The Origins of Ethical Failures: Lessons for Leaders [2 ed.] 1032334568, 9781032334561

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“In this updated edition, Gentilin has refected on the events of the past few years and provided us with a deeper, more expansive understanding of governance failures within institutions. By doing so, he has taken the exploration of ethical challenges in business to a completely new level.” Lindsay Tanner, Australian Minister for Finance 2007–2010 “If you liked the frst edition of The Origins of Ethical Failures, then you MUST read this largely revised edition. Gentilin has gone back to the drawing board to review the research and recent industry developments, including case studies that emerged from the Hayne Royal Commission. His readable style brings to life rigorous research fndings and presents the case for a less idealistic and more hardnosed focus on institutional arrangements.This is a fascinating and challenging account of why people behave badly at work and what can be done about it.” Professor Elizabeth Sheedy, Macquarie Business School “Gentilin provides a challenging narrative for those of us who commit our professional lives to promoting ethics and governance. By drawing our attention to our capacity to err, he builds a compelling argument that ethics codes, although necessary, are not sufcient. To make ethical conduct a reality, leaders must ‘focus obsessively’ on putting in place ‘institutional arrangements’ that support the pledges within these foundational documents. This book is a must-read for leaders, regulators and students who are serious about creating lasting positive change.” Cris Parker, Director,The Banking and Finance Oath “The Origins of Ethical Failures ofers the reader a range of powerful insights into what drives misconduct in fnancial service institutions. Ethics, culture, economic incentives, public and private governance and group dynamics in big organisations are all dissected to draw the reader to the inevitable conclusion that there is no one silver bullet for solving this problem. Rather, the answer lies in examining the insights gained from a range of disciplines and drawing the threads together, something that Gentilin does well. I commend this book to anyone seeking a more holistic understanding of ethical failure.” Helen Bird, Senior Lecturer, Swinburne Law School

“Gentilin knows the research, and the theory, but more importantly – he has lived and exemplifed the reality. If you want to be a better professional, and to be a better professional organisational leader with credibility, you will buy and read this book.” A. J. Brown, Professor of Public Policy & Law, Grifth University; Board member,Transparency International

The Origins of Ethical Failures In this thoroughly updated new edition of his ground-breaking and award-winning book, Dennis Gentilin draws on both his personal experience as a well-known whistleblower and recent events in the Australian fnancial services industry to provide insights into how widespread, systemic ethical failure can take hold in an industry and, crucially, what leaders need to focus on to avoid it. In 2001, as a young university graduate, Dennis Gentilin became a member of an FX trading desk at one of Australia’s largest banks, the National Australia Bank. In the years that followed, the desk became involved in a trading scandal that resulted in the resignation of the chairman and CEO, the collapse of the board, signifcant fnancial loss and incalculable reputational damage. Over the past decade, the frequency of ethical failure within the Australian fnancial services industry has only increased. Among other failures, there have been multiple breaches of the Anti-Money Laundering and Counter-Terrorism Financing Act, rigging of the benchmark BBSW interest rate, mis-selling of consumer credit insurance and predatory sales practices. In this new edition, Gentilin draws on experimental research from economics and fnance to illustrate how, when the conditions are permissive, humans have a predisposition towards dishonesty, and therefore, to reduce the likelihood of ethical failure, leaders must focus obsessively on putting in place appropriate institutional arrangements. Gentilin’s combination of intellectual rigour and real-life refections makes this book a must-read for students, practitioners and leaders alike who would like to develop a deeper understanding of corporate ethics, governance and conduct. Dennis Gentilin is a risk and governance professional with over 20 years’ experience in the banking and fnance industry. A unique experience early in his career in which he was publicly named as a “whistleblower” was the catalyst for his strong interest in ethics, conduct and culture. He has contributed articles to The Australian Financial Review and The Australian on these topics and is invited to lecture at some of Australia’s leading business schools. Dennis currently works with UniSuper, one of Australia’s largest superannuation funds.

The Origins of Ethical Failures Lessons for Leaders SECOND EDITION

Dennis Gentilin

Designed cover image: Getty Images / erhui1979 Second edition published 2023 by Routledge 4 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN and by Routledge 605 Third Avenue, New York, NY 10158 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2023 Dennis Gentilin The right of Dennis Gentilin to be identifed as author of this work has been asserted in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identifcation and explanation without intent to infringe. First edition published by Routledge 2016 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Names: Gentilin, Dennis, author. Title: The origins of ethical failures: lessons for leaders / Dennis Gentilin. Description: Second edition. | Abingdon, Oxon; New York, NY: Routledge, 2023. | Includes bibliographical references and index. Identifers: LCCN 2022032286 (print) | LCCN 2022032287 (ebook) Subjects: LCSH: Business ethics. | Organizational behavior—Moral and ethical aspects. | Professional ethics. | Leadership. Classifcation: LCC HF5387 .G465 2023 (print) | LCC HF5387 (ebook) | DDC 174/.4—dc23/eng/20220707 LC record available at https://lccn.loc.gov/2022032286 LC ebook record available at https://lccn.loc.gov/2022032287 ISBN: 978-1-032-33456-1 (hbk) ISBN: 978-1-032-36832-0 (pbk) ISBN: 978-1-003-33536-8 (ebk) DOI: 10.4324/9781003335368 Typeset in Bembo by codeMantra

To my wife and daughters, who provide corporate ethics with the necessary context.

Contents

Preface

xi

List of acronyms

xiii

Introduction

1

2

1

References

13

Our fawed humanity

17

Are humans honest?

21

Fee-for-no-service scandal

32

Lessons for leaders

37

References

37

Incentives

41

Are incentives effective?

45

Balanced scorecards

48

Long-term incentives

57

The role of public institutions

61

Lessons for leaders

66

References

68

ix

Contents

3

4

Accountability

71

Does accountability promote ethical behaviour?

74

A failure of self-regulation

82

The role of public institutions

89

Lessons for leaders

97

References

99

Group dynamics

102

Leadership

103

Group norms

111

Whistleblowing

115

The role of public institutions

123

Lessons for leaders

126

References

128

Conclusion: What are the lessons for leaders?

131

It starts at the top

133

What about purpose?

137

Don’t forget ethical followership

139

Finally

140

References

141

Index

143

x

Preface

For a variety of reasons, this edition was a long time in the making. A failed collaboration, a global pandemic and work commitments all caused me to continually revise and push back the anticipated completion date. But I was determined to produce a largely reviewed and improved version of the frst edition. In addition to my understanding of the issues having evolved, a lot has happened since it was published in early 2016. The book benefted from the opinions provided by a range of reviewers.What was a nine-chapter manuscript was pared back to what you are currently reading. Due to their input, the book is now far easier to read and a more faithful second edition. I am deeply appreciative to them for not only reading earlier versions (that were far more difcult to consume) but for also taking the time to provide valuable feedback. I would also like to thank countless friends who have been patient and supportive as I have worked on this project; my employers, both past and present, who have also shown tremendous support and allowed me to pursue my interests in ethics, governance and writing; and my family, who have had to tolerate a dad and husband spending a lot of his spare time with his head buried in a laptop. This edition represents a paradigm shift of sorts for me. In the frst edition, I placed far more faith in our capacity for honesty. In this edition I am more circumspect, placing greater emphasis on our capacity to err (especially when the conditions are permissive). Ultimately, the evidence was too overwhelming.What does not change is the central role of leadership, albeit the lessons for leaders have evolved. Like the frst edition, my primary goal is to educate. I hope that students and emerging leaders (and perhaps current leaders) across the private and public sectors fnd something of value within this book. Dennis Gentilin 9 June 2022 xi

Acronyms

ADI AMP ANAO ANZ APRA ASIC ASX AUD AUSTRAC BBSW BEAR BS CBA CEO CG CHF CRO EPA EUR FASB FoFA FP FR FSB

authorised deposit-taking institution Australian Mutual Provident Society Australian National Audit Ofce Australia and New Zealand Banking Group Australian Prudential Regulation Authority Australian Securities and Investments Commission Australian Securities Exchange Australian dollar Australian Transaction Reports and Analysis Centre bank bill swap rate Bank Executive Accountability Regime balanced scorecard Commonwealth Bank of Australia chief executive ofcer compliance gateway Swiss Franc chief risk ofcer Environmental Protection Agency Euro Financial Accounting Standards Board Future of Financial Advice fxed pairs fxed remuneration Financial Stability Board

xiii

Acronyms

FX LIBOR LTI LTIP MLC NAB NEPA OSC PIO PWC R&D RP SRO STI WBC WWTW

foreign exchange London Interbank Ofered Rate long-term incentive long-term incentive plan Mutual Life and Citizens Assurance Company Limited National Australia Bank Norwegian Environmental Protection Agency Open Science Collaboration principal integrity ofcer PricewaterhouseCoopers research and development random pairs self-regulating organisation short-term incentive Westpac Banking Corporation Whistling While They Work

xiv

Introduction

Doubt is not a pleasant condition, but certainty is absurd. Oeuvres Complètes de Voltaire (translated from p. 703,Voltaire, 1817) As the readers of the frst edition of this book are aware, the experience that was the catalyst for my interest in ethics, governance and conduct was the foreign exchange (FX) trading scandal that rocked the National Australia Bank (NAB) in 2004. The incident, which resulted in the ofending traders receiving custodial sentences and the resignations of the then chairman and chief executive ofcer (CEO), cost the NAB AUD 360 million.Although marginal by international standards, it remains the largest incident of its kind in Australia (Rafeld, Fritz-Morgenthal & Posch, 2020). It followed the typical trajectory associated with trading scandals. Although initially nominal, the losses being concealed mounted. When a method to conceal losses is discovered and deployed, it is very difcult to put that genie back in the bottle. As the losses mounted, so too did the size of the position taken to try to recoup them. Wash, rinse, repeat. It all gets very ugly, very quickly. I was publicly named as one of the whistleblowers in the scandal and like most whistleblowers, spent the years that followed in deep refection. Among the questions I pondered, one was “Why?” Specifcally, why do ethical failures happen? And why will they continue to happen? One of my motivations for writing the frst edition of this book was to provide plausible responses to these questions.The FX trading scandal provided me with some extraordinary insights. I felt that by combining those insights with the research in the behavioural sciences, I could ofer a unique perspective on the origins of ethical failure. In many ways the exercise proved successful.The book received plaudits, a prize, and was endorsed by some prominent individuals. But as the years passed an urge DOI: 10.4324/9781003335368-1

1

Introduction

arose to write a second (and hopefully improved) edition. There were primarily two reasons for this urge.The frst was the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (hereafter the Royal Commission). The second was a review of the book written by Professor Andreas Ortmann from the University of New South Wales Business School (Ortmann, 2018). The Royal Commission was established in December 2017, just under two years after the frst edition of this book was published. Those who read the frst edition would have recognised that at the time of its publication, I felt that the Australian fnancial services industry was at a crisis point. Given what has transpired since, this observation has not aged well. At that point in time, we were still enjoying pre-dinner drinks with respect to ethical failures in the banking and fnance industry. In the short period between the book’s publication and the announcement of the Royal Commission, there were a range of signifcant, high-profle ethical failures, as the following examples attest. The rigging of the bank bill swap rate (BBSW), Australia’s benchmark interest rate, frst hit the headlines in 2017. It had many parallels with the London Interbank Ofered Rate (LIBOR) scandal which swept through the Northern Hemisphere a few years earlier. Australia’s four major banks were charged with market manipulation and unconscionable conduct. The NAB (Dunkeley & Danckert, 2017), Commonwealth Bank of Australia (CBA) (Yeates, 2018) and Australia and New Zealand Banking Group (ANZ) (Danckert & Yeates, 2017) agreed to pay combined fnes of AUD 125 million. Westpac Banking Corporation (WBC) contested the charges with some success, although they were still found to have behaved unconscionably (Danckert, 2018). Although it did not result in similar penalties, the scandal that besieged CommInsure (the CBA’s insurance arm) was highly symbolic as it captured the public’s attention. Unlike many of the prior governance failures, it vividly demonstrated how misconduct in the fnancial services industry can have real impacts on real people. Former CommInsure chief medical ofcer turn whistleblower Dr Benjamin Koh went to the media to reveal how CommInsure used technicalities in insurance contracts to avoid making payouts to clients. Listening to victims tell their story on Four Corners, one of the national broadcaster’s fagship documentary programs, made for uncomfortable viewing (Ferguson, 2016). Arguably the most signifcant incident was the breaches of the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth) by the CBA. In August

2

Introduction

2017, the Australian Transaction Reports and Analysis Centre (AUSTRAC) issued a statement of claim that alleged the CBA breached the Act on no fewer than 53,000 occasions (Yeates, 2017a). The breaches involved a failure to properly monitor and report a range of suspicious customer deposits made through “intelligent deposit machines”, some of which were associated with organised crime and terrorism activity.The enormity of the incident resulted in the Australian Prudential Regulation Authority (APRA) announcing an independent review of the CBA, the frst of its kind (Yeates, 2017b). These incidents (and others) only served to amplify the already raucous calls for some form of government inquiry into the sector. Then Prime Minister Malcolm Turnbull and his ruling Liberal-National Government, who were resisting the mounting public pressure, eventually capitulated after the chairs and CEOs of the four major banks sent an e-mail to the then Treasurer Scott Morrison requesting “a properly constituted inquiry” (Gartrell & Bagshaw, 2017). As outlined in Box I.1, what followed was further revelations of serious wrongdoing, causing many members of the government to publicly acknowledge the error in their earlier judgment that there was no need for an inquiry (Grattan, 2018). The evidence presented at the Royal Commission made me seriously question some of my views on both the causes of ethical failure but also the possible remedies. The frst edition of the book spoke about the important role of leadership and how by articulating “a meaningful social purpose for their organisations that is underpinned by a virtuous set of values” (p. 99, Gentilin, 2016), leaders could draw on human nature’s capacity for honesty. Elements of this remain true but the evidence emerging from the Royal Commission, coupled with recent research emerging from experimental economics, demonstrates that in some important ways it is also misguided. In addition to drawing attention to the above issue, in his review of the frst edition of the book Ortmann (2018) highlighted the shortcomings associated with the research referenced to support some of the conclusions drawn. Research emanating from the behavioural sciences, and in particularly from psychology, has come under signifcant criticism in recent times. Although the reckoning has gathered apace over the past few years, it could be argued that the canary in the coal mine was a famous article written by John Ioannidis in 2005 which claimed that for a range of reasons, many research fndings across a range of felds are spurious (Ioannidis, 2005).This proved to be prescient.

3

Introduction

Box I.1 The Royal Commission into misconduct in the banking, superannuation and fnancial services industry Although there had been calls for some type of inquiry into Australia’s fnancial services industry for many years (as early as 2014), the spate of governance failures during 2016 and 2017 placed increasing pressure on the former Liberal-National Coalition Government to establish a Royal Commission. During 2017, with government members threatening to cross the foor and support the then opposition Labor Party in calling for a Royal Commission, it seemed to be a foregone conclusion. Perhaps recognising this and the damage all of the speculation was doing to the industry, the chairs and CEOs of the four major banks sent an email to the then Treasurer Scott Morrison on 30 November 2017 stating, inter alia (Gartrell & Bagshaw, 2017): We now ask you and your government to act to ensure a properly constituted inquiry into the fnancial services sector is established to put an end to the uncertainty and restore trust, respect and confdence. Then Prime Minister Malcolm Turnbull announced the establishment of a Royal Commission shortly thereafter and former High Court judge Kenneth Hayne was appointed as the commissioner. The terms of reference provided him with authority to investigate misconduct that was not only illegal but fell below “community standards and expectations” (Commonwealth of Australia, 2017). As part of his inquiry, Commissioner Hayne was also asked to ascertain whether wrongdoing was attributable to “particular culture and governance practices” or “other practices, including risk management, recruitment and remuneration practices”. In addition, any conduct that was being “dealt with by another inquiry or investigation or a criminal or civil proceeding” was disqualifed (ruling out many notable incidents). Despite this latter requirement, the extent of what was revealed surprised and shocked many, including me. The majority of the wrongdoing occurred within the wealth sector of the industry and to a lesser extent, within the retail banking sector. Even then, the wrongdoing involved the use of dubious sales practices by retail bankers to push wealth products onto customers. As will be described in Chapter One, the banking sector made a raft of acquisitions

4

Introduction

in the wealth sector around the turn of the twentieth century. Many of these assets were acquired at signifcant premiums, with one of the justifcations for the infated purchase prices being the promise of “cross sell” (a big driver of the dubious sales practices). The product that was at the centre of the majority of these sales practices was consumer credit insurance, insurance products that were “added on” to the sale of a home loan, personal loan or credit card. In theory, consumer credit insurance was supposed to provide customers with protection when life circumstances resulted in them no longer being able to fulfl their obligations under their loan or credit card contracts. In one of the case studies examined, the CBA sold consumer credit insurance to customers who were never eligible to make a claim under the agreement as they did not fulfl certain employment eligibility criteria (in some cases they were not employed and were receiving social security benefts). Another source of wrongdoing was inappropriate fnancial advice. In many ways, the revelations associated with this conduct were not surprising as it has been a known problem in the Australian fnancial services industry for some years. In 2014, the Senate Economics Reference Committee investigated an incident within the fnancial planning division of the CBA where so-called “rogue” fnancial planners engaged in a range of inappropriate behaviour, including the overcharging of fees, forging signatures and creating unauthorised investment accounts (Ferguson & Vadelago, 2013). Although arguably not as egregious, the misconduct exposed at the Royal Commission primarily involved dubious sales practices (for example, churning products or selling products that clearly were not in the customer’s best interest). The most startling revelation was the fee-for-no-service scandal, an incident that will be described in greater detail in Chapter One. In short, the scandal involved institutions debiting fees from customers’ investment or superannuation accounts on the promise of providing a service (typically some form of review) which was subsequently not delivered. The incident frst came to the public’s attention in 2015 when the Australian Securities and Investments Commission (ASIC) announced it would commence an investigation into the conduct. The following year they announced that over 27,000 customers had been compensated approximately AUD 23.7 million for the conduct.

5

Introduction

This fgure has subsequently blown out to over AUD 1.2 billion (Australian Securities and Investments Commission, 2021). In some circles, there have been criticisms of the Royal Commission. For example, some have questioned whether the inquiry addressed the root cause of the wrongdoing it exposed, such as why the system prioritises shareholders (and in many cases, the employees within institutions) ahead of customers. Others have questioned whether the way in which the inquiry was conducted, whereby a small number of case studies were handpicked for deep examination, fed a media circus. Commissioner Hayne pre-empted such criticism and provided an explanation for why he narrowed his focus on particular issues and how the case studies were selected. Regardless of what your opinion might be, what cannot be denied is that when combined with the governance failures that came to the public’s attention in the lead-up to the inquiry, the Royal Commission exposed systemic and extensive unethical behaviour across the fnancial services industry. Although there had been failed attempts to replicate fndings of research from psychology in the interim, the epiphany for the feld arrived in 2015 when the Open Science Collaboration (OSC) – a group of almost 300 scientists – published the results of the frst large-scale replication project (Open Science Collaboration, 2015).This project attempted to replicate the fndings of 100 experiments published in three leading psychology journals. The results weren’t fattering. Findings were replicated in only about one out of three experiments and when they were, the efect size was only about half of what was found in the original study. Ironically, and relevant to this book, even research into honesty has since been exposed as being fawed (refer to Box I.2). Sufce to say, there has been sufcient criticism of much of the research referenced in the frst edition of this book, including the Stanford Prison Experiment (Haslam, Reicher & Van Bavel, 2019; Le Texier, 2019), Milgram’s obedience studies (Perry, 2012), priming research (Chivers, 2019; Kahneman, 2022; Schimmack, Heene  & Kesavan, 2017), ego depletion (Vadillo, Gold & Osman, 2018) and mortality salience (Klein et al., 2019; Sætrevik & Sjåstad, 2022). In this edition of the book, I have been more discerning when selecting research used to support the conclusions.This has resulted in me drawing on felds beyond psychology, leaning more heavily on research from experimental economics and fnance.

6

Introduction

This is not to suggest that research from these latter felds is bereft of shortcomings. The statistical fallacies that have played a central role in many of the questionable fndings emerging from psychology (for example,“p-hacking” [Simmons, Nelson & Simonsohn, 2011] and “forking paths” [Gelman & Loken, 2014]) can wreak havoc in any feld that requires the analysis of experimental data. Furthermore, the highly controlled laboratory conditions experimental economists create to conduct their research creates trade-ofs. On the one hand, these conditions provide a far more precise and clearer picture of how a particular variable of interest (in our case, ethical behaviour) is infuenced by another variable (for example, incentives). On the other hand, the setting can be excessively artifcial and not represent what someone would encounter in real-world settings. However, research from experimental economics and fnance is more likely to contain features that provide greater confdence in what the results tell us about human behaviour (or, for our purposes, about ethical behaviour). Most prominently, these features include refraining from employing deception as an experimental tool (something that, as Hertwig and Ortmann [2001] outline, can compromise results) and using incentives or real-world data in their methodology (something that increases the likelihood that participant behaviour refects what would occur in natural settings – when nothing is at stake, it is far easier for a participant to claim that they are “ethical” and will do the “right thing”).

Box I.2 “Nudging” for honesty: too good to be true The term “nudge” was popularised by a book of the same name authored by Richard Thaler and Cass Sunstein (Thaler & Sunstein, 2008). In their book, nudging was defned as follows (p. 6): A nudge, as we will use the term, is any aspect of the choice architecture that alters people's behavior in a predictable way without forbidding any options or signifcantly changing their economic incentives.To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting fruit at eye level counts as a nudge. Banning junk food does not.

7

Introduction

Since being conceived, the idea has spawned an industry. According to consulting frm McKinsey and Company, over 400 so-called “nudge units” have been established, many of these associated with governments and providing advice on public policy (Fusaro & Sperling-Magro, 2021). In addition, there have been countless research articles published investigating the efectiveness of diferent nudge techniques. The concept has delivered some successes, arguably the most notable being so-called “defaults”. When people are required to make a choice and one of the possible options is pre-selected for them, there is a strong likelihood they will choose the pre-selected option (Jachimowicz, Duncan,Weber & Johnson, 2019). Beyond this, fndings have been patchy. As Hummel and Maedche (2019) concluded in their review of the nudging literature,“it remains unclear if nudges really work and, if so, under which conditions” (p. 47). Nudging people towards honesty is one example of such an outcome. One of the most widely cited examples of an honesty nudge is the positioning of honesty pledges on forms that ask people completing them to make certain declarations. In the original experiment of its kind, Shu et  al. (2012) asked participants in a laboratory experiment to complete a simple arithmetic task. After completing the task, they were randomly assigned to three groups and required to self-report, on a separate form, both (a) their performance on the task and (b) the length of time it took them to commute to the experiment. In both cases the incentives created a temptation to over-report (higher performance and longer commuting times earned the participants a higher monetary payout).To assess how honesty pledges would infuence self-reporting behaviour, the form on which participants provided their information difered between the three groups. Specifcally, one group was required to date and sign the top of the form alongside a statement that read: I declare that I carefully examined this return and that to the best of my knowledge and belief it is correct and complete. A second group was required to provide the date and their signature at the bottom of the form alongside the same statement. Meanwhile the third group was not required to date or sign the form (the control group).

