could so many serious and systemic conduct failures occur under ASIC's watch?

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THE REVELATION during the financial services royal commission that AMP misled the Australian conduct regulator on at least 20 separate occasions was a watershed moment. The dissection of AMP group executive Jack Regan on the stand this week was one of the most poignant moments in the inquiry to date. At one point, Regan smiled sheepishly as he lost count of the number of times his organisation had misled the Australian Securities and Investments Commission (ASIC).

"It's clear that we preferenced shareholders in that exchange at the expense of customers," he said during an interrogation from Michael Hodge, counsel assisting the commission.

The royal commission is officially an inquiry into the financial services industry. As the process gathers momentum, however, there is a more amorphous and less visible entity on trial: the regulatory system itself.

Misleading the regulator

The level of disregard AMP had shown toward regulators was "deeply disturbing", Scott Morrison, the treasurer, said during a doorstop interview in Sydney yesterday.

"This type of behaviour can attract penalties which include jail time. That's how serious these things are." — Treasurer Scott Morrison

Morrison said he is confident that ASIC has the staff, the funding and the mandate to bring the industry to heel. "We have a new deputy chairman coming into ASIC who starts later this year. He will have the specific powers and the specific backing to be out there prosecuting these types of cases," he said.

ASIC, meanwhile, said it had been investigating AMP's conduct in relation to "fees for no service" and the provision of false or misleading statements. The regulator has requested thousands of documents as evidence and has interviewed 18 AMP staff members. It has left open the possibility it may resort to criminal charges against individuals.

"Making false or misleading statements to ASIC can result in civil and criminal sanctions," the regulator said in a statement earlier this week.

"The paradigm is broken" 

Despite these assurances, regulatory experts are mixed in their views on ASIC's capacity to restore trust and accountability to the financial services sector. At the Australian Regulatory Summit in Sydney last week policy experts came together with politicians, industry associations, senior compliance executives and regulators to discuss the future of regulation.

One of the key topics of debate was the way forward for regulators — and the system itself — following the slew of damaging revelations from the Hayne Inquiry.

Justin O'Brien, professor of financial regulation at Monash Business School, said the revelations from the royal commission left little doubt that the existing regulatory model was broken. While ASIC was not the subject of the inquiry, its regulatory failures were a consistent theme throughout the commission hearings, he said.

"I think the problem is that the paradigm's broken. It's fundamentally broken; it's pointless to pretend otherwise." — Justin O'Brien, Monash 

The findings could prove so damaging, and the regulatory failures so extensive, that it may be difficult to retain ASIC in its existing form, he said.

"All markets are held together by a combination of rules, principles and social norms. When the social norms get out of kilter with community expectations, you have a problem," O'Brien said. 

"The former Financial Services Authority in London was disbanded as a consequence of the failure of its paradigm," he observed.

A worthwhile process 

Kevin Davis, professor of finance at the University of Melbourne, said some financial services firms had become both too big to fail and too large to manage.

"I don't think the entire system is broken. The challenge is, we're dealing with large institutions in general and the issues of culture and control and command within those institutions are very difficult," Davis said.

"I was originally of the view that a royal commission was not necessary … but I've come to the view that it's a worthwhile process. It's somewhat cathartic." — Kevin Davis, University of Melbourne

One outcome of the royal commission may be a dismantling of the vertically integrated financial services model, Davis said. Some banks have already begun this process by divesting their non-core businesses, such as life insurance or wealth management.

"What's going to come out of the royal commission we don't know, but it's clear that it's focusing a lot of attention on how institutions can instil a culture and manage the conduct associated with that culture all the way down through the institution," Davis said.

"We're yet to see how that'll work but we've at least got the mechanisms coming into place."

Focus on individual accountability

Senior compliance practitioners, meanwhile, are confident the financial sector will emerge from the royal commission with greater accountability and a clearer focus on customer outcomes.

The focus should be on enforcement and accountability, rather than a systemic overhaul, said Anatoly Kirievsky, Asia-Pacific head of compliance at Optiver, a market maker. Many different regulatory regimes could be effective in securing good societal outcomes, he said. 

"There's not one system that's necessarily going to be better than others, a priori. It's just a matter of how you enforce it. I think we have a decent structure. It just hasn't been fully utilised," he said.

One of the most important priorities following the commission should be to re-set the balance between personal profit and the lack of individual accountability, Kirievsky said. This could be achieved using the existing powers that regulators have been reluctant to engage.

The introduction of the Banking Executive Accountability Regime (BEAR) was a significant step in the right direction, he said.

"I really think the focus on individual outcomes hasn't been there. I think that's something that [the Australian Prudential Regulation Authority] has called out. Senior executives have very disproportionate pay-offs. They get the upside with very limited downside," he said.

"I think that focus [with BEAR] on what happens to individuals, on both the upside and the downside, will drive the change. So I think the royal commission will have an impact that way."

Conclusion: A separation of power?

One of the key themes throughout the Hayne inquiry has been the pervasive problem of allowing financial services firms to become too big to manage, too big to fail and too big to regulate. It's a dangerous combination. What we're seeing play out in Melbourne is a tussle between the corporate sector's largest and most influential players and the judiciary.

Who will prevail?

The dominant regulatory theory suggests that consolidation is a good thing. Regulators have taken the view that it is easier to manage a smaller number of vertically consolidated, well-run firms. The bancassurance model (currently being dismantled in Australia due to unacceptable reputational risks) is a good example of this. Industry consolidation was also an unstated goal of the Future of Financial Advice reforms. At the time, policymakers and senior regulators knew that FoFA would strengthen the position of the major players.

ASIC and other financial regulators supported this vertically integrated "megabank" model as they thought consolidation would ultimately make oversight easier. It harks back to the old philosophical question: would you rather herd 1,000 ant-sized rhinos, or one rhino-sized ant? Canberra decided to back the latter.

As it turned out, however, the rhino-sized ant had become so large and powerful over a period of decades that it no longer feared the regulators, politicians or the judiciary. The discovery that major players were deliberately misleading ASIC, in spite of criminal penalties, leaves little doubt that this was the case.

This is a disaster for consumers. And it's also a disaster for the financial sector, as consumer outcomes are sacrificed in the quest for market share and short-term profitability.

The royal commission has demonstrated that in too many instances the rhino was herding the regulator. The first casualty of this type of regulatory warfare is "trust", the intangible commodity that binds financial markets together.

Alan Fels, the regulatory heavyweight, academic luminary and former competition tsar, has weighed into the debate overnight. He says that forced separation is now inevitable and will give regulators a fighting chance at maintaining order in the financial system.

Fels is a true legend in the regulatory sphere. His comments will carry a lot of clout in Canberra.

If I was a betting man (or a bank shareholder for that matter), I'd say ASIC will survive the royal commission intact. It will emerge with a renewed mandate and the right political support and funding for it to take an aggressive enforcement stance.

The vertically integrated bank model, on the other hand, may not prove so resilient.

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