RBA issues warning over fear-provoking lending penalties

In his address to the Committee for Economic Development of Australia annual dinner, governor of the Reserve Bank of Australia Philip Lowe sought to emphasise the need for a distinction between penalties imposed for misconduct in the financial sector and penalties incurred for responsible lending breaches.

Mr Lowe said that in his view, the key issues raised by the financial services royal commission include:

• the inadequate way in which banks have dealt with conflict of interest issues;
• 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; and
• the fact that the consequences for not doing the right thing have, in some cases, been too light.

Mr Lowe claimed that strengthening trust in financial institutions is incumbent on such issues being addressed and made particular reference to the use of incentives in the industry.

He continued: “Central to this task is creating a strong culture of service within Australia’s financial institutions. Too often our financial institutions prioritised sales over service. Correcting this starts with 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. So, establishing the right incentives is key.”

However, while noting the “important role” that “strong penalties” can play in incentivising good behaviour, Mr Lowe issued a warning over the potential for “unintended consequences” of similar penalties in the lending space.

“In my view, it is worth making a distinction between the penalties that apply for poor conduct and those that apply for making loans that ultimately cannot be repaid.

“On conduct issues, we should set our expectations and standards high, and if they are not met, the penalties should be firm.”

Mr Lower added: “On lending, matters are more complex. 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.

“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, a balance needs to be struck here.”

Further, Mr Lowe noted the importance of accountability in rebuilding trust, stating that the Banking Executive Accountability Regime (BEAR) would be “helpful” in improving accountability across financial institutions.

However, Mr Lowe stressed that it is ultimately up to the financial institutions to improve accountability frameworks, not regulation.

“[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.

“It is unrealistic to expect that an appropriate culture can be created through regulation and penalties. Creating the right culture is a core responsibility of boards and management.”

[Related: Reform to focus on culture, says Assistant Treasurer]