8

Introduction

Shu et al. (2012) reported diferences in dishonesty across the three groups. Specifcally, 37 per cent of the participants who were required to date and sign the top of the form dishonestly infated their actual performance on the arithmetic task compared to 79 per cent of participants who were required to date and sign the bottom of the form and 64 per cent of the participants who were not required to provide their signature. Similarly, participants who were required to date and sign the top of the form claimed less travel time than the other groups. Overall, they were compensated on average USD 5.27 compared to USD 9.62 for participants who dated and signed the bottom of the form and USD 8.45 for those who were not required to sign. Shu et al. (2012) then went on to test this seemingly simple but efective nudge in a feld experiment.Working with a car insurance company, they changed the format of the policy review form on which customers were required to record the reading on their odometer. Some customers were required to provide a date and signature at the top of the form alongside a statement declaring that the information provided was true (“I promise that the information I am providing is true”). Others were required to do the same at the bottom of the form. As predicted, those signing the top of the form reported higher odometer readings, requiring them to pay higher premiums (as it is an indicator of more driving and, by extension, a higher likelihood of being involved in an accident). Voilà. A simple manipulation and it seems the problem of human dishonesty can be largely solved. It seems too good to be true. It was. As others tried but failed to replicate the fndings, the researchers involved in the original study joined Ariella Kristal and Ashley Whillans to conduct a replication of their own (Kristal et al., 2020). The laboratory experiment proceeded as described above, except that no control group was included, thus allowing a comparison between participants who signed and dated the top and bottom of the form. Using a much larger sample of 1,235 participants (compared to 101 in the original study), there was no discernible diference between the two groups with regards to the reported number of matrices solved and the time taken to travel to the experiment. In addition to failing to replicate the laboratory study, Kristal et al. (2020) looked at the feld experiment “with new eyes” and were “concerned with its potential faws”. The diference found in the reported odometer readings

9

Introduction

appears to have been due to diferent driving behaviours rather than dishonesty. That is, there was a failure to conduct a proper random assignment of participants between the experimental groups (a foundational requirement in good experimental design). In describing their fndings, they concluded (p. 7106): With the new data presented here, we recommend that practitioners take this fnding out of their intervention “tool-kit” as it is unlikely to increase honesty. Unfortunately for Shu et al. (2012), the failure to conduct a proper random assignment may have been the least of their concerns. In an article published on their web site Data Colada, Simonsohn et al. (2021) provide credible evidence demonstrating that the reason Kristal et al. (2020) were unable to confrm the fndings of the research with the car insurance company was because the data was fabricated.The journal that published the article authored by Shu et al. (2012) has since issued a retraction notice, citing the evidence provided by Simonsohn et al. (2021) (Berenbaum, 2021). To give you a sense of the magnitude of the crisis gripping scientifc research, according to Retraction Watch, a website that tracks and maintains a database of all retracted scientifc articles, a total of 9,004 articles were retracted from journals in the fve calendar years to December 2020 (Retraction Watch, n.d.). Only 278 of these were psychology papers (a feld that has experienced intense criticism). Most concerning, for approximately half of these articles, fraud (which includes plagiarism or the fabrication or falsifcation of results) is the reason provided for retraction (Brainard & You, 2018). Not surprisingly, many of the themes discussed in this book also explain the origins of this ethical failure in academic research.

In summary, my objectives for writing this second edition are twofold. First, I aim to update the frst edition so that the research cited provides a more reliable précis of both the origins of ethical failure but also the lessons that ethical failure provides leaders. But more importantly, given what has transpired since the publication of the frst edition, I aim to document the enduring lessons that have emerged from the Royal Commission. To achieve the latter, this edition of the book uses the Australian fnancial services industry as a case study. Admittedly, there were numerous other examples of ethical failure I could have drawn from. Unfortunately, royal commissions have become a 10

Introduction

feature of public life in Australia over recent years. Among others, there have been inquiries into the aged care sector and responses to institutional child sexual abuse. And, of course, there are countless case studies I could have drawn from that occurred in other countries. However, although some have encouraged me to look beyond the banking and fnance industry, I have decided to remain targeted. Not only is it an industry with which I have an afnity, but the lessons it provides can be broadly applied. Like the frst edition, this book contains four chapters and a conclusion, albeit the content and structure have been modifed.To describe the origins of ethical failure, I begin by exploring what recent research emerging from the feld of experimental economics tells us about human nature. Is it in our nature to be ethical and honest? Or do we have a predisposition towards dishonesty, thus making ethical failure more likely? No book seeking to explain ethical failure can go without a properly grounded discussion of these questions and in this edition, it is provided precedence. What we will fnd through this discussion is that humans have a predisposition towards dishonesty, especially when the circumstances are favourable. This conclusion leads us to one of the central themes of this book: the importance of “institutional arrangements”. This is a term you will read a lot in this edition. If we accept that a predisposition towards dishonesty exists (something the research clearly suggests we should), then to avoid ethical failure we must focus obsessively on putting in place institutional arrangements that reduce the likelihood of us succumbing to our fawed nature. And what exactly are these institutional arrangements? Although there are many we could point to, Chapters Two and Three focus on the arrangements surrounding incentives and accountability, two of the more prominent catalysts of wrongdoing in the Australian fnancial services industry. In both cases we fnd that the proposed remedies are not necessarily straightforward.Although incentives can elicit dishonesty, they also motivate discretionary efort. By scrapping them we risk throwing the baby out with the bathwater. And as necessary as it might be, in practice accountability can be difcult and costly to apply. In short, there are trade-ofs. Furthermore, in discussing incentives and accountability, we fnd that responsibility for putting in place appropriate institutional arrangements does not exclusively reside with the fnancial institutions within which the wrongdoing occurs. To be sure, they have a lot to answer for. But we would be remiss to overlook the pivotal role played by our public institutions, the leaders within them, and our elected ofcials. Independent and well-resourced public institutions and a political class that acts with probity, passes efective legislation and holds those who transgress to account are crucial institutional arrangements if our goal is to create a fnancial system that is more resilient to ethical failure. 11

Introduction

Chapter Four explores group dynamics, a central theme of the frst edition. Ethics and morality are, above all else, social constructs. It is people interacting together that ultimately determine the type of behaviour that is to be condemned and condoned. And so often, people of seemingly “good” character act in “bad” ways when they become submerged in a group within which unethical behaviour emerges and is endorsed. I also discuss how extraordinarily difcult it can be to speak up in groups. Given the important role employee voice plays in detecting a minor indiscretion prior to it becoming a full-blown scandal (especially when it comes to “conduct” or “non-fnancial” risk), this is an unfortunate reality. Like the frst edition, each chapter concludes by providing lessons for leaders. Unlike the frst edition, there is less focus on purpose, values and principles. This is not to suggest that the exercise of defning purpose, values and principles is not important for institutions. To the contrary. Rather, as will be described in the Conclusion, the argument made in this edition is that without the supporting institutional arrangements, the utterances and proclamations made in these statements of intent will not, in and of themselves, be efective in promoting ethical behaviour. Despite the urge I had to write a second edition, I also had a signifcant reservation. Namely, what if this is as good as it gets? That is, what if ethical failure is the gift that keeps on giving, and the best we can do is accept that it happens and pick up the pieces when it occurs? These questions weighed heavily on me, especially given the history of the industry that serves as the case study.And not just its recent history. In his book White-collar crime in modern England, George Robb devotes a chapter to banking fraud (Robb, 1992). Apparently, the mid-nineteenth century was fertile ground for banking scandals in the United Kingdom. A string of bank failures through the 1840s and 1850s were the precursor to the banking crisis of 1857, during which several major banks in Scotland and Northern England collapsed, sparking a nationwide panic. Subsequent to the crisis, a public parliamentary inquiry was called (sounds familiar) that focused on the failure of three major banks. According to Robb (p. 64): In a report issued in 1858, the Commons catalogued a litany of abuses including fctitious bills, false reports, manufactured dividends and advances made on doubtful securities. Although we could argue that the modern-day banking scandals are not as egregious as those of the mid-nineteenth century, the parallels are telling. It could be that dealing with ethical failure is akin to a game of whack-a-mole – as they occur,

12

Introduction

we deal with the fallout, put in place the institutional arrangements to reduce the likelihood of a similar failure recurring, and await for the next one to arise. After all, regardless of how hard we might try, there will never be an ethical utopia. Even the idealist in me is prepared to concede this (and as the evidence in this book will demonstrate, we would be foolish to conclude otherwise). However, despite these caveats, I conclude that we can do better.Yes, our fawed humanity ensures that ethical failure will be inevitable, but there are shortcomings in institutional arrangements that can be addressed. Doing so will reduce the likelihood and frequency of ethical failure. My hope is that I have illustrated this in a way that strikes the right balance, highlighting that although the ethical resilience of our institutions can be enhanced, doing so inevitably requires us to navigate trade-ofs. Alas, no foolproof or straightforward solution exists. Most importantly, I hope I can help readers deepen their understanding of ethical failure. References Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth). https://www. legislation.gov.au/Details/C2021C00243. Australian Securities and Investments Commission. (2021, July 16). ASIC fnalises investigation into AMP Financial Planning ‘fees for no service’ criminal conduct [Press release]. https://asic.gov.au/about-asic/news-centre/fnd-a-media-release/2021releases/21-173mr-asic-fnalises-investigation-into-amp-fnancial-planning-feesfor-no-service-criminal-conduct/. Berenbaum, M. R. (2021). Retraction for Shu et al., Signing at the beginning makes ethics salient and decreases dishonest self-reports in comparison to signing at the end. Proceedings of the National Academy of Sciences of the United States of America, 118(38). https://doi.org/10.1073/pnas.2115397118. Brainard, J., & You, J. (2018, October 25).What a massive database of retracted papers reveals about science publishing’s ‘death penalty’. Science. https://www.science. org/content/article/what-massive-database-retracted-papers-reveals-aboutscience-publishing-s-death-penalty. Chivers, T. (2019, December 11). What’s next for psychology’s embattled feld of social priming? Nature. https://www.nature.com/articles/d41586-019-03755-2. Commonwealth of Australia. (2017, December 14). Letters Patent, Royal Commission into misconduct in the banking, superannuation and fnancial services industry. https://fnancialservices.royalcommission.gov.au/Documents/ Signed-Letters-Patent-Financial-Services-Royal-Commission.pdf.

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Danckert, S. (2018, November 8). ‘Ridiculous’: Judge challenges ASIC’s push to fne Westpac $58m. Sydney Morning Herald. https://www.smh.com.au/business/ banking-and-fnance/plainly-ridiculous-judge-challenges-asic-s-push-to-fnewestpac-58m-20181108-p50eq6.html. Danckert, S., & Yeates, C. (2017, October 23). ANZ settle interest rate rigging case. Sydney Morning Herald. https://www.smh.com.au/business/banking-andfnance/anz-settles-interest-rate-rigging-case-20171023-gz62x7.html. Dunkeley, M., & Danckert, S. (2017, October 27). NAB admits staf wrongdoing as it settles BBSW. Sydney Morning Herald. https://www.smh.com.au/ business/banking-and-fnance/nab-admits-staf-wrongdoing-as-it-settles-bbsw20171027-gz9zva.html. Ferguson, A. (Director). (2016). Money for nothing [Television documentary]. Sydney, Australia: Australian Broadcasting Corporation. https://www.abc.net. au/4corners/money-for-nothing-promo/7217116. Ferguson, A., & Vadelago, C. (2013, June 1). CBA covered up misconduct by rogue fnancial planner. Sydney Morning Herald. https://www.smh.com.au/business/ cba-covered-up-misconduct-by-rogue-fnancial-planner-20130531-2nh9x.html. Fusaro, R., & Sperling-Magro, J. (2021, August 6). Much anew about ‘nudging’. McKinsey and Company. https://www.mckinsey.com/business-functions/ strategy-and-corporate-fnance/our-insights/much-anew-about-nudging. Gartrell, A., & Bagshaw, E. (2017, November 30). PM Malcolm Turnbull announces Royal Commission into banking sector. Sydney Morning Herald. https://www. smh.com.au/business/banking-and-fnance/big-four-banks-tell-governmentto-set-up-inquiry-20171130-gzvlfr.html. Gelman, A., & Loken, E. (2014). The statistical crisis in science. American Scientist, 102(6), 460–465. https://doi.org/10.1511/2014.111.460. Gentilin, D. (2016). The origins of ethical failure: Lesson for leaders. Routledge. Grattan. M. (2018, April 19). Grattan on Friday: Government’s misjudgement on banking Royal Commission comes back to bite it. The Conversation. https://theconversation.com/grattan-on-friday-governments-misjudgementon-banking-royal-commission-comes-back-to-bite-it-95317. Haslam, S. A., Reicher, S. D., & Van Bavel, J. J. (2019). Rethinking the nature of cruelty: The role of identity leadership in the Stanford Prison Experiment. American Psychologist, 74(7), 809–822. https://psycnet.apa.org/doi/10.1037/ amp0000443.

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Hertwig, R., & Ortmann, A. (2001). Experimental practices in economics: A methodological challenge for psychologists? Behavioral and Brain Sciences, 24, 383–451. http://doi.org/10.1037/e683322011-032 Hummel, D., & Maedche,A. (2019). How efective is nudging? A quantitative review on the efect sizes and limits of empirical nudging studies. Journal of Behavioral and Experimental Economics, 80, 47–58. https://doi.org/10.1016/j.socec.2019.03.005. Ioannidis, J. P. A. (2005). Why most published research fndings are false. PLoS Medicine, 2(8). https://doi.org/10.1371/journal.pmed.0020124. Jachimowicz, J., Duncan, S., Weber, E. U., & Johnson, E. J. (2019). When and why defaults infuence decisions: A meta-analysis of default efects. Behavioural Public Policy, 3(2), 159–186. https://doi.org/10.1017/bpp.2018.43. Kahneman, D. (2022, March 1). Adversarial collaboration. Edge. https://www.edge. org/adversarial-collaboration-daniel-kahneman. Klein, R.A., Cook, C. L., Ebersole, C. R.,Vitiello, C.A., Nosek, B.A., Chartier, C. R., … Ratlif, K. A. (2019). Many Labs 4: Failure to replicate mortality salience efect with and without original author involvement. https://doi.org/10.31234/osf.io/vef2c. Kristal, A. S., Whillans, A. V., Bazerman, M. H., Gino, F., Shu, L. L., Mazar, N., & Ariely, D. (2020). Signing at the beginning versus at the end does not decrease dishonesty. Proceedings of the National Academy of Sciences of the United States of America, 117(13), 7103–7107. https://doi.org/10.1073/pnas.1911695117. Le Texier,T.(2019).Debunking the Stanford Prison Experiment.American Psychologist, 74(7), 823–839. https://psycnet.apa.org/doi/10.1037/amp0000401. Open Science Collaboration. (2015). Estimating the reproducibility of psychological science. Science, 349(6251). https://www.science.org/doi/10.1126/science.aac4716. Ortmann, A. (2018, February 11). Ethical failures: Where they come from and how to address them. Core Economics. https://economics.com.au/2018/02/11/ ethical-failures-where-they-come-from-and-how-to-address-them/. Perry, G. (2012). Behind the shock machine: The untold story of the notorious Milgram psychology experiments. Scribe. Rafeld, H., Fritz-Morgenthal, S. G., & Posch, P. N. (2020). Whale watching on the trading foor: Unravelling collusive rogue trading in banks. Journal of Business Ethics, 165, 633–657. https://doi.org/10.1007/s10551-018-4096-7. Retraction Watch (n.d.). https://retractionwatch.com/. Robb, G. (1992). White-collar crime in modern England: Financial fraud and business morality 1845–1929. Cambridge University Press.

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Sætrevik, B., & Sjåstad, H. (2022). Mortality salience efects fail to replicate in traditional and novel measures. Meta-Psychology, 6. https://doi.org/10.15626/ MP.2020.2628. Schimmack,U.,Heene,M.,& Kesavan,K.(2017,February 2).Reconstruction of a train wreck: How priming research went of the rails. https://replicationindex.com/2017/02/02/ reconstruction-of-a-train-wreck-how-priming-research-went-of-the-rails/. Shu, L. L., Mazar, N., Gino, F., Ariely, D., & Bazerman, M. H. (2012). Signing at the beginning makes ethics salient and decreases dishonest self-reports in comparison to signing at the end. Proceedings of the National Academy of Sciences of the United States of America, 109(38), 15197–15200. https://doi.org/10.1073/ pnas.1209746109. Simmons, J. P., Nelson, L. D., & Simonsohn, U. (2011). False-positive psychology: Undisclosed fexibility in data collection and analysis allow presenting anything as signifcant. Psychological Science, 22(11), 1359–1366. https://doi. org/10.1177%2F0956797611417632. Simonsohn, U., Nelson, L., & Simmons, J. (2021, August 17). Evidence of fraud in an infuential feld experiment about dishonesty. http://datacolada.org/98. Thaler, R. H., & Sunstein, C. R. (2008). Nudge: Improving decisions about health, wealth, and happiness.Yale University Press. Vadillo, M. A., Gold, N., & Osman, M. (2018). Searching for the bottom of the ego well: Failure to uncover ego depletion in Many Labs 3. Royal Society Open Science, 5. http://doi.org/10.1098/rsos.180390. Voltaire. (1817). Oeuvres Complètes de Voltaire, 12(1). Chez Th. Desoer. Yeates, C. (2017a, August 3). Austrac alleges CBA in ‘serious’ breach of money laundering act. Sydney Morning Herald. https://www.smh.com.au/business/ banking-and-finance/austrac-alleges-cba-in-ser ious-breach-of-moneylaundering-act-20170803-gxoirw.html. Yeates, C. (2017b, August 28). Commonwealth Bank facing APRA probe. Sydney Morning Herald. https://www.smh.com.au/business/banking-and-fnance/commonwealth-bank-facing-apra-probe-20170828-gy5ck7.html. Yeates, C. (2018, May 9). Investors head for the door as scandals weigh on CBA. Sydney Morning Herald. https://www.smh.com.au/business/companies/cba-topay-25m-to-settle-rate-rigging-allegations-proft-slips-20180509-p4ze5t.html.

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Chapter One Our fawed humanity

Everyone is a moon, and has a dark side which he never shows to anybody. Following the Equator: A Journey Around the World (p. 654,Twain, 1897) “Rogue NAB traders face their judgement day” read the headline on 1 July 2006 in the lead-up to the sentencing of two of the four traders involved in the FX trading scandal at the NAB (Moncrief & Miletic, 2006). As mentioned in the introduction, I was publicly named as one of the whistleblowers in the incident. When I began working on the FX options trading desk at the NAB as a trainee in 2001, one of my duties was to feld calls from the operations area of the bank that advised the desk of transactions that had been entered into the trading system incorrectly. I would proceed to correct the errors, oblivious of the changes in the value of the portfolio and daily proft and loss these corrections would create. At some point, a senior trader advised me that some of the errors I was correcting were created by design, not accident. As was explained, entering spot FX transactions with incorrect rates was a practice used to reduce the volatility in the daily proft and loss of the desk. The independent investigation into the scandal completed by audit frm PricewaterhouseCoopers (PWC) described the loopholes that made this possible (PricewaterhouseCoopers, 2004). By taking advantage of a “one-hour window” between when trades were entered into the trading system and subsequently reconciled by the operations area, the traders could, just prior to the daily proft and loss being posted to the general ledger, enter a spot FX transaction at a rate that would infate or defate (more often the former than the latter) its value.This value would be captured in the daily proft and loss report, creating an outcome which, for all intents and purposes, was fctitious.

DOI: 10.4324/9781003335368-2

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This practice was widely known, used and endorsed at senior levels. It was clearly dishonest, used initially to avoid any scrutiny that a volatile proft and loss would invite and eventually to conceal large losses.And it was rationalised as being necessary, given the pressure to avoid volatility in (but also to grow) profts. One technique used to rationalise the practice was to colloquially label it as “smoothing”, something that sounds far more palatable than “manipulating the value of the daily proft and loss”. As psychologist Albert Bandura has proposed, adopting “euphemisms” to describe reprehensible conduct is one way we morally disengage (Bandura, 2016). In the years that followed the scandal and subsequent court cases, I was fascinated and preoccupied by the question of what drove the conduct of those involved. Specifcally, was the dishonest behaviour, as the 1 July 2006 headline in the paper suggested, the work of a few rogue traders? Or was it supported and abetted by a fawed system? Or perhaps a mixture of both? These are the types of questions that I seek to answer in this book. Knowing the answers to them is central to developing an understanding of business ethics. If it is the case that unethical and illegal behaviour is caused by a handful of rogues, the solution is relatively straightforward: identify and deal with them appropriately. If systems play a role, the remedy is far less straightforward. Rectifying fawed systems is difcult, as is identifying the individuals ultimately responsible for shaping them. A good place to begin looking for answers to these questions is exploring human nature. Are we selfsh, dishonest and devious beings who will deceive, exploit and plunder when the opportunity presents itself? Or is it in our nature to be honest, giving and to never take advantage of others? This is precisely where we begin. As will become apparent, like all matters to do with human nature, the answers to these questions are not straightforward. But before we begin exploring these questions, some defnitions are in order.What do I mean when I use the term (un)ethical? In Box 1.1, I attempt to answer this question. Box 1.1 What does it mean to be (un)ethical? How does one make a judgement on whether conduct is “ethical”? This is a complex question, but one that cannot be ignored in a book about ethical failures. It is especially important to give this question due attention in light of the terms of reference that guided the Royal Commission. The Letters Patent directed Commissioner Hayne to inquire into “whether any conduct,

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practices, behaviour or business activities by fnancial services entities fall below community standards and expectations” (Commonwealth of Australia, 2017). In his book Outlines of the History of Ethics, Sidgwick (1886) describes the challenges that come with defning “ethics”.Across time, diferent schools and traditions have applied diferent meanings (p. 1): There is some difculty in defning the subject of Ethics in a manner which can fairly claim general acceptance; since its nature and relations are variously understood by writers of diferent schools, and are in consequence conceived somewhat indefnitely by educated persons in general. To add to the confusion, in his book Sidgwick chose to use the words “moral” and “ethical” synonymously. For the purposes of this book, the word “moral” is used to describe the things we value and consider to be “good” or “right”. As elucidated by Singer (2005), whether one couches morality in the various religious traditions, the writings of the great philosophers or more recently, evolutionary biology, moral behaviour has emerged to enable humans to co-operate and live together in large groups. After all, being able to successfully live together in large groups successfully carries with it numerous benefts (the most important being an increased likelihood of survival). For this reason, there is broad (if not universal) agreement that killing (the sanctity of life), stealing (property rights) and failing to treat all people with dignity and respect (human rights) are morally “wrong”. These acts compromise group cohesion. Granted, morality does evolve over time. For example, prior to amendments being made to the Commonwealth Electoral Act 1918 (Cth) in 1962, Indigenous Australians were not aforded the basic right to vote in federal elections, something that by today’s standards is clearly immoral. Despite this emergent quality, at any point in time there is broad (albeit not unequivocal) agreement on what is considered “moral”. Ethics, meanwhile, is the process where one must deliberate and determine what is the moral thing to do. We are said to be facing an ethical dilemma when we are required to make a decision between two or more competing moral values. Consider the Heinz dilemma, a hypothetical scenario developed

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by Lawrence Kohlberg (Heinz dilemma, n.d.). In it, Heinz’s wife is terminally ill and Heinz cannot aford to purchase a drug that will save her life. Despite his pleas, the pharmacist refuses to sell the drug to Heinz at a discount. In this dilemma, Heinz must make a decision between letting his wife die (the sanctity of human life) or stealing the drug (property rights). What should he do? These types of ethical dilemmas, where moral values are pitted against each other, are often referred to as “right-versus-right” ethical dilemmas. In these situations, two knowledgeable, well-meaning people can arrive at diferent ethical decisions. We are unable to claim indisputably that one is morally “right” and the other morally “wrong”. Navigating these types of ethical dilemmas can be excruciatingly difcult. However, the various shades of wrongdoing which were showcased at the Royal Commission did not ft into this class of ethical dilemma. Whether we consider charging fees for services not rendered, selling junk insurance or opportunistic sales tactics, these are not by most people’s standards and expectations (that is, by the community’s standards and expectations) examples of people making decisions between competing moral values. Rather, in these situations, people are making a decision between what is clearly morally “right” and what is morally “wrong”. They are facing a “right-versus-wrong” ethical dilemma. In this book, “ethical failure” refers to incidents in which people, when facing a “right-versus-wrong” ethical dilemma, choose what is morally “wrong”. A plausible argument could be made that if the Royal Commission terms of reference had only asked Commissioner Hayne to inquire into conduct that was illegal (rather than conduct that fell below “community standards and expectations”), a signifcant proportion of the case studies examined would still have qualifed as being worthy for consideration under this more rigorous benchmark. As he stated when describing the nature of the conduct reviewed during the Royal Commission (p. 1, Royal Commission, 2019): Very often, the conduct has broken the law. And if it has not broken the law, the conduct has fallen short of the kind of behaviour the community not only expects of fnancial services entities but is also entitled to expect of them.

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In many ways this made Commissioner Hayne’s task a little less complicated. For the most part, he was not required to deliberate on “right-versus-right” ethical dilemmas and whether conduct fell below community standards, whatever they might be. Similarly, it makes the task of writing this book far more straightforward, as I too need not concern myself with “right-versusright” ethical dilemmas and passing judgement on what is the “right” thing to do. Rather, the focus is solely on “right-versus-wrong” dilemmas. Specifcally, why is it that when faced with a decision between doing what is morally “right” and morally “wrong”, people choose the latter? Are humans honest? Ancient literature and scripture are full of stories that speak to human fallibility. Whether it be Odysseus fastening himself to a mast in Homer’s epic poem The Odyssey, King David seducing Bathsheba in the Hebrew Bible, or Adam eating from the tree of knowledge in the Old Testament, the idea that humans can succumb to temptation is not new. But stories, although compelling, do not necessarily provide evidence. Can a propensity towards dishonesty be proven? And if so, is it widespread? In recent years, experimental economists have turned their mind to studying the question of human honesty. Although several approaches have been employed, one of the more prominent is the die rolling paradigm developed by Fischbacher and Föllmi-Heusi (2013). In the original experiment, 389 participants were asked to roll a die and self-report the outcome. Participants received a payment based on the outcome they reported. Specifcally, the payment (in Swiss Francs) was equal to the outcome reported, apart from when the participant reported an outcome of six in which case the payment was zero (that is, a participant self-reporting an outcome of one received CHF 1, an outcome of two received CHF 2 and so on up to an outcome of fve). Although the experimenters were unable to determine whether each participant was acting honestly when self-reporting, they could, through some relatively straightforward statistical analysis, determine the proportion of participants being dishonest. The reason for this is that each outcome in a die roll is equally likely (0.1667 probability), meaning that with a sample size of 389, the expected outcome was that approximately 65 participants would roll each outcome. Of course, although the experimenters went to great lengths to assure the participants that their actual

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Figure 1.1: The reported outcomes of die roles completed by 389 participants in the experiment undertaken by Fischbacher and Föllmi-Heusi (2013).

outcome of the die roll was not being recorded, some may have remained suspicious (a topic we will return to later). The results, illustrated in Figure 1.1, clearly demonstrate the presence of dishonesty. Thirty-fve per cent of participants reported that they rolled a fve (the outcome that provided the largest payment), more than double the expected outcome of 16.67 per cent. It is also clear that some participants report dishonestly but temper their greed, claiming to have “only” rolled a four (27.2 per cent reported this result, once again well above the expected outcome). In addition, there were some honest participants who accepted a payment of zero. In summarising their results, Fischbacher and Föllmi-Heusi (2013) found that participants could be divided into three categories: • “Honest subjects”: Those who reported the outcome they actually rolled (this could be as many as 39 per cent of the participants). • “Income maximising subjects”: Those who lied to maximise their monetary payment by reporting a fve (this could be as many as 22 per cent of participants). • “Partial liars”: Those who did not lie to maximise their payment but did lie to infate it (approximately 20 per cent of participants). In an extraordinary piece of research, Abeler et al. (2019) collected data from all experiments undertaken to date that have adopted the Fischbacher and Föllmi-Heusi (2013)

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paradigm. Not all the experiments they reviewed used die rolling as their method for assessing honesty. In some experiments, participants reported the outcome of a coin toss. In others, they reported the colour of a ball drawn from an urn. Whatever the case, in all instances the experiments (a) enabled participants to self-report outcomes without revealing the true result, (b) contained an asymmetric payment profle such that some reported outcomes were more proftable than others and (c) provided the experimenters with certainty on the expected distribution of outcomes. The undertaking was enormous. In total, data was collected from 90 experiments that provided information on 270,616 decisions made by 44,390 participants. The experiments were run in 47 countries that in total represented 69 per cent of the world’s population. A sample size this large and representative is rare. It provides confdence that there is far less of a likelihood that the results are caused by some type of statistical fuke. The fndings support those described by Fischbacher and Föllmi-Heusi (2013). Specifcally, although there were a group of participants who lied for maximum beneft, they were not in the majority – approximately 75 per cent of the total gains available to participants were not exploited. However, there was clear evidence for dishonesty, given outcomes that provided higher payments were made far more frequently (the dishonest participants and so-called “partial liars” identifed by Fischbacher and Föllmi-Heusi [2013]). Also, there was a proportion of participants who reported honestly, even if this resulted in zero payment. One of the fndings in the experiments described above that has puzzled researchers is that dishonesty did not increase when the size of the potential payof rose. For example, when Fischbacher and Föllmi-Heusi (2013) tripled the stakes, so that a participant who reported an outcome of fve earned CHF 15, the distribution of results did not signifcantly difer. Similarly, in the extraordinary sample size complied by Abeler et al. (2019), dishonest behaviour was not infuenced when there was potential for far higher monetary gains.This led Abeler et al. (2019) to conclude (p. 1147): Our new experimental results, combined with our theoretical predictions, demonstrate that a preference for being seen as honest and a preference for being honest are the main motivations for truth-telling. These types of fndings are inconsistent with the standard economic model of dishonesty developed by Becker (1968) – as the probability of being detected falls or the size of the payof rises, the level of dishonesty should increase.That people do

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not always behave like the fgurative Homo economicus dictates is not a new idea, and experimental economists have provided explanations for why this might be a feature of their research. One is experimental design. As Levitt and List (2007) describe, there are numerous factors that can infuence how participants respond in laboratory experiments.These include the degree to which participants believe they are being scrutinised and their anonymity is being protected.These types of factors are especially pertinent in experiments where participants are required to make decisions with moral import. In support of this, experiments adopting techniques that make it impossible for participants to be exposed as liars do induce increased dishonesty. For example, Kajackaite and Gneezy (2017) conducted a variant of the original Fischbacher and Föllmi-Heusi (2013) experiment known as the “mind game”. In this experiment, participants were frst asked to think of a number between one and six before rolling a die. If the number rolled was the same as the number they had thought of, they were provided with a payment.When the results were compared to a control group who were rewarded if (and only if) they reported that they had rolled a fve, participants in the mind game were more dishonest (and their level of dishonesty increased as the size of the payment increased). However, even in the “mind game”, where the probability of being exposed as a liar is zero, not all of the participants chose to be dishonest. As will be described in Chapter Three when we review some of the experimental fndings relevant to accountability, researchers have proposed alternative explanations for these types of results. A prominent one is the role of social identity – people place value in being seen as a moral, upstanding citizen. To create this perception, they tend to resist maximising their payofs in experiments that require dishonesty. In addition, some researchers have pointed to potential reputational concerns, whereby participants refrain from being dishonest because they fear there might be consequences (such as being precluded from participating in future experiments). But one thing that appears to be clear is that when the experimental design (or context) is made more permissive, dishonesty does increase. This was ingeniously demonstrated in recently published research conducted by Tergiman and Villeval (2021). Their experiment, which is highly relevant to this book, demonstrates that although Abeler et al. (2019) may have been right on one hand (people have “a preference for being seen as honest”), they were of the mark on the other (people have “a preference for being honest”). They demonstrated this by introducing the possibility for plausible deniability – the ability to proft from deception and dishonesty but being able to deny that you have done so.

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In their experiment, participants were randomly assigned into the role of adviser (“project manager”) or investor. The advisers were provided with three cards, each being either blank or containing a star. They then sent a message to the investor informing them of how many of the three cards contained a star. Based on this information, the investor made a decision on whether to invest. If an investment was made, one of the three cards was randomly selected and revealed. If the card contained a star, the investment was deemed to be a success. The incentives were structured such that (a) payofs were maximised for the adviser when the investor chose to invest and (b) payofs were maximised for the investor after a successful investment. Specifcally, if an adviser could cajole the investor to invest, their potential payof increased by approximately seven times.The investor meanwhile received an endowment which they could keep or put at risk by investing. If they chose to invest and the investment was a success, the size of the endowment tripled. If, however, the randomly selected card did not contain a star and the investment was unsuccessful, the size of the endowment was reduced by 70 per cent. Therefore, the adviser stood to gain handsomely if they could entice the investor to invest, an outcome that could be achieved by being deceitful and misrepresenting the true number of stars on the cards. Assuming adviser dishonesty always involves exaggerating the true number of stars, Figure 1.2 illustrates the four types of lies an adviser could make use of, each with diferent probabilities of being detected.They were: • “Extreme risk” lies which were detected by the investor on all occasions. • “High risk” lies which, given the card used to determine whether the investment was a success was chosen at random, had a probability of being detected on two-thirds of occasions. • “Low(er) risk” lies which, once again due to the random selection of the card, had a probability of being detected on one-third of occasions. • “Deniable” lies which, regardless of which card was drawn to determine if the investment is a success, could never be substantiated. Through the inclusion of plausible deniability, Tergiman and Villeval (2021) departed  from the Fischbacher and Föllmi-Heusi (2013) experimental paradigm where a participant could change the magnitude of a lie but not lie in a way that was deniable. In addition, it allowed them to explore how various mechanisms, such as concern for reputation and consequence, infuence dishonesty. Do these mechanisms increase honesty when they are introduced or do people simply change how they lie?

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Figure 1.2: The experimental design employed by Tergiman and Villeval (2021) meant that dishonest advice provided by the adviser had different probabilities of being detected and in some cases was deniable.

To answer this question, participants in the experiment completed 27 rounds of the investment task in four diferent experimental conditions, the results for two of which are described here. In the baseline “random pairs” (RP) condition, an adviser was randomly paired with an investor for each of the 27 rounds of the task. To assess whether concerns for reputation leads to greater honesty, a “fxed pairs” (FP) condition was created in which an adviser was randomly assigned to an investor at the beginning of the experiment and then completed all 27 rounds of the task as one dyad. Finally, consequence for the adviser was introduced by allowing the investor to desist from investing in any round. The results demonstrate that when the arrangements are permissive, dishonesty is a feature of human nature. Figure 1.3 illustrates, across the RP and FP experimental conditions, the percentage of dishonest announcements by advisers, the percentage of advisers who are dishonest in the frst round, the percentage of advisers who

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Figure 1.3: The percentage of dishonest announcements made by advisers and the percentage of advisers lying at different stages of the experiment, as per the research conducted by Tergiman and Villeval (2021).

are dishonest within the frst fve rounds and the percentage of advisers who are dishonest at some stage across all 27 rounds of the experiment. Clearly, concerns for reputation and consequence play a role in dissuading dishonesty, as overall there are more dishonest announcements in the RP conditions versus the FP condition. However, by the fnal round, a greater proportion of advisers in the FP condition were dishonest (and a large proportion at that). The results from Figure 1.3 are even more revealing when viewed in conjunction with those displayed in Figure 1.4, which illustrates the types of lies employed by advisers who were dishonest at least once across the 27 rounds of the task. What is obvious is that the “riskier” lies (that is,“extreme risk” and “high risk” lies) were used far more prominently by advisers in the RP condition.Advisers in the FP condition predominantly made use of “deniable lies”. Therefore, concerns for reputation and consequence did not necessarily reduce dishonesty per se, but rather changed the types of lies used by advisers. At this point it is worth repeating that, as was described in the Introduction, there are trade-ofs associated with experimental research conducted in laboratories. By creating a controlled environment that eliminates confounding variables, the experimental design provides a far more precise and clearer picture of how the independent variable (for example, incentives and reputation) infuences the

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Figure 1.4: In the experiment conducted by Tergiman and Villeval (2021), advisers were more likely to use risker lies that had a higher likelihood of being detected in conditions where their reputation was not at stake because they were assigned to a new investor after each round of the experiment.

dependent variable (for example, honesty). However, the experimental design also creates an environment that is both unique and highly artifcial, something that can infuence how participants placed within it respond and behave. For example, it is possible that participants in the research conducted by Tergiman and Villeval (2021) (and other research described in this chapter for that matter) may have interpreted the experiment as being a game in which the whole point was to deceive and be dishonest.1 However, by employing plausible deniability, Tergiman and Villeval (2021) do call into question how previous fndings from dishonesty research have been interpreted. As they conclude (p. 4): But because we allow for a wider breadth of lies (from extreme – detectable for sure – to deniable – not detectable lies), our work shows that individuals adapt their lying to the market environment they face, and how people lie in markets plays out very diferently compared with what might have been expected given the prior literature on cheating and deception games. More importantly, their fndings make it clear where our focus should be if our goal is to reduce the likelihood of unethical behaviour (p. 7):

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Instead, because only few subjects exhibit preferences for honesty per se, the nature of lies responds to the institutions in place, which delivers clear policy recommendations. And herein lies one of the central themes of this book – if our goal is to reduce the frequency of ethical failure, the focus must be on institutional arrangements. This conclusion naturally emerges from the fact that when the institutional arrangements are permissive, humans do not tend to exhibit a preference for honesty. More on this in the fnal section of the chapter. In the interim, below is described one of the more notable ethical failures examined at the Royal Commission – the fee-for-no-service scandal. What happened? Why did it happen? Was the behaviour associated with the incident dishonest? And if so, what were the institutional arrangements that abetted the conduct? Before then, Box 1.2 describes a key concept that underpins much of the wrongdoing exposed at the Royal Commission, conficts of interest. Box 1.2 Conficts of interest Simply put, a confict of interest exists when an individual or institution has multiple interests and therefore, when serving one of those interests, is unable to do so without bias or prejudice, given their competing priorities. Although disclosure is often seen as a remedy to conficts of interest, at times it can infate the bias or prejudice of the conficted party (Sah, 2018). High-powered incentive schemes are arguably the most prominent form of confict of interest.They result in an individual putting their own personal interest ahead of the client or institution to which they have a duty (something the research conducted by Tergiman and Villeval [2021] demonstrates). These will be discussed in the following chapter. In this box, another form of confict of interest that has received considerable attention in Australia’s fnancial services industry over the past decade is discussed: the conficts of interest created by vertical integration. Towards the end of the twentieth century, major banks began acquiring a range of assets that both manufactured and distributed investment and insurance products. The distribution of these products was typically the responsibility of fnancial advisers who were employed by advice licensees. At

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times, these licensees operated under a trading name that was unrelated to the major bank that owned and provided product to them, creating the perception that they were independent. This institutional arrangement created conficts of interest for fnancial advisers. As one of the submissions made by Australian Government Treasury to the Royal Commission outlined, these stretched beyond the incentives provided to fnancial advisers (Australian Government Treasury, 2018): The incentive for in-house or afliated advisers to recommend in-house products is likely to be more deeply rooted than remuneration incentives alone and include factors like career progression, greater visibility of and access to information/training on in-house products and a tendency for advisers to identify with a frm and its products. Given these conficts, there are numerous legal and operational safeguards that have been put in place to protect consumers. For example, under Division 2 of Part 7.7A of the Corporations Act 2001 (Cth), fnancial advisers providing personal advice must (a) act in the best interests of the customer, (b) provide the customer with appropriate advice and (c) prioritise the customer’s interests over their own. Therefore, if a product manufactured by the institution that owns an advice licensee does not fulfl these requirements, fnancial advisers employed by this licensee would be in breach of the Corporations Act if they recommended it. For this reason, advice licensees typically compile an “approved product list”. This is a list of products that fnancial advisers employed by them can sell to their customers.The approved product list contains a mix of “in-house” products (that is, products manufactured by the institution that owns the licensee) and products manufactured by other non-related institutions. This arrangement is put in place to ensure that advisers, as they seek to serve the best interest of their customers, are not put in a position where they are non-compliant because they are only able to ofer in-house products. Given the above arrangements, did fnancial advisers prioritise their duty to the client ahead of self-interest? In January 2018, ASIC published the fndings of a review into how institutions manage these conficts of interest (Australian Securities and Investments Commission, 2018).The review involved the collection of data from ten advice

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licensees that were all owned by fve large institutions (the four major banks and AMP Limited) and selected based on their size (the two largest advice licensees for each institution, based on the number of advisers employed). Some of the advice licensees that formed part of the review were business units within the institutions themselves, while in other cases they were frms owned by the institutions trading under their own brand name. For the period reviewed by ASIC, on average 27 per cent of the products on the approved product lists of the ten advice licensees were in-house (meaning over 73 per cent of products were manufactured by a non-related institution). This ranged from 52 per cent for the licensee with the most in-house products on their approved product list to seven per cent for the licensee with the least. However, when ASIC turned its attention to sales practices, a diferent picture emerged. On average, the proportion of funds that customers invested in in-house products across the ten licensees was 62 per cent. In the most extreme case, customers at one licensee invested 88 per cent of funds in in-house products. When ASIC conducted a review of 200 customer fles as part of the review, there was evidence in 75 per cent of these fles that the adviser was in breach of the best interests duty under the Corporations Act. In ten per cent of fles, ASIC had “signifcant concerns about the impact of the non-compliant advice on the customer’s fnancial situation” (p. 35).This led ASIC to conclude (p. 9): this, the high level of non-compliant advice, combined with the high proportion of funds invested in in-house products, suggests that the advice licensees we reviewed may not be appropriately managing the confict of interest associated with a vertically integrated business model. These types of outcomes, where self-interest trumped duty, were common in the evidence presented at the Royal Commission. It led Commissioner Hayne to propose the following as one of the key questions that should inform policy response to the inquiry (p. 5, Royal Commission, 2019): Should the approach to addressing conficts of interest change from managing conficts to removing them, either by banning all or some forms of conficted remuneration and sales or proft-based remuneration and/or changing industry structures?

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With regards to the conficts of interest created by vertical integration, it has transpired that many of them have been addressed by removing them. In the lead-up to, during and following the Royal Commission, the major banks divested many of the wealth assets they had acquired around the turn of the twenty-frst century. No doubt these would have been challenging decisions for the boards of these institutions, as in many cases, the assets were acquired at a signifcant premium. But as painful as they may have been for incumbent directors, the directors who hold ofce in decades to come will be grateful that these decisions were taken. They address institutional arrangements that were creating fertile ground for unethical behaviour.

Fee-for-no-service scandal Of all the wrongdoing that was showcased at the Royal Commission, the fee-forno-service scandal was arguably the most notable. The practice of charging advice fees without providing clients with the requisite service frst came to the public’s attention in 2015. In April of that year Australia’s corporate regulator, ASIC, announced that as part of its Wealth Management Project it would be undertaking an investigation into the practice (Australian Securities and Investments Commission, 2015). However, the seeds for the scandal were sown many years earlier. The wealth industry in Australia rides on the back of the superannuation system. This system requires employers to make contributions to eligible superannuation funds on behalf of their employees which the latter can access once they reach an eligible retirement age. Although in some cases employee and industry groups voluntarily created superannuation funds for their members (so-called industry funds), it was government legislation that made the system ubiquitous. The landmark reform was the Superannuation Guarantee (Administration) Act 1992 (Cth) which was passed in 1992. It extended the system so that it covered 72 per cent of Australian workers and required employers to make contributions totalling three per cent of an employee’s salary, a fgure that increased to nine per cent over the decade that followed. With rivers of money fowing into superannuation funds, it was not long before the banks wanted a piece of the action. As mentioned in Box 1.2, towards the end of the twentieth century, Australia’s four major banks began making acquisitions in the wealth industry. The two most signifcant transactions were the acquisition of

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Colonial Limited by CBA for AUD 5.7 billion (McIlwraith, Hudson & Carson, 2000) and the acquisition of MLC by the NAB for AUD 4.6 billion (Hughes, 2000). These purchase prices were largely premised on the enhanced returns that would come by supplementing income from traditional banking products (deposits and loans) with income from wealth products (superannuation, insurance and advice). In theory, this strategy made sense. In practice, it resulted in ambitious “cross sell” targets. Roll the clock forward to 2012 and the government, in an attempt to address the issues that emerged in the fnancial advice industry during the global fnancial crisis, introduced the Future of Financial Advice (FoFA) reforms. Among other things, these reforms placed a ban on conficted remuneration (such as the upfront and trail commissions associated with selling superannuation products). Although there were some exceptions or “carve outs” associated with these bans, they had the efect of transforming the revenue model for the fnancial advice industry. As will be described, this change was not without consequence. Eighteen months after announcing it would commence an investigation into fee-for-no-service, ASIC published its preliminary fndings (Australian Securities and Investments Commission, 2016). It revealed systemic issues across the industry and announced that as at 31 August 2016, over 27,000 customers had been compensated approximately AUD 23.7 million for fees they had been charged without receiving any associated service. Furthermore, they warned that they expected “these compensation fgures to increase substantially in the coming months as the process to identify and compensate afected customers continues” (p. 44). This was an understatement. In evidence presented at the Royal Commission in August 2018, this fgure was updated to AUD 260 million with the expectation that the fnal fgure could be as large as AUD 850 million. However, Peter Kell, the Deputy Chair of ASIC, stated that he “wouldn’t at all be surprised if it ends up being in excess of a billion dollars” (p. 137, Royal Commission, 2019). This proved to be prescient. In subsequent updates provided by ASIC in March 2019 (Australian Securities and Investments Commission, 2019),August 2020 (Australian Securities and Investments Commission, 2020) and July 2021 (Australian Securities and Investments Commission, 2021), the amount of compensation paid to consumers grew from AUD 350 million to AUD 800 million and fnally to AUD 1.24 billion (the fnal fgure being efective as at 31 December 2020). Interestingly, in conversations I have had with individuals employed at institutions dealing with the fee-for-no-service fall out (both current and former),

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many question whether the behaviour was “dishonest”. This is something that Commissioner Hayne also encountered during the Royal Commission. Some witnesses put the whole afair down to “processing errors”, “poor systems” and “carelessness”. Commissioner Hayne left no allusions as to where he stood on these rationalisations in his interim report (p. 121, Royal Commission, 2018): Charging for doing what you do not do is dishonest. No-one needs legal advice to tell them that. The root cause for what happened was greed; the greed of both licensees and advisers. My view is a little more nuanced. First, there is nothing to be gained from mincing words: As Commissioner Hayne states, charging a fee and not providing a requisite service is dishonest. By labelling it otherwise, we are simply using euphemisms to downplay the severity of what occurred. At this point, we enter the territory of the FX option traders at the NAB where behaviour that was clearly dishonest (manipulating the true value of the proft and loss) is rationalised by calling it something it is not (“smoothing”).This is dangerous territory.Who then makes the decision when “smoothing” (or a “processing error” or “carelessness”) enters into the domain of dishonesty? Or illegal conduct? If history teaches us anything, it is that bankers are not good at making these types of moral judgements. Calling it anything other than dishonest is trying to rationalise dishonesty. However, on Commissioner Hayne’s second proposition (“The root cause for what happened was greed”), I am a little more equivocal.To be sure, there may have been occasions where greed did play a central role. But my personal view is that there were not cabals of people operating within institutions wearing dark coats and catching up in secret rooms to scheme about how they could charge fees without providing a product or service. Rather, I believe the fee-for-no-service scandal followed the typical trajectory of all ethical failures. Arguably, the vast majority of advisers who had their customers sign an agreement that committed them to paying an ongoing fee for an annual review did so with the best of intentions. At that point, they were confdent they could deliver the service associated with the fee. But in committing the customer to an annual fee, they had efectively created a default (which, as per Box I.2, is a highly efective “nudge”). Then, a year went by with no service delivered, a second, a third, and so on. Before they knew it, fees were being charged of people who had deceased since they had signed the agreement. Just like the FX trading scandal, it all got very ugly, very quickly.

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But if not greed, what was motivating and sustaining this behaviour? I believe it was the institutional arrangements. As the following passages outline, these came in numerous guises. The most prominent were conficts of interest. Although there were a variety of conficts, two were central to the fee-for-no-service scandal. The frst is the confict of interests associated with being a publicly listed company. It is interesting to note that it was the superannuation funds owned by publicly listed institutions (so called “retail funds”) that were largely responsible for the fee-for-no-service scandal. Industry superannuation funds, which are owned by members, were largely immune from the conduct. Retail funds were required to generate a return for their corporate owners which were publicly listed, something that became increasingly challenging when the FoFA reforms put an end to other revenue streams. Unlike the frst, the second confict of interest was one that institutions have greater ability to manage: incentives. As previously mentioned, although the FoFA reforms placed a ban on conficted remuneration, there were several exceptions or “carve outs” to this ban. One was the “grandfathering provisions” that allowed trail commissions to continue to be paid on products that had been sold prior to July 2013.The second was to allow performance pay (such as bonuses) to continue to be paid if it could be demonstrated that they did not adversely impact on the advice provided. Therefore, fnancial advisers stood to beneft from generating advice fee income, as did the executives who oversaw the businesses that employed advisers. The FoFA reforms point to legislation as being another institutional arrangement that abetted the fee-for-no-service scandal. When public ofcials develop reform, they must consider the trade-ofs and potential for frst, second and third order consequences. It is well known that the economics of the fnancial advice industry has always been questionable and the ban on trail and upfront commissions heralded by the FoFA reforms did nothing to rectify this.With a signifcant source of revenue disappearing, advisers (and those running the institutions that employed them) embarked on a search to plug the gap. As Commissioner Hayne described in the Royal Commission fnal report, this search was a catalyst for the fee-for-no-service scandal (p. 132, Royal Commission, 2019): Rather, in what appears to have been an attempt to replicate the revenue stream that fowed from a combination of upfront and trail commissions, many advisers charged an upfront fee for preparation of a statement of

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advice, and encouraged clients to enter into an “ongoing fee arrangement”, under which the adviser would charge an ongoing fee in exchange for particular services. A further institutional arrangement that played a role was accountability – there was minimal evidence of consequence being applied for the conduct. Prior to the Royal Commission, there were no dismissals or resignations of senior executives that could be directly attributed to the fee-for-no-service scandal.The “retirement” of the CEO of CBA in August 2017 could be one possible exception, but this announcement came on the back of a string of governance failures, the money laundering scandal being the most prominent (Yeates, 2017). In addition, there was scant evidence of appropriate adjustments being made to remuneration for the conduct, a topic discussed in Chapter Three. Meanwhile, the corporate regulator, rather than apply consequence, displayed a preference for negotiating outcomes with institutions. Finally, there were institutional arrangements within the institutions themselves that contributed to the fee-for-no-service scandal. One of these has been mentioned above (minimal consequence for the conduct through performance management systems). But as ASIC described in its report detailing the preliminary fndings of its investigation, there were others (Australian Securities and Investments Commission, 2016). For example, in many cases, the size of the portfolio managed by fnancial advisers made it practically impossible for them to provide an annual review to every client (this being the service the client was paying a fee for). Furthermore, advisers did not have systems in place that could keep track of the services being provided to clients for the fees being charged. However, there were systems in place to record incoming fee revenue. It is difcult to state defnitively which of the above institutional arrangements played a more important role. The most likely outcome is that they all contributed in some way. And yes, as Commissioner Hayne stated in the Royal Commission interim report, greed could also be thrown into the mix. But I doubt that greed was the sole or primary reason for the conduct underpinning the fee-for-no-service scandal. However, the conduct was without question both dishonest and unethical. For this reason, the scandal perfectly illustrates the central theme of this book: If our goal is to reduce the likelihood of ethical failure, then we must focus obsessively on putting in place the appropriate institutional arrangements.

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Lessons for leaders There are two clear lessons that emerge for leaders in this chapter. First, dishonesty is a feature of human nature.The pioneering experiment conducted by Fischbacher and Föllmi-Heusi (2013) and the raft of research it inspired demonstrates that for many of us, even when the incentives are slight, dishonesty is a tempting proposition. And as Tergiman and Villeval (2021) illustrated, when the conditions for dishonesty are made more permissive (something that was achieved in their experiment by introducing plausible deniability), the proportion of us who will engage in dishonesty for personal gain only increases. From this frst lesson naturally fows the second, more important lesson. If avoiding ethical failure is an end we would like to pursue within institutions, calls to honesty and virtuous conduct will not be sufcient. Rather, one needs to focus obsessively on institutional arrangements. In this book, the term “institutional arrangements” is used in its broadest possible sense. It includes the governance, compliance, risk management, performance management and accountability frameworks that exist within institutions (and all of the policies, processes and systems that support these), and the regulations and legislations put in place by our public institutions (and the willingness and capacity of public institutions to enforce these). The focus of the following two chapters is on the institutional arrangements surrounding incentives and accountability. These have played central roles in the ethical failures that have plagued the fnancial services industry. However, what we will fnd is that although there is much that leaders within fnancial institutions can do (and much that they have failed to do) to improve the arrangements for incentives and accountability, public institutions also play a pivotal role.What’s more, when public institutions fail in this role, there is little incentive for leaders within fnancial institutions to put in place the institutional arrangements that buttress the ethical foundations of their organisations. Thus, responsibility rests at the feet of leaders across both the public and private sectors. Note 1 Thanks to Jason Collins for alerting me to this possibility. References Abeler, J., Nosenzo, D., & Raymond, C. (2019). Preferences for truth-telling. Econometrica, 87(4), 1115–1153. https://doi.org/10.3982/ECTA14673.

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Australian Government Treasury. (2018, July 13). Financial Services Royal Commission: Submission on key policy issues. https://fnancialservices.royalcommission.gov.au/ publications/Documents/Treasury-background-paper-24.pdf. Australian Securities and Investments Commission. (2015,April 16). ASIC update on Wealth Management Project – Investigation into charging of advice fees without providing advice [Press release]. https://asic.gov.au/about-asic/news-centre/fnd-a-mediarelease/2015-releases/15-081mr-asic-update-on-wealth-management-projectinvestigation-into-charging-of-advice-fees-without-providing-advice/. Australian Securities and Investments Commission. (2016, October 27).Financial advice: Fees for no service (Report 499). https://download.asic.gov.au/media/4054607/ rep499-published-27-october-2016.pdf. Australian Securities and Investments Commission. (2018, January 24). Financial advice: Vertically integrated institutions and conficts of interest (Report 562). https:// download.asic.gov.au/media/4632718/rep-562-published-24-january-2018.pdf. Australian Securities and Investments Commission. (2019, March 11). ASIC provides update on further reviews into fees-for-no-service failures [Press release]. https://asic. gov.au/about-asic/news-centre/fnd-a-media-release/2019-releases/19-051mrasic-provides-update-on-further-reviews-into-fees-for-no-service-failures/. Australian Securities and Investments Commission. (2020, August 24). ASIC update on compensation for fnancial advice related misconduct [Press release]. https://asic.gov. au/about-asic/news-centre/fnd-a-media-release/2020-releases/20-193mr-asicupdate-on-compensation-for-fnancial-advice-related-misconduct/. Australian Securities and Investments Commission. (2021, July 16). ASIC fnalises investigation into AMP Financial Planning ‘fees for no service’ criminal conduct [Press release]. https://asic.gov.au/about-asic/news-centre/fnd-a-media-release/2021releases/21-173mr-asic-fnalises-investigation-into-amp-fnancial-planning-feesfor-no-service-criminal-conduct/. Bandura, A. (2016). Moral disengagement: How people do harm and live with themselves. Worth Publishers. Becker, G. S. (1968). Crime and punishment: An economic approach. Journal of Political Economy, 76(2), 169–217. http://www.jstor.org/stable/1830482. Commonwealth Electoral Act 1918 (Cth). https://www.legislation.gov.au/Details/ C2016C01022. Commonwealth of Australia. (2017, December 14). Letters Patent, Royal Commission into misconduct in the banking, superannuation and fnancial services industry. https://fnancialservices.royalcommission.gov.au/Documents/Signed-LettersPatent-Financial-Services-Royal-Commission.pdf. 38

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Corporations Act 2001 (Cth). https://www.legislation.gov.au/Details/C2019C00216. Fischbacher, U., & Föllmi-Heusi, F. (2013). Lies in disguise – An experimental study on cheating. Journal of the European Economic Association, 11(3), 525–547. https:// doi.org/10.1111/jeea.12014. Heinz dilemma. (n.d.). In Wikipedia. https://en.wikipedia.org/wiki/Heinz_dilemma. Hughes,A. (2000,April 11). $4.56bn takeover puts NAB at front of the pack. Sydney Morning Herald, p. 1. Kajackaite, A., & Gneezy, U. (2017). Incentives and cheating. Games and Economic Behavior, 102, 433–444. https://doi.org/10.1016/j.geb.2017.01.015. Levitt, S. D., & List, J. A. (2007). What do laboratory experiments measuring social preferences reveal about the real world? The Journal of Economic Perspectives, 21(2), 153–174. https://pubs.aeaweb.org/doi/10.1257/jep.21.2.153. McIlwraith, I., Hudson, P., & Carson, A. (2000, March 11). Merger to claim icon, jobs. The Age, p. 1. Moncrief, M., & Miletic, D. (2006, July 1). Rogue NAB traders face their judgement day. The Age. https://www.theage.com.au/national/rogue-nab-traders-facetheir-judgement-day-20060701-ge2mpg.html. PricewaterhouseCoopers. (2004, March 12). Investigation into foreign exchange losses at the National Australia Bank. Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. (2018). Interim report (Vol. I). https://fnancialservices.royalcommission.gov.au/Documents/interim-report/interim-report-volume-1.pdf. Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. (2019). Final report (Vol. I). https://www.royalcommission.gov. au/sites/default/fles/2019-02/fsrc-volume-1-fnal-report.pdf. Sah, S. (2018). Conficts of interest and disclosure. Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. https:// sunitasah.com/media/pdfs/Sah-2018-Conflicts-of-interest-and-disclosureBanking-Royal-Commission.pdf. Sidgwick, H. (1886). Outline of the history of ethics. MacMillan and Co. Singer, P. (2005). Ethics and intuitions. Journal of Ethics, 9, 331–352. http://www. jstor.org/stable/25115831. Superannuation Guarantee (Administration) Act 1992 (Cth). https://www.legislation. gov.au/Details/C2021C00251. Tergiman, C., & Villeval, M. C. (2021). The way people lie in markets: Detectable vs. deniable lies (Discussion Paper No. 14931). IZA Institute of Labor Economics. https://docs.iza.org/dp14931.pdf. 39

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Twain, M. (1897). Following the equator: A journey around the world. American Publishing Company. Yeates, C. (2017,August 14). Commonwealth Bank chief Ian Narev to leave bank by end of fnancial year. Sydney Morning Herald. https://www.smh.com.au/business/ banking-and-fnance/commonwealth-bank-chief-ian-narev-to-leave-bank-byend-of-fnancial-year-20170814-gxvg33.html.

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Chapter Two Incentives

The term cobra efect was coined by economist Horst Siebert based on an anecdote of an occurrence in India during British rule.The British government, concerned about the number of venomous cobras in Delhi, ofered a bounty for every dead cobra. Initially, this was a successful strategy; large numbers of snakes were killed for the reward. Eventually, however, enterprising people began to breed cobras for the income. When the government became aware of this, the reward program was scrapped. When cobra breeders set their now-worthless snakes free, the wild cobra population further increased. Wikipedia (Perverse incentive, n.d.) In compiling their case against the traders involved in the NAB FX trading scandal, the corporate regulator, ASIC, focused on the period leading up to 30 September 2003.They did this for good reason – 30 September is the date that the NAB draws a line under its books.The fnancial performance during the twelve months leading up to this date is what is used to determine the payment of bonuses. The independent inquiry into the incident conducted by PWC detailed how the losses being concealed grew over time (PricewaterhouseCoopers, 2004). For example, the losses being concealed at the end of July and August 2003 were AUD 4.0 million and AUD 5.5 million respectively. These losses grew to AUD 42.1 million on 30 September, largely due to the size of the exposure increasing and a sharp decline in the value of the USD. Between them the traders pocketed AUD 790,000 in bonuses for their eforts during the 2003 fnancial year. A central pillar of the regulator’s case was that these bonuses were illicitly obtained given the losses being concealed on 30 September,

DOI: 10.4324/9781003335368-3

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an argument the courts subsequently upheld. Given some of the territory already covered in this book, it would be reasonable to assume that these monetary incentives played a role in driving the behaviour of the traders. However, following 30 September, the losses continued to mount. At the end of December 2003, the total volume of losses being concealed was just shy of AUD 92  million and the initial announcement to the Australian Securities Exchange (ASX) on 13 January 2004 estimated the losses to be AUD 180 million. There were no bonuses up for grabs at the end of December 2003 (or January 2004 for that matter). Clearly there were other motivations at play beyond fnancial incentives, one no doubt being the potential consequences if the conduct was exposed (something we will turn to in the following chapter). Of all the conficts of interest facing employees within institutions, high-powered incentive schemes are arguably the most pernicious.As the previous chapter demonstrated, monetary incentives can cause people to act in self-interested, dishonest ways and they need not be large to elicit this type of response. However, can they also have benefcial outcomes? That is, if they are administered and managed appropriately, do they motivate discretionary efort and performance? This chapter explores these questions. This is an important line of inquiry because, if monetary incentives do not motivate discretionary efort and performance, the solution is quite straightforward: base salary aside (everyone deserves to earn some type of return for their toil), ban all forms of performance-based incentives.Why firt with ethical failure when there are no potential benefts? However, if they do motivate discretionary efort and performance (as the evidence suggests is the case), then what form should remuneration arrangements take? Answering this question is a challenging task because what we will fnd in this chapter, for the frst time in this book, is that reforming institutional arrangements typically involves trade-ofs. Changes that aim to address one issue will invariably create others (or require benefts to be sacrifced). Thus, in the case of incentives, it is all but impossible to design an arrangement that captures the benefts they can provide (in the form of increased efort) while eliminating their capacity to seduce wrongdoing. We begin our discussion in this chapter by reviewing recent research that investigates whether monetary incentives are an efective tool for motivating efort. Before then, two concepts are introduced that are necessary background for any discussion on remuneration: the principal-agent problem and imperfect contracts

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(see Box 2.1).These concepts help us understand why the challenges associated with incentive scheme design are particularly acute when considering roles that require the completion of complex work. Box 2.1 The principal-agent problem and imperfect contracts The principal-agent problem exists in situations where a principal (be they an individual or entity) appoints or engages an agent (once again either an individual or entity) to complete a task to a specifed standard. It is labelled a problem for two reasons. First, the principal and agent may have diferent preferences for how the task should be completed (for example, the efort or quality standards required). Second, there exists information asymmetry, in that the principal does not at all times have insight into how the agent is performing (for example, the efort they are expending or the standards they are setting). This combination of heterogeneous preferences and information asymmetry creates what economists refer to as “moral hazard”.The agent, recognising that the principal does not have line of sight into the efort they are applying or the standards they are setting, is faced with the ever-present temptation to deceive the agent and “shirk” (that is, behave dishonestly). Shirking by the agent results in a substandard outcome for the principal, placing them in a position where they must decide on whether to trust or monitor the agent (the latter coming at a cost). Given the benefts associated with shirking loom large for the agent, the dominant outcome in theoretical models of the principal-agent problem is dishonesty by the agent and monitoring by the principal. However, in circumstances where the interactions between the principal and agent are ongoing, theoretical models of the principal-agent problem do provide for the possibility of increased honesty and trust. In an ongoing relationship, both the principal and agent are not just concerned about the outcome for today, but also for tomorrow, the day after tomorrow and so on. Therefore, both parties stand to gain over the long-term through increased cooperation.This makes honesty from the agent and a more relaxed approach towards monitoring by the principal a more common, albeit unstable, outcome (Dal Bó & Fréchette, 2018). In fnancial institutions (or any publicly listed organisation for that matter), there are multiple examples of principal-agent relationships. Shareholders

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engage a board to steward the company and take responsibility of governance, strategy and long-term performance. The board appoints a CEO to run the institution. The CEO appoints managers to deliver strategy, performance and put in place the necessary governance safeguards. Managers hire employees to complete the required work. And so on. Indeed, institutions are a cascade of principal-agent relationships and there is no shortage of principal-agent problems within them (Ortmann & Squire, 2000). One mechanism used by principals to monitor an agent and document how they will be remunerated is the contract. Properly stipulated, the contract outlines exactly what is expected of the agent. However, in situations where an agent is engaged to complete a complex task, it is impossible to create a perfect contract. There are primarily two reasons for this. First, there are too many variables that go into determining what is required for the task to be successfully completed, some of them unknown. Second, the fnal output provides an imprecise measure of performance – other factors, beyond the agent’s control, could have played a role in producing the outcome.This gives rise to the issue of imperfect contracts. Contract theory is a branch of economics that examines how principals and agents design contracts.Although there have been contributions to the feld over time, arguably the most infuential work was undertaken by Nobel Laureate Professor Bengt Holmström. One of his most signifcant theoretical contributions is the “informativeness principle” (Holmström, 1979). Simply put, it proposes that a principal should link an agent’s payment to any signal that provides information about performance, even those that are beyond the agent’s control. Although in theory designing a contract in this manner is ideal for the principal, in practice it is difcult to institute. In an infuential paper summarising the theory and empirical evidence associated with the provision of incentives in institutions, Prendergast (1999) showed how it is the exception rather than the rule that contracts are specifed in a way that is consistent with the informativeness principle (p. 21): Instead, perhaps the most striking aspect of observed contracts is that the Informativeness Principle, that is, that all factors correlated with performance should be included in a compensation contract, seems to be violated in many occupations.

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As Prendergast (1999) went on to explain, the reason for this is that the occupations contracts are written for are highly complex. What is more, this outcome leads to “dysfunctional behavioural responses” as agents will focus on the aspects of their work that are specifed in their contract, to the detriment of other aspects which have been omitted because they cannot be efectively measured and monitored. Among the multiple examples Prendergast (1999) provides to illustrate these dysfunctional responses, one is the practice of earnings management (a topic explored in Box 2.2). But examples of imperfect contracts abound in many felds, several of which will be familiar to readers. Asking teachers to improve grades increases the risk that they will “teach to the test” to the detriment of stimulating curiosity, independence and responsibility in their students. Asking doctors to decrease waiting times increases the risk that they will improve throughput to the detriment of patient health and proper diagnosis. And asking traders to make more money without tolerating an increase in the volatility of earnings increases the risk that they will fnd dubious means to “smooth” the proft and loss.

Are incentives effective? Do monetary incentives motivate discretionary efort? And if so, how do they compare to other approaches that could be used to motivate employees? These questions, especially the latter, require consideration, especially in light of some of the fndings emerging from the Royal Commission. Channelling evidence provided by CBA CEO Matthew Comyn, Commissioner Hayne stated the following in the fnal report (p. 369, Royal Commission, 2019): Of course, variable remuneration is not the only way to encourage desired behaviour. Banks can provide staf with positive feedback on their performance, encourage them to take pride in their work, encourage them to take satisfaction from assisting customers, give them additional responsibilities and ofer them a promotion or a higher base salary.

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He then went onto state (p. 369): The ends that entities are seeking to achieve through variable remuneration can be achieved through other means.Those other means are to be preferred, if they carry fewer intrinsic risks with them. In an experiment that investigated the ability of monetary and other forms of incentives to motivate behaviour, DellaVigna and Pope (2018) had participants complete a very straightforward task – consecutively pressing the keys “a” and “b” on a keyboard as many times as possible over a ten-minute period. Being repetitive and mundane, the task was not one that would exist in modern workplaces. However, it successfully removed the infuence that variables like capability or luck could have on performance and made it impossible for participants to fnd ingenious (or dubious) ways to complete the task more efciently.The focus was exclusively on participant efort, not creativity. Each time a participant pressed the “a” and “b” keys consecutively, they received one point.The four baseline conditions focused on testing the efectiveness of traditional monetary rewards. These were structured as follows (all amounts in USD; quotes are excerpts from the instructions provided to participants): • A $1 fat fee for completing the task (“Your score will not afect your payment in any way”). • A $1 fat fee plus an additional $0.01 for every 100 points scored (“As a bonus, you will be paid an extra 1 cent for every 100 points that you score”). • A $1 fat fee plus an additional $0.04 for every 100 points scored (“As a bonus, you will be paid an extra 4 cents for every 100 points that you score”). • A $1 fat fee plus an additional $0.10 for every 100 points scored (“As a bonus, you will be paid an extra 10 cents for every 100 points that you score”). The results, illustrated by the frst four bars in Figure 2.1, can quite simply be summarised as follows: people respond to monetary incentives. In addition, the marginal increase in efort elicited by incentives decreased (that is, as incentives increase, efort increased at a reducing rate). Efort, after all, has a ceiling. With these conditions acting as baselines, DellaVigna and Pope (2018) proceeded to test the ability of a variety of other incentive schemes to motivate efort. These alternative schemes were non-fnancial in nature and designed by drawing on the 46

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Figure 2.1: In the experiment conducted by DellaVigna and Pope (2018), increasing the size of the monetary incentive increased participant effort at a decreasing rate. Furthermore, three incentive schemes that were inspired from research in psychology were not as effective at eliciting effort when compared to the baseline conditions that provided participants with a monetary bonus.

research from psychology and behavioural economics (the latter being a feld inspired by fndings in the former).Three examples of the incentive schemes tested were: • Social comparison (“Your score will not afect your payment in any way. Previously, many participants were able to score more than 2,000 points”). • Ranking (“Your score will not afect your payment in any way.After you play, we will show you how well you did relative to other participants”). • Task signifcance (“Your score will not afect your payment in any way. We are interested in how fast people choose to press digits and we would like you to do your very best. So please try as hard as you can”). As the fnal three bars in Figure 2.1 illustrate, all these conditions were more efective at motivating efort than the frst of the four baseline conditions that ofered participants a fat fee of USD 1.00. However, when compared to the other baseline conditions that provided a bonus, they failed to motivate as much efort. Therefore, although an argument could be made that they are more cost efective than monetary incentives as they increase output at no cost, they did not motivate similar levels of efort as monetary incentives. 47

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As mentioned, in order to control for potential confounding variables and focus on participant efort, DellaVigna and Pope (2018) employed a highly mundane, straightforward task. “If only all tasks were this straightforward” we hear the principal say, “monitoring agents would be a cakewalk.” The experiment provides an illustration of the trade-ofs associated with research conducted in laboratories. On the one hand, the controlled environment allowed DellaVigna and Pope (2018) to perform a more precise assessment of how incentives infuence efort. However, in the real-world, very few tasks completed by workers, especially by the most senior leaders in institutions, are this straightforward.They are complex and multidimensional.This, as was described in Box 2.1, gives rise to the problem of the imperfect contract. Therefore, we are left in a quandary. Monetary incentives motivate efort but, as the previous chapter demonstrated, can also motivate dishonesty. And for complex work, where developing a comprehensive list of measures that accurately assess performance is not possible, providing rewards for a subset of measures can promote suboptimal outcomes and unethical behaviour. The trade-ofs begin to reveal themselves. Is it possible to harness the benefts incentives provide while mitigating the potential for ethical downsides? In the fnancial services industry, two prominent approaches have emerged that attempt to do this: the “balanced scorecard” and “long-term incentive” (LTI) schemes. It is to these institutional arrangements that we now turn. Balanced scorecards The idea of a balanced scorecard (BS) frst entered the public arena in a 1992 Harvard Business Review article authored by Robert Kaplan and David Norton (Kaplan & Norton, 1992).The idea was quite straightforward: to manage an organisation and execute strategy, one must look at a range of measures, not just fnancial performance. As the authors state: Think of the balanced scorecard as the dials and indicators in an airplane cockpit. For the complex task of navigating and fying an airplane, pilots need detailed information about many aspects of the fight. They need information on fuel, air speed, altitude, bearing, destination, and other indicators that summarize the current and predicted environment. Reliance on one instrument can be fatal. Similarly, the complexity of managing an organization today requires that managers be able to view performance in several areas simultaneously.

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According to Kaplan and Norton, in addition to a “fnancial perspective”, performance measures should also provide an “internal perspective”, a “customer perspective” and an “innovation and learning perspective”. As Box 2.1 described, the informativeness principle developed by Holmström (1979) immediately provides us with cause for concern. For complex tasks, it is unlikely that all of these “perspectives” would provide a comprehensive assessment of performance. Even if they did, some of the metrics required to assess them would either be difcult to fnd or impossible to measure and quantify.Therefore, critical metrics will either be omitted or deprioritised (evidence for the latter provided below). To say that the BS has become an industry in itself in the world of executive remuneration would be an understatement. Not surprisingly, the fnancial services industry leads the charge. In 2019, the Financial Stability Board (FSB) released the results from a survey of its 20-member jurisdictions that reviewed progress on the implementation of their compensation principles and standards frst developed in 2009 (Financial Standards Board, 2019).They found that (p. 40): Mixed or balanced scorecards are used to compute compensation outcomes and include a mixture of fnancial and non-fnancial metrics against which employees are scored. This is a mechanism that banks have used to provide the right incentives to employees to reduce misconduct. The use of mixed scorecards has become widespread at banks. Eighteen jurisdictions report that banks use mixed scorecards for senior executives and “other MRTs [material risk takers].” As expected, the suboptimal outcomes described in Box 2.1 and documented by Prendergast (1999) are not uncommon.To illustrate, in a review into the remuneration practices of twelve large fnancial institutions in Australia, the prudential regulator APRA not only found that the number of metrics used to assess performance varied considerably, but important components like risk management were deprioritised (p. 17, Australian Prudential Regulation Authority, 2018): ... institutions applied over eight metrics (on average) in calculating STI [short-term incentive] outcomes with an overall range of between 2 to 20 measures. For the majority of the sample, risk management was given an average weighting of 14 per cent of the total performance scorecard, with an overall range between 5 and 25 per cent. As a result of the low weighting, the

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review did identify instances of individuals with very poor risk management scores still receiving over 90 per cent of their STI target.This clearly indicates misalignment between efective risk management and remuneration outcomes. To explore how BS arrangements infuence conduct and performance, Sheedy et al. (2021) conducted an experiment in which participants, who were all employees of the Australian fnancial services industry, were asked to complete as many transactions as possible over a 20-minute “trading session”. The maximum number of transactions that could be completed in the 20-minute period was 60. However, half of these transactions were non-compliant. There were two scorecard arrangements in the experiment that are of interest to the present discussion: the BS condition and the compliance gateway (CG) condition. In both conditions, participants were guaranteed a minimum payment of AUD 50 but could earn as much as AUD 300. The fnal payment for a participant was determined both by their performance (that is, the number of transactions completed) and their compliance (that is, the number of transactions completed that were compliant). This is typical of real-world BS arrangements – reward is determined by both fnancial performance and other non-fnancial measures such as risk or compliance. The most signifcant diference between the two conditions was how non-compliance impacted participant payment. In the CG condition, the performance payments were contingent on compliance. If less than three non-compliant transactions were completed, the participant’s payment increased with performance, reaching a maximum of AUD 300 if the number of transactions completed was in the top ten per cent of their trading session. However, if three or more non-compliant transactions were completed, the participant received AUD 50 regardless of how well they performed. This arrangement mirrors the so-called “compliance gateway”, a mechanism that has become a feature of many incentive schemes. The FSB report referenced earlier that surveyed institutions within its 20-member jurisdictions described how “gateways” have become a common feature of remuneration schemes (p. 41, Financial Standards Board, 2019): Gateways are binary decisions about compensation awards in which employers decide not to award any variable compensation as a result of misconduct or material poor performance by employees. Gateways are generally applied for

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serious or repeated breaches of standards and/or in relation to signifcant fnancial losses. Nineteen jurisdictions report that banks apply gateways to senior executives’ compensation and also 19 jurisdictions report that banks apply them to “other MRTs [material risk takers]”. In the BS condition, participants could supplement their payments by being compliant. If no non-compliant transactions were completed, they earned an extra AUD 60. This reduced to AUD 10 if one or two non-compliant transactions were completed and to AUD 0 if three or more non-compliant transactions were completed.Therefore, the amount that good behaviour (compliance) contributed to overall reward was marginal, not too dissimilar to the “overall range between 5 and 25 per cent” APRA found in their review of remuneration practices at Australia’s largest fnancial institutions (Australian Prudential Regulation Authority, 2018). To draw further parallels with real-world settings, the experimental set up ensured some policy violations would go unnoticed.Although 30 of the 60 possible transactions that could be completed were non-compliant, only 20 per cent of all transactions were audited. Overall, the incentives were skewed towards maximising performance and pushing the boundary on compliance. To provide a baseline for comparison, there was also a fxed remuneration (FR) condition.“Fixed” is perhaps a slight misnomer as the payment did vary. However, it only varied according to compliance outcomes, not performance. Participants in this condition received AUD 50 if there were three or more non-compliant transactions completed,AUD 60 if there were one or two non-compliant transactions completed and AUD 110 if all completed transactions were compliant. Financial reward could not be improved by completing more transactions and improving performance. The results are illustrated in Figure 2.2 (compliance in graph A and performance in graph B). If we frst focus on compliance, perhaps surprisingly the CG condition had the lowest percentage of participants with zero non-compliant transactions or less than three non-compliant transactions (the latter a less strict measure). Regression analysis showed that the CG condition reduced the proportion of participants who chose to commit zero (less than three) policy breaches by 20.9 per cent (29.2 per cent) relative to the baseline FR condition.The corresponding outcome for the BS condition is 16.0 per cent for both the strict (zero breaches) and less strict (less than three breaches) measures of compliance. Turning to performance, on average participants completed signifcantly more transactions in the CG condition (23.5) relative to the FR condition (18.6).

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Figure 2.2: Compliance (graph A) and performance (graph B) in the balanced scorecard (BS), compliance gateway (CG) and fxed remuneration (FR) conditions created by Sheedy et al. (2021) in their experiment investigating how balanced scorecards infuence performance and compliance.

Regression analysis demonstrated that relative to the FR condition, the BS and CG conditions produced a signifcant increase in the total number of transactions completed (3.7 and 4.7 respectively). That is, incentives work. However, when considering only completed compliant transactions, any superior performance produced by the scorecard conditions was marginal. Overall, the fndings

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suggest that the ability of the BS to simultaneously promote both performance and compliance is questionable. Increases in performance, when they did occur, came at the detriment of compliance. As mentioned, the BS is one approach that has been adopted to try and capitalise on the potential benefts provided by monetary incentives while mitigating the dishonest and suboptimal outcomes they can promote. The research conducted by Sheedy et al. (2021) suggests their ability to achieve this outcome is questionable. Another approach that has been adopted is LTI schemes. Here, incentives are contingent on reaching performance targets over the medium to long-term (typically two to three years). In the following section, the efcacy of LTI schemes is considered. Before doing so, a rarely discussed but widely deployed practice in the corporate world requires introduction: earnings management. The fnancial metrics that LTI arrangements are so often attached to (earnings per share, proft and sales) are open to manipulation.As Box 2.2 describes, how institutions achieve these fnancial outcomes is not solely through the performance of their underlying business – there can at times be (possibly more often than we imagine) some shenanigans at play.

Box 2.2 The dark art of earnings management In their review of remuneration practices at twelve large fnancial institutions, APRA stated (p. 26, Australian Prudential Regulation Authority, 2018): As performance-related remuneration metrics are often linked to cash earnings, any adjustments made to statutory proft to calculate cash earnings may directly afect remuneration outcomes. There was limited evidence of BRCs [board remuneration committees] expressly reviewing adjustments to statutory proft which could directly afect whether targets and hurdles for variable remuneration are met. If the research into the ethical minefeld that is earnings management is anything to go by, BRCs who go to the trouble of determining how earnings are calculated might be surprised at what they fnd.

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Put simply, earnings management is the practice whereby institutions manipulate the value of items in their income statements to increase (and sometimes decrease) reported earnings. The array of techniques used to achieve this feat are grouped into two categories: accrual-based earnings management and real earnings management. Accruals-based earnings management is made possible because many of the components that go into calculating earnings are not refected in an institution’s cash fows. Determining the value of these non-cash items requires some management discretion. For example, when a sale is made on credit there is some room for interpretation on when this is recognised as revenue. The method used to depreciate an asset can infuence how much of the asset’s value is expensed in the income statement. And, as illustrated by Norden and Stoian (2013), loan loss provisions are, for fnancial institutions, an item that is regularly relied upon to enable earnings management. Real earnings management, meanwhile, occurs when the timing or structure of an investment, operation or transaction is manipulated to infuence earnings. For example, current period earnings can be infated by delaying expenditure on research and development (R&D) or general and administration expenses. By increasing production, organisations can spread fxed costs over a larger volume of inventory and decrease costs of goods sold. Delaying hiring decisions or employee-related expenses is a further technique that is used to infate current period earnings. One of the pioneering studies into earnings management was conducted by Healy (1985). In the research, the association between bonus schemes and earnings management for the 250 largest U.S. industrial organisations listed on the 1980 Fortune Directory was analysed. Healy (1985) found that when bonus schemes were linked to earnings there was greater earnings management by executives. Executives tended to adopt accounting techniques that underreported earnings for the current accounting period when they (a) had already reached a target beyond which their bonus could not increase any further or (b) were unlikely to reach a target above which bonuses were triggered. There have been numerous studies exploring earnings management since the research by Healy (1985) was published, but one of the most comprehensive was undertaken by Bennett et al. (2017). It analysed reported accounting performance for the 725 largest institutions by market capitalisation listed

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on U.S. stock exchanges between 1998 and 2012. The research compared reported accounting outcomes for these institutions with the expectations created by executive performance goals in remuneration schemes. From the initial sample, Bennett et al. (2017) were able to extract 5,810 examples of compensation grants made to executives (primarily CEOs) linked to outcomes on an earnings, sales or proft-based accounting metric. There are multiple incentives at play that motivate executives to exceed performance goals, but only to do so by small margins. The most obvious is compensation (that is, a reward, be it in the form of cash, shares or options, for achieving a performance goal). However, executives might also be concerned about job security, especially if the board of an institution focus on accounting performance as a benchmark to assess executive performance (something Bennett et al. [2017] referred to as the “forced turnover efect”). In addition, if current period performance is used to establish subsequent period performance goals, this would work to reduce an executive’s desire to signifcantly exceed accounting performance goals (what Bennett et al. [2017] referred to as the “target ratcheting efect”). Together, these factors should create a scenario where, for a disproportionate number of institutions, the actual performance on an accounting metric that has a compensation grant linked to it will only marginally exceed the target performance level for that metric (an outcome strongly suggestive of earnings management). To assess this, Bennett et al. (2017) calculated the diference between actual performance and target performance for the 5,810 accounting measures that the executives in their sample had compensation grants linked to. They then standardised these outcomes across the diferent earnings, sales and proft-based accounting measures to create distributions centred around zero. To determine whether there was a disproportionate number of outcomes that fell just above zero (that is, where actual performance was marginally better than the target), a range of statistical tests were conducted. For example, in one analysis, “bins” were created of the values obtained when actual accounting performance was deducted from the target performance. One thousand random samples of size 50 of these actual less target values were drawn. On average, the number of observations from these samples that belonged to the bin just to the right of zero was signifcantly greater than the number of observations that belonged to the bin just to the left of zero.

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Other tests were also conducted to further confrm this tendency for actual accounting performance to land just above the target. For example, when compensation grants linked to a single accounting measure were compared to compensation grants linked to multiple accounting measures, the likelihood that actual performance landed just above the target was far more likely in the former. Marginally exceeding targets is an outcome that is difcult to engineer when there are multiple metrics involved. Similarly, if the target was a relative performance measure (that is, how the institution performed relative to its peers), there was no tendency for performance to marginally exceed the target – an executive’s ability to manage earnings does not cross institutional boundaries. Furthermore, Bennett et al. (2017) found evidence for the forced turnover efect (CEOs who failed to meet performance targets in one year were more likely to experience a forced turnover the following year) and the target ratcheting efect (institutions were far more likely to meet their performance targets in the current performance period if they did so by a small amount in the previous period). In addition, institutions that just met their earnings targets had high abnormal accruals and smaller changes in operating expenses, the latter suggesting that institutions decrease discretionary spending to meet earnings targets. As two Chief Financial Ofcers (CFOs) stated in survey research completed by Graham et al. (2005),“you have to start with the premise that every company manages earnings” (p. 29) and “businesses are much more volatile than what their earnings numbers would suggest” (p. 44). In their research, Graham et al. (2005) surveyed 312 fnance executives working at publicly listed companies in the U.S. and supplemented the survey with 20 one-on-one interviews.They concluded that “[a]n overwhelming majority of CFOs prefer smooth earnings (versus volatile earnings)” and “[a] surprising 78% of the surveyed executives would give up economic value in exchange for smooth earnings” (p. 5). “Smoothing”; the word I frst encountered during my time on the FX options trading desk at the NAB. Clearly it is widely practiced but some techniques (manipulating accruals and reducing investment expenditure) are more tolerated than others (incorrectly entering the details of a FX transaction). Best one knows when the practice crosses the line from “honest” to “dishonest”.

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Long-term incentives As previously mentioned, LTIs are, along with the BS, an approach to rewarding performance that attempt to capture the benefts that monetary incentives can provide while reducing the likelihood of wrongdoing and other suboptimal outcomes they can promote.As their name suggests, they are designed to encourage those who stand to beneft from them to focus on an institution’s long-term performance and viability. LTIs come in various forms but, broadly speaking, they are a combination of the following: • Shares that are rewarded to employees but cannot be sold in the short-term (typically a period of two to fve years must lapse before the shares are available for sale). • Options that are rewarded to employees but cannot be exercised in the shortterm (less common than restricted shares). • Long-term incentive plans (LTIPs) that reward employees (in cash, shares or options) for hitting performance targets over the long-term. The astute reader will recognise that LTIPs essentially represent a blend of LTIs and the BS.That is, although an LTIP could require that an executive focus exclusively on one metric (for example, earnings per share), quite often an institution will require an executive to achieve targets on several metrics (for example, earnings per share, proft, sales and other non-fnancial metrics) over the long-term. Furthermore, it can also be the case that any shares (or options) awarded for doing this successfully have selling (exercise) restrictions associated with them, such that they cannot be sold (exercised) as soon as they are granted. There is research suggesting that institutions that implement LTIs do create more value in the long run.Testing this is problematic, primarily because it is difcult to prove causation.That is, it might be possible to prove that an institution outperforms subsequent to putting LTI arrangements in place. But, was it the LTIs that drove outperformance? Management ability? The investment opportunities available to the institution? Or just plain luck? Identifying and controlling for all the possible variables that contribute to performance is an impossible task. In an ingenious study design that overcame this issue, Flammer and Bansal (2016) exploited a quasi-natural experiment by observing the diference in long-term

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performance between institutions whose shareholders either approved or rejected a proposal to put in place LTI arrangements for executives. By building a comprehensive database of all shareholder proposals that came to vote in the U.S. between 1997 and 2012, they found 808 proposals that asked for shareholder approval of long-term executive compensation schemes. The majority of these proposals were rejected by shareholders – approximately 55  per cent of the proposals received less than 30 per cent support from shareholders. But to gain insight into the causal impact of LTIs on an institution’s long-term performance, Flammer and Bansal (2016) were not interested in the proposals that were unanimously approved or rejected. Rather, they focused on the so-called “close call” outcomes. Of the 808 proposals, shareholders approved or rejected 65 of these by a margin of between plus or minus fve per cent.As Flammer and Bansal (2016) state (p. 4): The passage of such “close call” proposals is akin to a random assignment of long-term incentives to companies therefore provides a quasi-experimental setting to measure the causal efect of long-term orientation on frm performance. When considering returns on the day the shareholder vote was taken, Flammer and Bansal (2016) found that companies whose shareholders narrowly approved the LTI proposal experienced a signifcantly higher increase in their share price relative to companies whose shareholders narrowly rejected the proposal. When considering the entire sample, any diference in one-day returns between companies dissipated. This pattern was caused by companies whose shareholders voted by large margins to approve or reject the LTI proposal, suggesting that the market had expected these outcomes and had already priced in these unanimous decisions. To assess how long-term performance difered between companies whose shareholders approved or rejected the LTI proposal in the close call sample, three measures of operating performance were considered: return on assets, net proft margin and sales growth. Across all three measures, Flammer and Bansal (2016) found that the companies whose shareholders marginally approved the LTI proposal produced superior results two to four years after the resolution. However, in the year following the vote, they underperformed on these measures, suggesting that positioning for long-term performance comes with short-term costs. In support of this, in the period immediately following the vote, companies whose shareholders marginally approved LTI proposals invested more in R&D and stakeholder relationships.

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This makes for some promising fndings. Granted, the sample size was small and we should therefore be cautious in drawing defnitive conclusions. However, the research design goes some way to providing evidence for causation between LTI schemes and performance. But before we get too excited, the wide use of earnings management (described in Box 2.2) should give us pause. At some point, the shares associated with a LTI scheme vest. Or the period arrives during which the performance against a target associated with a LTI scheme is assessed. What happens at these junctures? Do executives delve into their earnings management toolkit to ensure performance hits the required landing point? To answer these questions, we turn to another piece of research that also takes advantage of a quasi-natural experiment. Ladika and Sautner (2020) analysed changes institutions made to their total investment expenditure (the sum of R&D and capital expenditure) in fnancial years when, due to changes in accounting standards, the exercise of share options awarded to CEOs was accelerated.This change meant that options held by CEOs had their vesting date brought forward to the fnancial year when compliance to the new accounting standard was required. Efectively, what was an LTI became a short-term incentive (STI). Before we proceed, some background on the accounting treatment of share options is required.The approach used to expense share options awarded to executives as part of their remuneration was frst established in 1972. At the time, the Accounting Principles Board determined that the expense recorded in fnancial statements should be the intrinsic value of the option (the share price at the date of issue less the exercise price of the option).To avoid recording any expense, institutions rewarded executives share options with zero intrinsic value (typically, the exercise price was set to be equal to the prevailing share price). Of course, the fair value of an option is more than its intrinsic value. Apart from some exceptions, options also have time value.1 That is, even if an option is “out of the money” and has no intrinsic value, there is a chance that at some stage over its life the underlying share price will move favourably and cause the option to move from being “out of the money” to “in the money”. This potential for the option’s intrinsic value to change and increase in value is refected in its time value. At the turn of the twenty-frst century, a range of high-profle ethical failures (most notably Enron and WorldCom) focused attention on the quality of accounting disclosures. In March 2004, the Financial Accounting Standards Board (FASB) released a new proposal that was adopted as FAS 123-R later that same year.

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It required that all U.S. publicly listed institutions expense, at fair value, share options granted to executives as remuneration (this included share options that had been historically granted to executives and had not yet vested or expired). Institutions were required to comply with FAS 123-R at the beginning of their frst full fnancial year following 15 June 2005. To avoid claiming an expense for historically granted options, FASB allowed institutions to accelerate their expiry date so that it would occur prior to the compliance date. If institutions chose to accelerate the expiry date of “out of the money” options, they incurred no expense as the prevailing accounting standards only required intrinsic value to be expensed. However, an expense would be incurred for such options post introduction of FAS 123-R (equal to the time value of the option). For “in the money” options, acceleration required the intrinsic value to be expensed (which, in the vast majority of cases, was less than the fair value of the options).Therefore overall, expenses could be reduced through acceleration. In their research, Ladika and Sautner (2020) found 562 examples of acceleration events at 558 U.S. listed institutions (four institutions accelerated expiry dates in two consecutive years). In total, the 558 institutions accelerated 58 per cent of all unvested share options that had been granted to their CEOs, allowing CEOs to exercise some options more than three years ahead of their original expiry date. Relative to institutions who did not accelerate, CEOs at accelerating frms were 10.9 per cent more likely to experience a complete elimination of unvested options. Taken together, the results show that acceleration signifcantly decreased the time horizon of CEO incentive provision and efectively transformed what was a LTI to a STI. How did CEOs respond? Ladika and Saunter (2020) found that institutions that accelerated option expiries reduced total investment. A one standard deviation increase in the fraction of options accelerated resulted in a circa fve per cent decrease in total investment. R&D was more sensitive to option acceleration than capital expenditure. For these institutions, the result was higher earnings and shareholder returns in the period following acceleration. In addition, option exercises by CEOs at accelerating institutions increased by 65 per cent in the fnancial year following acceleration. Given most of the shares associated with these exercises were sold, CEOs personally beneftted from the higher share price. These results confrm prior research undertaken by Edmans et al. (2017), which analysed investment decisions made by CEOs in quarters when share or options issued to them in prior periods vested. In their research, Edmans et al. (2017) analysed 26,724 CEO vesting events at U.S. publicly listed institutions between the

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2007 and 2010 fnancial years. Edmans et al. (2017) found that in those quarters, CEOs were more likely to (a) reduce R&D and capital expenditure and (b) issue positive earnings guidance. In addition, analysts were more likely to provide positive revisions to forecast earnings. And, perhaps unsurprisingly, the vesting of equity to a CEO was found to be highly correlated with CEO equity sales. In summary, there is evidence suggesting that the imposition of LTIs does result in improved outcomes over the long-term. However, at some point, the shares or options associated with LTIs will vest (or alternatively, the accounting period arrives when a performance target associated with a LTI must be exceeded). When this happens, the temptation for executives can be too great, especially when they have access to the levers that enable them to manage and manipulate the performance outcomes that are used to determine reward.Therefore, although LTIs are designed to reduce the dishonest behaviour STIs can motivate, they do not necessarily succeed in doing so. The role of public institutions In the Royal Commission’s fnal report, Commissioner Hayne made the following observation (p. 350, Royal Commission, 2019): But there being no agreed “ideal” or “optimal” remuneration system, there are limits to what can or should be regulated or prescribed. And it must be recognised and accepted that it may never be possible to identify a single “ideal” or “optimal” system. It is true that no “ideal” or “optimal” remuneration arrangement exists.The simple reason for this is that, as mentioned in the introduction to this chapter, we must contend with trade-ofs. However, the research reviewed in this chapter does provide some principles that should be applied if our goal is to fnd a more desirable balance between motivating efort on the one hand and avoiding unethical behaviour on the other. This is a subject we shall return to in the fnal section of this chapter. In this section, the role of regulation in remuneration is discussed. Although, as Commissioner Hayne pointed out, there are limits, as we shall see the role of public institutions is indispensable. There is no question that legislative and regulatory intervention is fraught. In addition to the ever-present risk of government overreach (an issue the COVID-19

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pandemic provided a stark reminder of), there are trade-ofs and the risk of unintended consequences. In their survey of eforts to regulate executive compensation in the U.S., Murphy and Jensen (2018) provide numerous examples of the latter. Attempts to legislate executive pay infamed the very problems they were aiming to address (refer to the Cobra Efect). Murphy and Jensen (2018) conclude that “the best way the government can fx executive compensation is to stop trying to fx it” (p. 1). However, of the many lessons that could be drawn from the Royal Commission, one was the limits of self-regulation. And as the following chapter illustrates, without the credible threat of regulatory and legislative intervention, private institutions have minimal incentive to put in place arrangements that promote ethical conduct. If remuneration arrangements that are approaching ideal or optimal is the goal, then public institutions need to do a large proportion of the heavy lifting. This is especially the case in oligopoly markets like the Australian fnancial services industry where there is signifcant interdependence between the dominant institutions – the decisions by one frm invites responses from others. Such dynamics creates situations where if an institution introduces institutional arrangements which invites unethical conduct but provides them with a competitive advantage, absent any regulatory intervention the most likely outcome is that its competitors will play “follow the leader”. Conversely, if an institution was to put in place institutional arrangements that promote ethical conduct but the arrangements place them at a competitive disadvantage, it is highly unlikely that rival institutions will follow.A quintessential example of this latter outcome was on full display at the Royal Commission. In Australia, mortgage brokers are compensated via commissions they receive from the institutions they refer customers to for loans. The commissions are paid both upfront and on an ongoing basis (the latter referred to as “trail commissions”) and are calculated by multiplying the face value (or principal) of the loan by an agreed percentage. Therefore, although ostensibly mortgage brokers are acting in the best interests of the customer, these remuneration arrangements create a range of conficts of interest that make it extraordinarily difcult for them to do so.They encourage brokers to focus more heavily on the institution to which they refer their customers to and the size of the loan they originate. When providing evidence to the Royal Commission, the CEO of CBA (Matthew Comyn) refected on how in his previous role as head of CBA’s retail bank, he strongly considered changing the commission arrangements for mortgage brokers, 62

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recognising the potential for detrimental customer outcomes they could promote. Ultimately, he decided against doing so because of the “commercial detriment” that would be sufered by CBA if their competitors did not respond in kind (p. 67, Royal Commission, 2019): It is evident that, after CBA had made its study of customer outcomes, it gave very close consideration to changing the terms on which it would ofer to deal with brokers. In his then capacity as head of Retail Banking Services within CBA, Mr Comyn was on the edge of announcing a change to a fxed fee model, paid by the lender, but did not proceed. He decided that other lenders would not follow CBA’s lead without regulatory compulsion, and that, if CBA changed, it would sufer commercial detriment (by losing custom from brokers) for no real beneft for consumers. Although we may like to think that the leaders of institutions are all-powerful and can address institutional arrangements that abet unethical behaviour, as this example illustrates there are times when they are left in a hopeless bind.The costs such a decision would have imposed on CBA shareholders (in the form of reduced returns) and employees (in the form of redundancies) would have far outweighed any potential beneft to the customer. Why burn yourself on the pyre of integrity by making a decision with such poor economic and ethical dividends? The only way to address these types of defcient institutional arrangements, where there is minimal upside for institutions who move unilaterally, is via legislative or regulatory compulsion. Prior to the Royal Commission, there were two prominent pieces of legislation introduced by the Australian Government that targeted compensation arrangements within the fnancial services industry. The frst was the array of legislative reforms associated with FoFA. As mentioned in the previous chapter, these reforms targeted fnancial advisers and, amongst other things, included a “ban” on conficted remuneration (with some notable exceptions). The second and more recent legislative reform was the Bank Executive Accountability Regime (BEAR). As will be described, it requires certain individuals within fnancial institutions to defer variable remuneration for specifed periods. The origins of the FoFA reforms can be traced back to the global fnancial crisis. The losses sufered by consumers who entered into leveraged investments (and the bankruptcies of institutions that provided the capital and advice to manufacture them) was the catalyst for a parliamentary inquiry into “fnancial products and services in Australia”.The inquiry’s fnal report made a range of recommendations, 63

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two of which were central to the FoFA reforms (Commonwealth of Australia, 2009). They were: • The inclusion of a fduciary duty in the Corporations Act 2001 (Cth) requiring fnancial advisers to place a client’s interest ahead of their own (Recommendation One). • The development of a mechanism to cease the payments (commissions) from institutions who manufacture fnancial products to those who distribute them (Recommendation Four). As will be discussed in the following chapter, politicians in Australia are not immune from infuence in the policy development process. In relation to fnancial services legislation, FoFA is an example of how special interests can infuence policy outcomes. The horse trading between industry and law makers in the drafting of the reform led to signifcant compromise.The call for a fduciary duty was watered down to a “best interests duty” (Section 961B(1) of the Corporations Act), whereby a fnancial adviser is required to act in the best interests of their client when providing personal advice (as opposed to general advice). Meanwhile, the FoFA provisions banning conficted remuneration also contained signifcant compromises which, as described in the previous chapter, came in the form of a variety of so-called “carve outs”. Arguably the most notable were the “grandfathering” provisions that allowed for the continued payment of conficted remuneration associated with products that had already been issued (an obvious example being trail commissions associated with investment products). In addition, performance pay (such as bonuses) was not strictly prohibited under FoFA if it could be demonstrated that it did not “infuence the advice given” by a fnancial adviser (Australian Securities and Investments Commission, 2017). BEAR was a reform introduced as part of the 2017–2018 Commonwealth budget and became law in February 2018. Modelled of the Senior Managers and Certifcation Regime in the United Kingdom, its primary goal was to increase the accountability of leaders within authorised deposit-taking institutions (ADIs). The legislation requires that in addition to having certain obligations placed upon them, so-called “accountable persons” within ADIs must have the payment of their variable remuneration deferred for a period of four years. The minimum amount to be deferred depends on the position held by the accountable person (CEOs are required to defer greater proportions).

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Not surprisingly, remuneration was a major topic in the Royal Commission, with the fnal report containing no fewer than eleven recommendations relating to the issue. These ranged from the relatively straightforward (for example, repealing the carve outs incorporated into the FoFA legislation) to the highly transformative (for example, requiring mortgage broker commissions to be overhauled such that, over a period of time, mortgage brokers are paid by the customer rather than the lender). Since the handing down of the fnal report, there has been legislative and regulatory reform to implement some of these recommendations, a notable example of which is provided below. The prudential regulator APRA has, after signifcant industry consultation, developed a new prudential standard for remuneration (Australian Prudential Regulation Authority, 2021).The standard, CPS 511, was published in August 2021 with implementation for signifcant fnancial institutions to commence in January 2023. CPS 511 is multifaceted and provides a comprehensive framework for the design and oversight of incentive schemes. However, for the present discussion, there are two key features of the standard that speak directly to the research presented in this chapter. First, CPS 511 will require institutions to fnd a balance between how fnancial and non-fnancial metrics are used to determine variable remuneration. After receiving considerable push back, APRA stepped away from its original proposal that called for an upper limit on the number of fnancial measures that can be used to determine variable remuneration. In its place, APRA will ask that institutions adopt a principles-based approach – in determining an individual’s variable remuneration,“material weight” will need to be provided to non-fnancial measures. The research cited in this chapter would have us cast a sceptical eye on any approach that uses a range of measures to assess performance. First, given the roles that are in scope under CPS 511 involve complex work, it would be impossible to fnd a comprehensive set of measures that efectively assess overall performance. As Box 2.1 described, using a subset of measures in these circumstances leads to suboptimal (and at times unethical) outcomes as there will be undue focus placed on the selected measures. In addition, the ability of the BS to elicit both performance and compliance simultaneously is questionable, as demonstrated in the research conducted by Sheedy et al. (2021). A second key feature of CPS 511 is the requirement for deferral of remuneration. Although APRA tempered its proposed deferral arrangements after receiving industry feedback, the fnal requirements extend those that currently exist under

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the BEAR.This is a clear step in the right direction.The research demonstrates the upsides associated with increasing the horizon over which incentives are rewarded. Furthermore, such arrangements make the application of malus (that is, the recovery of variable remuneration that has been rewarded but not yet vested) for misconduct far easier to operationalise. However, as outlined in the “Lessons for leaders” section, the evidence cited in this chapter suggests the prudential standard could go further. Lessons for leaders Incentives are an important (some would say pivotal) institutional arrangement. It is quite clear that they played a role in much of the wrongdoing exposed at the Royal Commission; the only question is how big a role. But the research reviewed in this chapter shows that we should not throw the baby out with the bathwater – incentives can motivate discretionary efort. Therefore, the lesson for leaders is that incentives should not necessarily be abandoned. Rather, as with most institutional arrangements, we must deal with a range of trade-ofs. What are some of these trade-ofs? First and foremost, monetary incentives can motivate discretionary efort but as the previous chapter illustrated, they also motivate dishonesty. In addition, extending the time horizon over which incentives are rewarded seems to drive benefcial outcomes but linking the payment of incentives to targets, even if they are long-term, can lead to creative techniques being employed to reach these targets. And fnally, although increasing the range of measures used to measure performance might make intuitive sense, this can lead to suboptimal (and potentially unethical) outcomes in complex tasks where it is not possible to fnd a comprehensive set of measures to assess performance (the imperfect contract problem). Given the above, if leaders would like to use incentives to motivate discretionary efort while not increasing the likelihood of unethical conduct, the focus should be on (a) increasing the horizon over which incentives are rewarded and (b) wherever possible, decoupling the rewarding of incentives from attaining outcomes on specifc metrics.This is where the evidence leads us if our goal is to design incentive schemes that are approaching “ideal” or “optimal”.Although challenging, implementing such an arrangement will ensure (a) the focus is on the long-term, (b) attention is not limited to a handful of metrics to the detriment of others and (c) the temptation to game metrics is removed. One possible way of achieving this outcome is to grant leaders within institutions a large endowment of shares on the day they join the organisation. Every

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two to three years, a portion of this endowment “vests” and the leader becomes the benefcial owner. However, the ability to sell the shares is delayed and only becomes available to the leader several years after they leave the institution. Of the many benefts associated with such an arrangement, one is that it ensures the focus is on the long-term – the very long-term. But in addition, as leaders are no longer employed by the institution when the ability to sell the shares becomes available to them, they do not have access to the levers that would allow them to artifcially infate the share price (or any other performance metric). Despite a remuneration arrangement of this style having considerable merit and being supported by research, the likelihood that institutions will embrace it are slim. As was mentioned above, APRA tempered the deferral requirements under the new prudential standard for remuneration it developed after considering feedback from stakeholders. Among the issues raised in submissions to APRA was a concern that the deferral arrangements, as initially proposed, would compromise “an entity’s ability to attract and retain certain staf ” (p. 15, Australian Prudential Regulation Authority, 2020).This is an argument I also hear, but its validity has never been tested. And interestingly, there is experimental evidence challenging this proposition (Sheedy, Zhang & Liao, 2022). To be sure, trade-ofs also exist for a remuneration arrangement of this type. For example, for the arrangement to be most efective, the long-term share price must be a reliable measure of overall leader performance. However, in many cases, the long-term share price can be infuenced by a whole range of factors outside a leader’s control. In addition, if the benefciary of the unvested shares secures employment at a rival institution, there is the potential that the shareholdings they have accumulated could create conficts of interest that impact on their capacity to act in the best interest of their new employer.As stated, trade-ofs cannot be avoided when designing incentive schemes if our want is to retain some of the benefts they can provide. But there is a further beneft associated with this type of arrangement. As the following chapter will make clear, if our goal is to reduce the likelihood ethical failure, then accountability is a crucial piece of the puzzle. Performance management frameworks are a key institutional arrangement through which accountability can be applied. Incentive schemes like that described above, by making malus far easier to operationalise, can ensure that performance management frameworks place equal (if not more) focus on reducing variable remuneration for wrongdoing as they do on augmenting variable remuneration for a job well done. Unfortunately, the evidence presented at the Royal Commission demonstrated that far from applying accountability, performance management frameworks worked to fuel unethical behaviour.

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Note 1 Options that are very deep in the money, very deep out of the money or have expired have no time value. References Australian Prudential Regulation Authority. (2018, April 4). Information paper: Remuneration practices at large fnancial institutions. https://www.apra.gov.au/sites/ default/fles/180328-Information-Paper-Remuneration-Practices.pdf. Australian Prudential Regulation Authority. (2020, November 12). Response paper: Strengthening prudential requirements for remuneration. https://www.apra.gov.au/ sites/default/files/2021-02/Response%20Paper%20-%20Strengthening%20 prudential%20requirements%20for%20remuneration.pdf. Australian Prudential Regulation Authority. (2021, August 27). Response paper: Strengthening prudential requirements for remuneration. https://www.apra.gov.au/ sites/default/files/2021-08/Response%20paper%20-%20Strengthening%20 prudential%20requirements%20for%20remuneration.pdf. Australian Securities and Investments Commission. (2017, December 7). Regulatory guide 246: Conficted and other banned remuneration. https://download.asic.gov.au/ media/4566844/rg246-published-7-december-2017.pdf. Bennett, B., Bettis, J. C., Gopalan, R., & Milbourn, T. (2017). Compensation goals and frm performance. Journal of Financial Economics, 124(2), 307–330. https://doi. org/10.1016/j.jfneco.2017.01.010. Commonwealth of Australia. (2009, November 23). Parliamentary joint committee on corporations and fnancial services: Inquiry into fnancial products and services in Australia. https://www.aph.gov.au/binaries/senate/committee/corporations_ctte/fps/ report/report.pdf. Corporations Act 2001 (Cth). https://www.legislation.gov.au/Details/C2019C00216. Dal Bó, P., & Fréchette, G. R. (2018). On the determinants of cooperation in infnitely repeated games: A survey. Journal of Economic Literature, 56(1), 60–114. https://doi.org/10.1257/jel.20160980. DellaVigna, S., & Pope, D. (2018). What motivates efort? Evidence and expert forecasts. Review of Economic Studies, 85, 1029–1069. https://doi.org/10.1093/ restud/rdx033. Edmans, A., Fang,V. W., & Lewellem, K. A. (2017). Equity vesting and investment. The Review of Financial Studies, 30(7), 2229–2271. https://doi.org/10.1093/rfs/ hhx018.

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Financial Standards Board. (2019, June 17). Implementing the FSB principles for sound compensation practices and their implementation standards: Sixth progress report. https:// www.fsb.org/wp-content/uploads/P170619-1.pdf. Flammer, C., & Bansal, P. (2016). Does a long-term orientation create value? Evidence from a regression discontinuity. Strategic Management Journal, 38(9), 1827–1847. https://doi.org/10.1002/smj.2629. Graham, J. R., & Harvey, C. R., & Rajgopal, S. (2005). The economic implications of corporate fnancial reporting. Journal of Accounting and Economics, 40, 3–73. https://doi.org/10.1016/j.jacceco.2005.01.002. Healy, P. M. (1985).The efect of bonus schemes on accounting. Journal of Accounting and Economics, 7, 85–107. https://doi.org/10.1016/0165-4101(85)90029-1. Holmström, B. (1979). Moral hazard and observability. Bell Journal of Economics, 10(1), 74–91. https://doi.org/10.2307/3003320. Kaplan, R. S., & Norton, D. P. (1992). The balanced scorecard – measures that drive performance. Harvard Business Review. https://hbr.org/1992/01/ the-balanced-scorecard-measures-that-drive-performance-2. Ladika,T., & Sautner, Z. (2020). Managerial short-termism and investment: Evidence from accelerated option vesting. Review of Finance, 24(2), 305–344. https://doi. org/10.1093/rof/rfz012. Murphy, K. J., & Jensen, M. C. (2018). The politics of pay: The unintended consequences of regulating executive compensation. Journal of Law, Finance, and Accounting, 3(2), 189–242. http://doi.org/10.1561/108.00000030. Norden, L., & Stoian,A. (2013, December 19).Bank earnings management through loan loss provisions:A double-edged sword? (Working Paper No. 404). De Nederlandsche Bank. https://www.dnb.nl/en/binaries/working%20Paper%20404_tcm47-301517.pdf. Ortmann, A., & Squire, R. (2000) A game-theoretic explanation of the administrative lattice in institutions of higher learning. Journal of Economic Behavior & Organization, 43(3), 377–391. https://doi.org/10.1016/S0167-2681(00)00121-9. Perverse incentive.(n.d.).In Wikipedia.https://en.wikipedia.org/wiki/Perverse_incentive. Prendergast, C. (1999). The provision of incentives in frms. Journal of Economic Literature, 37(1), 7–63. http://www.jstor.org/stable/2564725. PricewaterhouseCoopers. (2004, March 12). Investigation into foreign exchange losses at the National Australia Bank. Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. (2019). Final report (Vol. I). https://www.royalcommission.gov. au/sites/default/fles/2019-02/fsrc-volume-1-fnal-report.pdf.

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Sheedy, E., Zhang, L., & Liao, Y. (2022). Deferred pay: Compliance and productivity with self-selection. Journal of Banking & Finance. https://doi.org/10.1016/j. jbankfin.2022.106657. Sheedy, E., Zhang, L., & Steffan, D. (2021). Scorecards, rankings and gateways: Remuneration and conduct in financial services. Accounting and Finance. https:// doi.org/10.1111/acfi.12886.

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Chapter Three Accountability

For man, when perfected, is the best of animals, but, when separated from law and justice, he is the worst of all; since armed injustice is the more dangerous, and he is equipped at birth with arms, meant to be used by intelligence and virtue, which he may use for the worst ends. Wherefore, if he have not virtue, he is the most unholy and the most savage of animals, and the most full of lust and gluttony. But justice is the bond of men in states, for the administration of justice, which is the determination of what is just, is the principle of order in political society. Politics (Aristotle, 1920) For the laws of nature, as justice, equity, modesty, mercy, and, in sum, doing to others as we would be done to, of themselves, without the terror of some power to cause them to be observed, are contrary to our natural passions, that carry us to partiality, pride, revenge, and the like. And covenants, without the sword, are but words and of no strength to secure a man at all. Leviathan (Hobbes, 1962) A moral being is an accountable being. An accountable being, as the word expresses, is a being that must give an account of its actions to some other, and that consequently must regulate them according to the good-liking of this other. Theory of Moral Sentiments (Smith, 1759) When misconduct was revealed, it either went unpunished or the consequences did not meet the seriousness of what had been done. Commissioner Hayne (Royal Commission, 2018)

DOI: 10.4324/9781003335368-4

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A question often asked of me is how I managed to survive at the NAB for over twelve years following the FX trading scandal.After all, my story does not seem to follow the stereotypical “whistleblower” script.The commonly agreed plot is that at best, whistleblowers sufer signifcant hardship.At worst, they are thrown under the proverbial bus. To be sure, there was some hardship. However, my long-term survival and subsequent success is surprising to many.There were a multitude of factors that facilitated this outcome. One of them was good old-fashioned luck. Another was the support I received from colleagues. But perhaps most telling was the important role played by accountability. Let me explain. When I walked into the London ofce of the NAB on the morning of Monday 12 January in 2004, the senior trader I worked with informed me that the losses had been found and that the bank was preparing to make an announcement. Given what had transpired over the weekend, this news did not surprise me (although I did my best to pretend it did). Shortly after that conversation, the senior trader was taken from his desk – that was the last I saw of him. Along with three of his colleagues in the Melbourne ofce, he was suspended on full pay. The following weeks was a revolving door of dismissals and resignations. The bank’s CEO resigned on 2 February 2004 (Australian Associated Press, 2004a) and the chairman two weeks later (Australian Associated Press, 2004b). On the day PWC made the report detailing the fndings of their independent inquiry public (12 March 2004), the traders – along with the co-head of the foreign exchange business – were dismissed while three other senior executives left the bank: the head of the markets division, the head of the corporate and institutional bank and the head of risk (Australian Associated Press, 2004c). If you were to draw a line on the organisational chart from the person that sat above me to the chairman, they were all either dismissed or resigned. In addition, in the weeks that followed, a range of other employees left the bank. Although I was not privy to the NAB’s recovery plan, it appeared that a policy was being adopted where anyone remotely associated with the incident, no matter how tenuously, was not encouraged to stay. This, I believe, was pivotal to my survival at the NAB. I did not have to deal with anyone who was associated with or supportive of the behaviour underpinning the scandal (or for that matter anyone who might have been antagonistic to the role I played in exposing it). As the following chapter will describe, retaliation against whistleblowers is very common. Fortunately for me, the likelihood of experiencing detriment was signifcantly reduced – anyone with an axe to grind was no longer employed at the NAB.

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In many ways, the response by the NAB to the FX trading scandal remains a model for how accountability should work. There was an independent inquiry to investigate what happened, how it happened, and who was responsible. The most senior leaders, recognising they were ultimately accountable, resigned. After the independent inquiry, those directly responsible were dismissed and, as detailed above, there were further resignations.And last but not least, the authorities pressed charges against the traders directly involved in the wrongdoing. Possibly the only question mark is whether the long arm of the law should have stretched to more senior levels of the organisation. To argue that the FX trading scandal is “a model for how accountability should work” presumes that accountability plays an important role in helping prevent ethical failure. Does it? Although I believe that it made my life easier as a whistleblower, does it play a role in creating and sustaining environments that are less likely to spawn wrongdoing? And if it does, what forms of accountability are most efective? These are the types of questions that are explored in this chapter. But before proceeding, it is important to describe what I refer to when I use the term “accountability”. There are numerous elements that underpin accountability. Three are particularly important: identifcation, assignment and liability. First, wrongdoing must be identifed. This requires appropriate monitoring and auditing mechanisms, or, low and behold, a whistleblower to raise concerns. Responsibility for the wrongdoing must then be assigned, either to an individual or group of individuals. Finally, those responsible for the wrongdoing must be held liable. Liability can be benign (for example, formal warnings), more severe (for example, forced resignation or dismissal) or extreme (for example, criminal charges). This chapter provides evidence demonstrating that for accountability to be efective, it is not sufcient for a subset of these elements to be in place. Rather, the institutional arrangements must support all three. Having mechanisms in place to identify wrongdoing, regardless of how efective they are, will not deter unethical conduct if (a) responsibility for the conduct is not assigned and (b) those responsible do not experience some form of liability.What we also fnd, for the second time in this book, is the important role public institutions play in helping create the institutional arrangements that enable accountability and thus reduce the likelihood of ethical failure. We will begin by looking at what the experimental evidence tells us about accountability, both in its soft (transparency) and hard (punishment) forms.

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Does accountability promote ethical behaviour? Let us return to where we began – our fawed human nature.You will recall from Chapter One that economists have demonstrated experimentally how humans have a propensity for dishonesty. In the original experiment of its kind, Fischbacher and Föllmi-Heusi (2013) had participants roll a die in private and self-report the outcome. The payof participants received increased if they reported a higher number, reaching its maximum when they reported a fve (at which point they were rewarded a payof of CHF 5). If a six was reported, the participant received no payment. The results, illustrated in Figure 1.1 (and reproduced below), show how the self-reported outcomes congregated around the outcomes that delivered the highest payofs. Adopting this experimental paradigm, Gneezy et al. (2018) explored whether transparency can act as an antidote to dishonesty.That is, if there is a higher likelihood of dishonesty being identifed, are people more likely to resist the temptation to plunder the cookie jar? In the experiment participants, in private, drew a number between one and ten. They then self-reported the number they drew knowing that the payof they would receive (in EUR) would equal the number they claimed to have drawn. However, there were two methods by which participants drew their number. In the frst condition, 390 participants sat in front of a computer and were presented with a screen containing ten blank boxes. They then selected a box and clicked on it to reveal their number. A subsequent screen appeared that provided a feld for participants to record their number. In the second condition, 103 participants were provided with a sealed envelope that contained ten pieces of paper with

Figure 1.1: The reported outcomes of 389 die roles in the experiment undertaken by Fischbacher and Föllmi-Heusi (2013) to assess honesty. 74

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the numbers one to ten written on them.The participants privately drew a piece of paper, replaced it in the envelope and then reported the number that appeared on the piece of paper. The frst condition was referred to as the “observed” condition. Although the participants were not explicitly told that the number that appeared after they clicked on their selected box along with the number they reported would be recorded, clearly they were aware that this was a possibility. In the second “non-observed” condition, the participants could take greater comfort that the number they drew from the envelope would not be tracked. If they liked, they could confrm the activity was not rigged by checking all the pieces of paper in the envelope. The results, illustrated in Figure 3.1, show that when the likelihood of being exposed for raiding the cookie jar increases, people are more likely to refrain from taking cookies. In the non-observed condition, far more participants reported having drawn a nine or ten (bar graphs represent the percentage of participants reporting each outcome).This skewed distribution resulted in the average reported number (payof) being higher in the non-observed condition (7.81) versus the observed condition (7.02). Interestingly, although dishonesty increased in the non-observed condition, many participants chose not to leave the cookie jar deplete. A signifcant proportion of the participants (22 per cent) report a nine (compared to 14 per cent in the observed condition). Gneezy et al. (2018) suggest that this result demonstrates the important role social identity plays in shaping our decisions on whether to deceive. As mentioned in

Figure 3.1: In the experiment conducted by Gneezy et al. (2018), dishonesty increased when the likelihood of being observed decreased.

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Chapter One, people place value on being perceived as honest. In this case, to create that perception for the experimenter, participants did not lie to the maximum amount. This is a fnding that appears consistently in the research conducted by experimental economists – people like to create the appearance that they are upstanding, “moral” citizens (Guzikevits & Choshen-Hillel, 2022). Among the research that has confrmed these fndings, one was an experiment conducted by Crede and von Bieberstein (2020), in which participants were left under no illusions that their reported outcome in the Fischbacher and FöllmiHeusi (2013) die rolling task would be saved and could potentially be used to assess consistency with the actual outcome. In a baseline condition, 56 participants completed the original version of the task that involved rolling a die in private and reporting the outcome. In the second condition, 84 participants completed an electronic version of the task where a virtual die roll occurred when a participant clicked a button on a computer screen. In both conditions, the payof structure was identical to the original experiment, albeit denominated in EUR (EUR 1 to EUR  5 for a reported outcome of one to fve respectively, with no payof for a six). To make it clear that their results were being recorded in the electronic version, the following line was added to the instructions: The result of your die roll is electronically stored but will not be verifed for the payment procedure. As illustrated in Figure 3.2, the profle of reported outcomes in the baseline condition were consistent with those from the original Fischbacher and FöllmiHeusi (2013) experiment. In the condition where the participants were informed that the outcome of their die roll was being recorded, dishonesty all but dissipated. To explain this pattern of results, Crede and von Bieberstein (2020), like Gneezy et al. (2018), also pointed to social identity as being one reason why participants tempered their dishonesty in the electronic version of the task. But, in addition, they proposed a potential role for reputational concerns – participants might be concerned with long-term consequences such as being excluded from taking part in future experiments. If you are caught raiding the cookie jar, you would much rather receive a warning than have the whole jar confscated. Therefore, it seems that when there is a high likelihood that wrongdoing will be identifed, the swindler will temper their dishonesty, further evidence (not that it was needed) that institutional arrangements matter. But how credible do the monitoring 76

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Figure 3.2: Crede and von Bieberstein (2020) replicated the original Fischbacher and Föllmi-Heusi (2013) die rolling experiment and also conducted an electronic version where participants were left under no illusion that the outcome of their die role was being recorded.

mechanisms need to be? Is the mere threat of being exposed enough? Or does a potential swindler need to feel certain that their duplicity will be identifed? And what about penalties for wrongdoing? Or rewards for honesty? Should they be thrown into the mix when deliberating what form the institutional arrangements should take? These questions were explored in yet to be published research conducted by Fochmann et al. (2020). In this experiment, an electronic version of the Fischbacher and Föllmi-Heusi die rolling task was employed.The payof structure diverged from that which applied in the original Fischbacher and Föllmi-Heusi (2013) experiment in that the amount that could be earned was equal to the number reported in EUR (that is, reporting an outcome of one resulted in a payof of EUR 1, a two EUR 2 and so on up to a reported outcome of six that earned EUR 6). In addition to the baseline condition in which participants viewed the video of the die roll and reported their number, Fochmann et al. (2020) ran a variety of scenarios in which they introduced (a) the possibility of being audited, (b) a reward for honesty and (c) a penalty for dishonesty. As panel A in Figure 3.3 illustrates, including the baseline, there were a total of seven conditions (with each containing over 100 participants).The probability of being audited took on one of three values: zero, 0.30 and 0.70. In addition, in each of these audit conditions, there was a condition in which participants were rewarded for honesty and a condition in which participants were penalised for dishonesty.

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Panel B of Figure 3.3 illustrates how the reward and penalty schemes operated should an audit have occurred. Under the reward scheme, honest participants received a payof equal to the number reported plus a EUR 1 reward for their honesty, while the payof for dishonest participants reverted to the actual number that was rolled (with no reward provided). In conditions with a penalty, honest participants received a payof based on the number they reported, while in addition

Figure 3.3: The seven conditions in the experiment conducted by Fochmann et al. (2020) (panel A) and an illustration of how the reward and penalty schemes operated in the experiment (panel B).

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to paying a EUR 1 penalty, the payof for dishonest participants reverted to the number that was rolled. The astute reader might query what diferentiates the baseline condition from the conditions where there is zero probability of being audited. In short, the diference is that in the baseline condition there is no mention of an audit.Aside from the participant perhaps suspecting that the experimenter could conduct a post hoc check and detect dishonesty, there is no formal monitoring program in place. In the audit conditions, the spectre of an audit becomes real, albeit with difering probabilities. Figure 3.4 illustrates the percentage of participants in each condition who rolled a number between one and fve inclusive and reported dishonestly (not surprisingly, everyone who rolled a six reported honestly). As can be seen, the level of dishonesty increased between the baseline condition and the conditions where the probability of being audited was zero – it appears that participants tempered their dishonesty in the baseline condition where, although not explicit, they may have suspected they were being monitored. Once the likelihood of an audit was made explicit, dishonesty decreased as the probability of being audited increased, peaking when participants were told that there was a zero probability of being audited. But, in addition, in the conditions where the probability of being audited was highest, the threat of a penalty was more efective at curbing dishonesty than the promise of a reward for honest reporting.

Figure 3.4: Fochmann et al. (2020) employed an electronic version of the Fischbacher and FöllmiHeusi die rolling task and found that (a) dishonesty decreased as the probability of being audited increased and (b) penalties rather than rewards were more effective in reducing dishonesty.

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These results should be viewed with caution given the fndings associated with other research that has explored whether penalties and sanctions, applied at diferent probabilities, discourage dishonest behaviour. In some cases, the fndings emerging from this research are not consistent with those documented by Fochmann et al. (2020). However, what appears to be driving these ambiguous results is diferences in experimental design. Behnk et al. (2018) provided a review of experiments that employed the “senderreceiver game” to determine whether penalties or sanctions discouraged dishonest behaviour.As they state, punishment was an efective deterrent to dishonesty in experiments where the “credibility of its threat” was increased.When it was costly to apply or the consequences to those it was applied to was slight, dishonesty was not curbed. In an experiment conducted by Behnk et al. (2018) employing the “senderreceiver game”, an endowment of money could be split between the participant playing the role of sender and the participant playing the role of receiver in three ways. Although the amounts varied, the three options divided the endowment in such a way that either (a) it was equally split between the sender and receiver, (b) the sender received a larger share or (c) the receiver received a larger share. Despite not having knowledge of how the money would be distributed in each of the three options, the receiver was charged with the responsibility of selecting which option would apply. To help the receiver make their decision, the sender sent them a message that informed the receiver which of the three options would earn them the most money. Clearly there was an incentive for a proft-maximising (and unethical) sender to be dishonest and encourage the receiver to select the option that provided the sender with the largest share.When there was no consequence for dishonesty, a signifcant majority of senders misled the receiver, especially in conditions where they stood to proft most handsomely if the receiver followed their cue. However, when the receiver was provided with the opportunity to sanction duplicitous senders by reducing their payout to a pittance, honesty increased markedly. As Behnk et al. (2018) explained, punishment proved to be efective in these latter conditions because it could be applied by the receiver at no cost and it carried signifcant consequence for the sender. In addition to (once again) illustrating the importance of institutional arrangements, this conclusion drives home a point made previously about the trade-ofs associated with laboratory experiments. Applying penalties and sanctions in the real-world is not as efcient and straightforward as it is in the laboratory. Rather, in the real-world, signifcant time and resources are required – evidence must be collected, a case made and due process followed when 80

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seeking a ruling. Clearly, this changes the calculus for the parties involved; it can act as a roadblock for those seeking redress and embolden those who perpetrate wrongdoing. It is also why efcient and efective approaches to applying liability (such as through performance management frameworks) are preferable. In summary, the fndings above suggest that monitoring does deter the swindler. But the mere threat of monitoring is not enough – it must be credible and people must feel that there is a strong likelihood that their wrongdoing will be identifed. Furthermore, accompanying monitoring with penalties for dishonesty (as opposed to rewards for honesty) also appears to deter the swindler, although once again there are caveats. Liability must be easy to apply and pack a punch. Collectively, institutional arrangements that achieve this will ensure that, although there will inevitably always be some pillage, the cookie jar will not be fully exploited. With these fndings providing our baseline, we now turn to what the Royal Commission taught us about how accountability was applied in practice. We will begin by considering self-regulation. That is, were the internal governance, compliance, risk, accountability and performance management frameworks developed and employed by institutions efective in assigning accountability? Given the extent of the wrongdoing that was exposed, it will not surprise the reader that within many institutions, these internal systems, for the most part, failed. A failure of self-regulation In their research report that surveyed policy and practice in self-regulation, Bartle and Vass (2005) presented diferent models for self-regulation. Although the models varied in detail and sophistication, in their simplest form they could be characterised by the “frst-level” model reproduced in Figure 3.5. In this model, regulation runs on a continuum from “no regulation” at one end (“No explicit controls on an organisation”) to “statutory regulation” on the other (“Regulations are specifed, administered and enforced by the state”). In between these two extremes sits “self-regulation” (regulated entities carry the burden for the administration and enforcement of regulation) and “co-regulation” (regulation is a jointly coordinated by both the regulated entities and the state). Of course, regulation does not fall neatly into any of these discrete categories. As Bartle and Vass (2005) state (p. 24),“[t]he reality of regulation is that there is a multiplicity of forms which do not ft easily into a small number of discrete categories.” Of the broad categories contained in the model pictured in Figure 3.5, co-regulation is the one that in most cases is representative of real-world arrangements. 81

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Figure 3.5: A “frst-level” model of self-regulation developed Bartle and Vass (2005) places regulation on a continuum with “no regulation” at one end of the spectrum and “statutory regulation” on the other.

There are many, both in the private and public sectors, who advocate for greater self-regulation. In theory, it does provide benefts. Regulation has many features of the principal-agent problem discussed in Box 2.1. In this light, self-regulation provides the regulated (the agent) with the authority to identify and prevent wrongdoing. Given that they are better informed than the regulator (the principal), this should make self-regulation less costly, as regulators do not need to spend as much time and resources developing regulations, monitoring for breaches and prosecuting those who transgress. However, as Box 2.1 also described, left unchecked, the agent will always be tempted by the benefts that can accumulate from dishonesty.Therefore, it will not surprise the reader that the principal (in this case, public institutions) is compelled to monitor. If public institutions fail to not only put in place efective legislation but also enforce it, the most likely outcome is that the regulated will not invest in the internal systems and processes (the institutional arrangements) that support selfregulation. And, in an oligopoly, if this posture is adopted by one institution and provides a competitive advantage, it will not take long for competitors to follow. Ultimately, the Royal Commission was an illustration of the above dynamic. We will turn to the role of public institutions shortly, but in the interim, arguably the most prominent illustration of the failure in self-regulation was the failure to apply accountability through performance management frameworks. Although there are numerous examples one could point to, the response of the CBA board to the numerous governance failures within their institution is an exemplar. During the 2016 fnancial year, the CBA board was aware of numerous conduct issues within its institution.This included shortcomings in its anti-money laundering procedures (shortcomings that led to a then record fne of AUD 700 million being 82

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imposed by Australia’s fnancial intelligence agency – AUSTRAC – two years later), the fee-for-no-service incident described in Chapter One, the mis-selling of credit card insurance and an ongoing investigation into treatment of customers in their life insurance business, CommInsure. Further to the above, in December 2015, the prudential regulator – APRA – sent a letter to the then CEO of CBA expressing concern about the efectiveness of the institution’s operational risk management framework and the institution’s inability to efectively deal with numerous risk issues. But even without this formal warning, it is clear that CBA had appropriate monitoring mechanisms in place – the board was aware of the array of wrongdoing within the institution. As the independent inquiry into CBA that was commissioned by APRA concluded, “CBA’s internal audit function discovered many of the most serious conduct and compliance issues faced by CBA” (p. 40, Australian Prudential Regulation Authority, 2018). However, when it came to applying liability for wrongdoing, the evidence presented at the Royal Commission told a very diferent story. There are various ways institutions can apply liability for employee wrongdoing. This can include formal warnings at the benign end of the spectrum to dismissals at the other. Between these extremes lie other measures, such as withholding promotions or removing responsibilities. However, as mentioned earlier, one of the most efcient and efective ways to apply liability for wrongdoing are adjustments to variable remuneration through the performance management framework. As the previous chapter outlined, variable remuneration can come in numerous forms. At its simplest, it represents remuneration an employee receives above their base salary for surpassing predetermined performance targets. Typically, an institution’s performance management framework allows for some type of adjustment to be made to variable remuneration if an employee is involved in behaviour that is non-compliant. In the Royal Commission’s fnal report, Commissioner Hayne made the distinction between the “design” and “implementation” of performance management frameworks (p. 348, Royal Commission, 2019): A well-designed system can be undermined by poor implementation. Equally, a well-implemented but poorly-designed system is unlikely to achieve good results.And, a poorly-designed system is even less likely to achieve good results however competently it is implemented.The two areas (design and implementation) present diferent issues, and require separate consideration. In the case of CBA, it appears that the design of the performance management framework allowed for adjustments to be made to variable remuneration. However, 83

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the executive and board failed to implement this design feature. Despite having knowledge of the numerous conduct issues described above, the chief risk ofcer (CRO) of CBA informed the board that he did not believe “that there were any risk issues or risk behaviours that would suggest that the short-term variable remuneration of the CEO or any of the Group Executives should be modifed in any way” (p. 360, Royal Commission, 2019). Based on this, the CEO recommended to the board that none of the group executives’ variable remuneration should be adjusted for the 2016 fnancial year. The CBA board proceeded to endorse the recommendations of the CEO and CRO, awarding the group executive their full short-term variable remuneration entitlement.There was one minor modifcation – the executive responsible for the CommInsure business had their variable remuneration reduced by fve per cent. It is important to note that these types of revelations were not unique to CBA. As some commentators pointed out, they confrmed concerns that already existed in the investor community (Maley, 2018): Most observers agree the Hayne royal commission has helped ferment this unprecedented investor insurrection. That’s because it confrmed the longstanding suspicion of many major institutional shareholders that bank boards have failed to use the bonus assessment process in the way it is intended to be used – that is, to deliver meaningful feedback to senior executives about their performance, by rewarding those who have performed strongly, and penalising those who have performed poorly. The major banks did change their approach to performance management in the year leading up to and during the Royal Commission. As Commissioner Hayne outlined, CBA reduced short-term variable remuneration to zero for its executive and CEO in the 2017 fnancial year, largely due to the statement of claim lodged by AUSTRAC in relation to the breaches of provisions in the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth). As the independent review of CBA commissioned by APRA concluded, this represented “a signifcant shift, setting a precedent for collective accountability at the most senior levels of the CBA” (p. 71, Australian Prudential Regulation Authority, 2018). Similar, less dramatic reductions were imposed the following year. Meanwhile, boards of other institutions also reduced variable remuneration payments for their executives and CEOs, primarily for shortcomings in risk management, compliance and conduct. Best this trend continues. As the research 84

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in this chapter shows, when mechanisms for accountability are in place but lack credibility, the path to ethical compromise can be swift. Returning now to our public institutions. In the following section, we review some of the fndings that emerged from the Royal Commission with regards to their performance. As will become evident, they failed to apply accountability in a way that would discourage wrongdoing. Before then, Box 3.1 provides evidence demonstrating that when public institutions do fail to apply accountability, there is little incentive for private institutions to invest in the arrangements that discourage unethical conduct. Box 3.1 The pivotal role of public institutions As described earlier in this chapter, the relationship between the regulator and the regulated can be described through the prism of the principal-agent problem. As per the discussion in Box 2.1, the principal (the regulator) must decide whether to invest in monitoring, while the agent (the regulated) decides on whether to conduct themselves honestly. When the interactions between the principal and agent are ongoing (as is the case with the regulator and the regulated), there are benefts to be gained from investing in trust – honesty from the agent encourages a more lenient approach by the principal. But this outcome is not stable – the gains from dishonesty (sometimes signifcant) are ever-present for the agent. Economists have also developed more sophisticated theoretical models to illustrate how the relationship between the regulator and the regulated operates. One example is the model developed by DeMarzo et al. (2005) in which an agent, who is afliated with a self-regulating organisation (SRO), provides a service to a customer. The agent can act honestly or dishonestly, something that can be observed by the SRO but not by the customer. To encourage honesty by the agent, one option that is available to the SRO is to put in place an arrangement that penalises dishonest agents. Such an arrangement will increase compliance costs for the SRO as they will be required to monitor the agent. However, these costs can (to some extent) be controlled by minimising how much is spent on monitoring. Left to its own devices, the SRO will strategically select an investigation probability that is high enough to provide comfort to customers that wrongdoing will be

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identifed and appropriately sanctioned, but low enough to maximise profts. Although not ideal for customers (as it will encourage dishonesty among agents), this is the most likely outcome under self-regulation. In their model, DeMarzo et al. (2005) propose a pivotal role for public institutions in disrupting this position established by the SRO. If government observes the investigation probability established by the SRO and subsequently establishes its own higher probability, the SRO will be persuaded to invest more heavily in compliance.The reason for this is that when agent dishonesty is exposed by government rather than by the internal monitoring mechanisms of the SRO, the costs associated with addressing the wrongdoing will be far greater.Therefore, if there is a credible threat of government intervention, the SRO will increase its investigation probability, an outcome that has been tested and verifed experimentally (Van Koten & Ortmann, 2016). Perhaps, more telling than these theoretical models, economists have also conducted feld experiments to assess how government oversight infuences compliance behaviour within regulated institutions. Typically, these experiments involve taking advantage of a change in regulation and enforcement practices by public institutions and examining how (or if) this changed the conduct of regulated frms. One such example occurred in 2007 when the Norwegian Environmental Protection Agency (NEPA) began a program to enforce regulations for 1,975 frms importing products likely to contain signifcant quantities of hazardous substances. The approach taken by NEPA naturally lent itself to an experiment. To begin with, NEPA segmented the universe of frms into groups based on industry, size and their potential to do harm. Firms from each group were randomly selected for monitoring and audits, thus providing a natural control group (the frms not audited). Furthermore, after the frst year, a large proportion of frms audited in year one were randomly selected for reaudit the following year, providing an assessment of whether year one audits improved future compliance. Telle (2013) took advantage of this change in regulatory approach and tracked how the conduct of importing frms changed over a three-year period (2008–2010). There were two enforcement techniques assessed by Telle (2013).The frst was a letter sent to randomly selected frms at the beginning of the program that informed them of the pending substantial increase in audit frequency and

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the consequences associated with breaches of the regulations.The second were self-audits and on-site audits (the latter conducted by NEPA civil servants) completed between 2008 and 2010 inclusive. In each of these years, NEPA randomly selected frms to receive an on-site audit or to conduct a self-audit (the remaining frms were not audited). Both types of audits used a similar process that required frms to provide information about their knowledge of (and compliance with) regulations. Telle (2013) frst found that the letters were not efective in motivating greater compliance. Of the frms receiving the letter advising them of an increase in audit frequency, 44 per cent were found to have committed violations in subsequent audits (compared to 33 per cent of frms who did not receive the letter).This appears to be at odds with fndings from experimental research that suggests dishonesty decreases when the probability of being audited increases (as per the research conducted by Fochmann et al. [2020], described earlier in the chapter). Telle (2013) provides a possible explanation for this fnding – environmental protection authorities like NEPA have a tendency to provide regulated frms with a warning when a violation is frst detected (p. 18): If frms expect to get a second chance upon detection of a violation, then they lack incentives to comply before violations are detected. If so, it is not surprising that we fnd no efects of the letters announcing higher audit frequency. Indeed, under such a regime, frms will have incentives to i) stay uninformed about the regulation, and ii) cooperate with the EPA [Environmental Protection Agency] to end the violation only after it becomes detected. In relation to the efectiveness of self-audits versus on-site audits conducted by NEPA,Telle (2013) found excessive evasive reporting by frms conducting selfaudits.At least one violation was detected in 54 per cent of on-site audits with the corresponding fgure for self-audits being 30 per cent (given the random assignment of frms to these conditions, one would expect these outcomes to be similar). Auditing did improve compliance in subsequent years, albeit this pattern was far more pronounced for on-site audits versus self-audits. On-site audits reduced the likelihood of future violations by 70 per cent with

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the corresponding fgure for self-audits being 30 per cent. According to Telle (2013), this underscores the importance of enforcement in deterring wrongdoing (p. 18): It appears clear that the mere detection of a violation in an audit is not sufcient to ensure the substantial specifc deterrence efects we observe. It seems plausible that a threat of sanctioning or actual sanctioning by the EPA is necessary for a detection of a violation to improve future performance.The higher specifc deterrence efect in on-site audits compared with self-audits may therefore result from diferences in the subsequent enforcement activities of the EPA across the two types of audits. The primary focus of this book is on the role played by private institutions in abetting ethical failure..This should not be discounted. However, the research presented above underscores the important role government and public institutions play in creating a system that is more resilient to ethical failure. Without public institutions that pass efective legislation, provide credible oversight and intervene when required, the likelihood that private institutions will invest in compliance is greatly diminished. More often than not, a failure in self-regulation has as one of its root causes the failure of public institutions to provide proper oversight. The role of public institutions In short, to ensure they are doing all they can to support and promote ethical behaviour, public institutions (and the leaders within them) must (a) conduct themselves with the highest level of probity, (b) implement efective policy, legislation and regulation and (c) properly enforce breaches of the law. These tasks are not mutually exclusive, and one tends to lead to the other – public ofcials and politicians with integrity tend to pass good law and good law makes enforcement far easier.There will be more said about the importance of probity in the following chapter when we turn our attention to the role of leadership. In this section we focus on creating and enforcing legislation. Developing efective legislation is challenging. As was mentioned in the previous chapter, when discussing legislating remuneration, there is the risk of government

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overreach. Trade-ofs are inevitable. And avoiding unintended consequences can be difcult.A big part of overcoming these challenges and getting it “right” is to engage in extensive consultation. Not only do legislators and regulators need to consult with those potentially impacted by legislation, but also with those who have relevant expertise in public policy, economics and human behaviour. Typically, this is where the process derails – consultation, when it occurs, tends to prioritise some voices over others. Australia is far from a corrupt, tin-pot dictatorship, but this does not mean that our public institutions are not vulnerable to policy capture. In September 2018, the Grattan Institute, an independent Melbourne-based think tank, published a report that examined the role that special interests play in Australian policymaking (Wood & Grifths, 2018). As they conclude, “even in a healthy democracy like Australia’s, special interests can sometimes successfully hijack the policy-making process” (p. 6). In their research, the Grattan Institute divided special interests into the following groups: • • • • • • •

Highly regulated industries. Low regulated industries. Industry peak bodies. Professional services. Consumer, community or cause (typically not for profts). Employees (that is, union groups). Mixed (this category captured institutions such as hospitals, research institutes, universities and local councils). • Individuals. The frst category, which included industries such as property development, transport, mining, energy, gambling, defence industries, fnancial services, telecommunications and media, were found to be far more active in attempting to infuence policy direction and debate in Australia.This was demonstrated in a number of ways. For example, and as illustrated in Figure 3.6: • An analysis of party declarations to the Australian Electoral Commission demonstrated that highly regulated industries are by far the largest contributor of donations to political parties (panel A in Figure 3.6). • In jurisdictions where details of meetings with ministers is made publicly available (New South Wales and Queensland), representatives from highly

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Figure 3.6: A report published by the Grattan Institute (Wood & Griffths, 2018) showed that in Australia, highly regulated industries (a) contribute the greatest proportion of donations to political parties (panel A), (b) have the greatest proportion of face time with ministers (in jurisdictions where ministerial diaries are made public; panel B) and (c) make up the greatest proportion of clients of registered federal lobbyists.

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regulated industries have far more access to ministers than other special interests (panel B in Figure 3.6). • Companies from highly regulated industries are by far the largest client base of registered federal lobbyists (panel C in Figure 3.6). As Wood and Grifths (2018) conclude in their report (p. 3): Access to decision makers is vital for anyone seeking to infuence policy. But some groups get more access than others. Businesses with the most at stake in government decisions lobby harder and get more meetings with senior ministers. Some industries … are hugely over-represented compared to their contribution to the economy. But access, although important, is one thing. Political clout is another.As policymakers and elected ofcials have told me, the most efective lobbyists are those who, through their industry bodies and interest groups, can sway voting intentions. Such lobbyists can cause even the most principled elected ofcial to acquiesce. Recall from the previous chapter that there were signifcant concessions made to the FoFA reforms due to the infuence of special interests (among other things, there were exceptions, or “carve outs”, to the ban on conficted remuneration). Not surprisingly, the industry group to which these reforms applied (fnancial advisers) are known to have significant political clout (Grieve, 2021).The Royal Commission is providing other similar examples, a prominent one being the response to the recommendations surrounding mortgage broker commissions (something we will turn to in the Conclusion). There is no straightforward solution to the challenges associated with policy development and legislative reform. Banning special interests and lobbyists from the policy debate, although a seemingly plausible arrangement, is not the antidote. To begin with, they will invariably fnd ways to infuence those in positions of power. But more importantly, given the complexity of the work, the potential for unforeseen consequences and the multitude of trade-ofs that need to be considered, even conficted parties can provide insight that adds value to the process (it is right to consult widely). However, when money, relationships or (most importantly) political clout provides some parties with greater prominence in the debate than others, the quality of legislation invariably sufers. The other important task our public institutions are charged with is enforcement. Passing the most well-crafted legislation is a pointless exercise if its boundaries are not enforced. In addition to exposing shortcomings in self-regulation, the Royal

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Commission exposed shortcomings in enforcement by the regulators (and the latter no doubt played a role in the former). The Braithwaite pyramid is a model used to outline the tools available to regulators to enforce the “bounds” of the law. The Commonwealth Government has adapted the model and issued it as a guide for regulators responsible for enforcing Australian Consumer Law (Commonwealth of Australia, 2017). Reproduced in Figure 3.7, the model illustrates the regulatory interventions on an increasing scale  – as one moves up the pyramid, the enforcement options increase in severity. At the bottom of the pyramid are enforcement tools like education, written warnings and advice, while towards the top is civil and criminal action (the latter at the apex).The option chosen will depend on a range of factors, including the nature of the breach and the level of consumer detriment. Ramsay and Webster (2017) conducted a review of the enforcement methods employed by Australia’s corporate regulator,ASIC, between 1 July 2011 and the 30 June 2016.The review drew primarily from information contained in the ASIC Enforcement Outcomes reports published biannually. In these reports, enforcement methods fall into fve categories which, although not mapping perfectly to the Braithwaite pyramid, did

Figure 3.7: The Braithwaite enforcement pyramid as adapted by the Commonwealth Government for regulators responsible for administering Australian Consumer Law (Commonwealth of Australia, 2017).

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form a hierarchy.The fve categories, listed from the least to most severe enforcement tools, are: public warning notices, enforceable undertakings/negotiated outcomes, administrative remedies, civil action and criminal action. In addition, the enforcement action in the reports is categorised by the enforcement teams within ASIC investigating the conduct.These are: • • • •

Market integrity. Corporate governance. Financial services. Small business compliance and deterrence (hereafter “small business”).

For the period 1 July 2011 to 30 June 2016, the majority of enforcement action (by far) is undertaken by ASIC’s small business team (over 68 per cent of all enforcement outcomes for the fve-year period). Ramsay and Webster (2017) put this down to the nature of the cases pursued by that team (largely summary ofences against company directors), which can be prosecuted by the ASIC in-house legal team.Therefore, it is not surprising that as illustrated in Figure 3.8, the small business team were more likely to employ more severe enforcement methods (over 89 per cent of their 2,370 enforcements involved criminal action). Figure 3.8 also illustrates the enforcement methods employed by the other enforcement teams within ASIC. Across all teams, criminal action was the most utilised enforcement method (used in two thirds of all cases). However, when the small business team data is removed from the results, criminal actions only constituted 18.5 per cent of all enforcement outcomes. The majority of cases were enforced through the use of administrative remedies (48.5 per cent) followed by enforceable undertakings/negotiated outcomes (19.9 per cent). Meanwhile, the fnancial services team largely relied on administrative remedies and enforceable undertakings/negotiated outcomes (together these were employed in 75 per cent of that team’s enforcement outcomes). In providing an explanation for the reluctance of the fnancial services team to use more severe enforcement tools, Ramsay and Webster (2017) made reference to a 2014 report produced by the Senate Economics Reference Committee on the performance of ASIC (Senate Economics Reference Committee, 2014). In this report, the committee concluded that (p. 278): The committee also recognises the diverse challenges ASIC faces in taking court action with the high rate of success expected of a government agency.

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Figure 3.8: The enforcement methods employed by each of ASIC’s enforcement teams.

Nevertheless, the committee is of the view that the public interest would be better served if ASIC was more willing to litigate complex matters involving large entities. There appears to be either a disinclination to initiate court proceedings, or a penchant within ASIC for negotiating settlements and enforceable undertakings. The end result is that there is little evidence to suggest that large entities fear the threat of litigation brought by ASIC. In the Royal Commission’s Interim Report, Commissioner Hayne painted a picture that supported the above conclusions (Royal Commission, 2018). For example, over the January 2008 to May 2018 period:

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• None of the 238 criminal proceedings and 277 civil proceedings were against major banks or their directors. • Forty-fve infringement notices were issued to the major banks that amounted to less than AUD 1.3 million in penalties. • The major banks accepted 13 enforceable undertakings that were “heavily negotiated”. The preference for negotiated outcomes was also identifed in the research undertaken by Ramsay and Webster (2017). In refecting on this, Commissioner Hayne stated (p. 288): The efect of negotiated outcomes that do not require approval by a court is that, at least to some degree, sanctions for breaches (or what ASIC considers to be breaches) are always within the control of the regulated entity.The consequence is that conduct that breaches the law, or is likely to breach the law, may be treated as involving calculated risks, taken in pursuit of some desired end (usually proft), with consequences that are seen as being manageable. Breach and the consequences of breach come to be treated as just a cost of doing business. Public institutions began considering the issue of accountability (or lack thereof) in the fnancial services industry prior to the Royal Commission. One of the fagship pieces of legislation that was introduced to address the issue was the BEAR. As outlined in the previous chapter, the BEAR became law in February 2018 after being introduced as a reform in the 2017–2018 Commonwealth budget. It requires ADIs to identify accountable persons, these being individuals with senior executive responsibility who manage or control the institution. In practice, the accountable persons within a large ADI typically comprise of the board, the executive and a handful of other senior leaders who hold key positions. In addition to the remuneration provisions described in Chapter Two, the BEAR requires identifed accountable persons to: • Conduct themselves with honesty, integrity, care and diligence. • Be open, constructive and cooperative in their dealings with the regulator (previously APRA but extended to ASIC by the Royal Commission). • Take “reasonable steps” to prevent issues arising that may be detrimental to the institution’s prudential standing or prudential reputation.

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Arguably, the design features of the BEAR that have done the most to strengthen accountability are “accountability maps” and “accountability statements”. For each accountable person, an ADI must outline (in the accountability statement) which aspects of the institution’s operations they are responsible for. In sum, the responsibilities outlined in each accountability statement must cover all parts of the ADI’s operation (as detailed by the accountability map). These requirements make it far easier to assign accountability, a task that can be challenging in large institutions. As the Royal Commission demonstrated, it is rare to fnd individuals who willingly take responsibility for wrongdoing – accountability tended to be collective. The Royal Commission has turbo-charged the application of the BEAR, with Commissioner Hayne recommending that it be applied to all APRA-regulated institutions and that it also be used as a mechanism to increase accountability for product integrity. With reference to the latter, each ADI must identify an individual who is responsible for the end-to-end design, development, maintenance and distribution of products. Draft legislation for the Financial Accountability Regime (FAR), which seeks to implement these recommendations, was released by Federal Treasury in July 2021 (Australian Government Treasury, 2021). The Royal Commission also handed down numerous recommendations geared towards increasing the capacity of our public institutions to drive accountability. The most notable among these was a recommendation that implored ASIC to take a more forceful approach to enforcement, proposing that it should: • At the outset, begin by asking whether a court should be the body determining whether there has been a violation. • Recognise the shortcomings associated with infringement notices and how, in many cases, they are not an appropriate enforcement tool. • Be conscious of the deterrence potential of enforceable undertakings. • Wherever possible, separate enforcement staf from the non-enforcement staf who have contact with regulated entities. In an address delivered at the Banking and Financial Services Law Association Annual Conference in 2019, ASIC Commissioner Sean Hughes described how signifcant progress had been made on many of these recommendations (Hughes, 2019). For example, ASIC has established a separate “Ofce of Enforcement”, has adopted a “Why not litigate?” approach to enforcement, and with the passing of the Treasury Laws Amendment (Strengthening Corporate and Financial Sector Penalties) Act 2019 (Cth), has the ability to impose more punitive penalties. However, as alluded

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to earlier, these types of reforms do not just require a regulator that is sufciently independent and resolute. They also require our elected ofcials to provide the necessary support through their leadership, legislative backing and the provision of funding and resources. For some of these Royal Commission recommendations (most notably the “Why not litigate?” regulatory posture), this support was not forthcoming from the former Liberal-National Government (Mizen, 2021). Lessons for leaders For leaders of institutions, accountability is the pointy end of the stick. We all agree that institutional arrangements must be supportive of accountability if ethical conduct is our desired end. However, when the need to apply it comes knocking at the door, we are very reluctant to do so.To be sure, there is a balance. An institution does not want to create a literal surveillance state where even the slightest indiscretion is met with hefty penalties.The costs associated with this – and not just fnancial – would be signifcant (remember those trade-ofs). But in Australia, a norm seems to have evolved among our corporate and political leaders where taking or assigning accountability for unethical behaviour within the institutions they lead is uncommon. The fnancial services industry is a case in point.The NAB FX trading incident aside, leading up to the Royal Commission it is difcult to fnd an example of a senior executive falling on their sword after an ethical failure (despite there being plenty of opportunities for them to do so). As mentioned in Chapter One, a possible exception is the CEO of the CBA who announced his “retirement” in August 2017 after a string of governance failures, the breaches of the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth) being the most notable (Yeates, 2017). To make accountability a reality, institutions must put in place the necessary arrangements that support it. This includes artefacts that establish standards of behaviour (for example, policies and codes of conduct), mechanisms for monitoring conduct and exposing wrongdoing (for example, controls, formal audits and, as the following chapter will discuss, whistleblowing) and avenues through which employees can be formally sanctioned and held liable when they have compromised standards (for example, warnings, adjustments to remuneration and dismissal). Typically, institutions had arrangements in place that established standards and, to some extent, monitored employee conduct. It is in the application of liability that they fell short. Unfortunately, without liability, there is no accountability.

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Of the numerous forms liability can take, arguably the most efective is adjustments to variable remuneration. There are primarily two reasons for this, both of which were highlighted earlier in the chapter. First, relative to formal warnings and other mild forms of sanctioning, it has real impact and consequence. Second, it can be easily and efciently implemented, sparing the signifcant time and resources required when redress is sought through other channels (such as the courts).This is where the remuneration scheme proposed in the previous chapter, where the ability of a leader to sell shares that have vested to them only becomes permissible several years after they have left the institution, proves to be extremely efective. It makes the application of liability through the performance management framework far easier to operationalise. Under such an arrangement, certain criteria could be established that outlines when malus will occur. For example, an infringement notice (or enforceable undertaking) could be an event that would trigger malus for a leader who was responsible for a business that is subject to the notice, even if that leader has since left the institution. Among the many reasons why this is a powerful arrangement, one is that in many cases the wrongdoing associated with an ethical failure only comes to light several years after the fact, by which time the responsible leader could have left the institution. In such instances, if the wrongdoing does not cross the threshold of illegality (as is often the case), there is no liability for the leader. The more likely outcome is that the leader handsomely benefted from the conduct as it augmented their variable remuneration when they were employed at the institution - if accountability (and by extension ethical behaviour) is our goal, this is not an ideal outcome. But arguably the most important insight emerging for leaders from this chapter is that if we expect fnancial (or other) institutions to put in place institutional arrangements that are supportive of ethical conduct, public institutions play a pivotal role. This insight brings to life the concept of the “six lines of defence” (6LoD).1 Most of us are familiar with the “three lines of defence” (3LoD), an approach to risk management within institutions that requires the frontline business (line one) to own and manage risk, a risk function (line two) to provide oversight and challenge and an independent audit function (line three) to provide assurance that risk is being appropriately managed. The 6LoD extends this model and proposes that there are also important roles for an institution’s board (line four), regulators and supervisors (line fve) and government and legislators (line six).When the “bad apple” versus “bad barrel” metaphor is used to draw attention to the role of “the system” in abetting ethical failure, be aware that the system stretches beyond the four walls of the institution within which the wrongdoing occurs.

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Note 1 Thanks to Helen Bird for drawing my attention to this idea. References Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth). https://www. legislation.gov.au/Details/C2021C00243. Aristotle. (1920). The Politics of Aristotle (B. Jowett,Trans.). Clarendon Press. (Original work published 350 B.C.). Australian Associated Press. (2004a, February 2). NAB’s Frank Cicutto resigns. Sydney Morning Herald. https://www.theage.com.au/national/nabs-frank-cicuttoresigns-20040202-gdx89b.html. Australian Associated Press. (2004b, February 17). Bank Chairman quits as trading fallout continues.The Age. https://www.theage.com.au/business/bank-chairmanquits-as-trading-fallout-continues-20040217-gdxbno.html. Australian Associated Press. (2004c, March 12). Heads roll at NAB over foreign exchange scandal. Sydney Morning Herald. https://www.smh.com.au/business/ heads-roll-at-nab-over-foreign-exchange-scandal-20040312-gdiizf.html. Australian Government Treasury. (2021, July 16). Exposure draft: Financial accountability regime bill 2021. https://treasury.gov.au/sites/default/fles/2021-07/c2021-169627_ exposuredraftlegislation_2.pdf. Australian Prudential Regulation Authority. (2018, April 30). Prudential inquiry into the Commonwealth Bank of Australia. https://www.apra.gov.au/sites/default/fles/ CBA-Prudential-Inquiry_Final-Report_30042018.pdf. Bartle, I., & Vass, P. (2005). Self-regulation and the regulatory state: A survey of policy and practice (Research Report 17). University of Bath School of Management. https://www.bath.ac.uk/case-studies/centre-for-the-study-of-regulatedindustries-investigating-the-regulatory-state/. Behnk, S., Barreda-Tarrazona, I., & Garcia-Gallego, A. (2018). Punishing liars: How monitoring afects honesty and trust. PLoS ONE, 13(10), e0205420. https://doi. org/10.1371/journal.pone.0205420. Commonwealth of Australia. (2017). Compliance and enforcement: How regulators enforce the Australian Consumer Law. https://consumerlaw.gov.au/sites/ consumer/fles/2019/01/ACL_Compliance_and_enforcement_guide.pdf. Crede,A., & von Bieberstein, F. (2020). Reputation and lying aversion in the die roll paradigm: Reducing ambiguity fosters honest behavior. Managerial and Decision Economics, 41(4), 651–657. https://doi.org/10.1002/mde.3128.

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DeMarzo, P. M., Fishman, M. J., & Hagerty, K. M. (2005). Self-regulation and government oversight. Review of Economic Studies, 72(3), 687–706. https://doi. org/10.1111/j.1467-937X.2005.00348.x. Fischbacher, U., & Föllmi-Heusi, F. (2013). Lies in disguise – An experimental study on cheating. Journal of the European Economic Association, 11(3), 525–547. https:// doi.org/10.1111/jeea.12014. Fochmann, M., Kölle, T., Mohr, P. N. C., & Rockenbach, B. (2020). Trust them, threaten them, or lure them? Efective audit systems to promote compliance. https:// papers.ssrn.com/sol3/papers.cfm?abstract_id=3645136. Gneezy, U., Kajackaite, A., & Sobel, J. (2018). Lying aversion and the size of the lie. American Economic Review, 108(2), 419–453. https://doi.org/10.1257/ aer.20161553. Grieve, C. (2021, March 16). “It’s out of control”: Financial planners plot attack on marginal Liberal seats in regulation protest.Sydney Morning Herald. https://www.smh. com.au/business/banking-and-finance/it-s-out-of-control-financial-plannersplot-attack-on-marginal-liberal-seats-in-regulation-protest-20210316-p57b60. html. Guzikevits, M., & Choshen-Hillel, S. (2022). The optics of lying: How pursuing an honest social image shapes dishonest behavior. Current Opinion in Psychology. https://doi.org/10.1016/j.copsyc.2022.101384. Hobbes, T. (1962). Leviathan. Simon & Schuster. (Original work published 1651). Hughes, S. (2019,August 30). ASIC’s approach to enforcement after the Royal Commission [Speech transcript]. https://asic.gov.au/about-asic/news-centre/speeches/asic-sapproach-to-enforcement-after-the-royal-commission/. Maley, K. (2018, December 27).The battle royale over bank bonuses. Australian Financial Review. https://www.afr.com/companies/fnancial-services/the-battle-royale-overbank-bonuses-20181217-h197c1. Mizen, R. (2021, August 26). ASIC dumps “why not litigate” policy as Frydenberg resets path. Australian Financial Review. https://www.afr.com/politics/federal/ asic-dumps-why-not-litigate-as-frydenberg-resets-path-20210825-p58lyx. Ramsay,I.,&Webster,M.(2017).ASIC enforcement outcomes:Trends and analysis.Company and Securities Law Journal, 35(5), 289–321. https://sites.thomsonreuters.com.au/ journals/2017/11/02/company-and-securities-law-journal-update-vol-35-pt-5/. Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. (2018). Interim report (Vol. I). https://fnancialservices.royalcommission.gov.au/Documents/interim-report/interim-report-volume-1.pdf.

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Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. (2019). Final report (Vol. I). https://www.royalcommission.gov. au/sites/default/fles/2019-02/fsrc-volume-1-fnal-report.pdf. Senate Economics Reference Committee. (2014).Performance of the Australian Securities and Investments Commission. https://www.aph.gov.au/Parliamentary_Business/ Committees/Senate/Economics/ASIC/Final_Report/index. Smith, A. (1759). The theory of moral sentiments (1st ed.). A. Millar. Telle, K. (2013). Monitoring and enforcement of environmental regulations: Lessons from a natural feld experiment in Norway. Journal of Public Economics, 99, 24–34. https://doi.org/10.1016/j.jpubeco.2013.01.001. Treasury Laws Amendment (Strengthening Corporate and Financial Sector Penalties) Act 2019 (Cth). https://www.legislation.gov.au/Details/C2019A00017. Van Koten, S., & Ortmann, A. (2016). Self-regulatory organizations under the shadow of governmental oversight: An experimental investigation. In S. J. Goerg & J. R. Hamman (Eds.), Experiments in organizational economics (Vol. 19, pp. 85–104). Emerald Group Publishing Limited. https://doi.org/10.1108/ S0193-230620160000019003. Wood, D., & Grifths, K. (2018, September). Who’s in the room? Access and infuence in Australian politics. Grattan Institute. https://grattan.edu.au/wp-content/ uploads/2018/09/908-Who-s-in-the-room-Access-and-influence-inAustralian-politics.pdf. Yeates, C. (2017,August 14). Commonwealth Bank chief Ian Narev to leave bank by end of fnancial year. Sydney Morning Herald. https://www.smh.com.au/business/ banking-and-fnance/commonwealth-bank-chief-ian-narev-to-leave-bank-byend-of-fnancial-year-20170814-gxvg33.html.

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And then, if you are drawn in, next week it will be something a little further from the rules, and next year something further still, but all in the jolliest, friendliest spirit. It may end in a crash, a scandal, and penal servitude; it may end in millions, a peerage and giving the prizes at your old school. But you will be a scoundrel. The Inner Ring (p. 63, Lewis, 1949)1 One of the most enlightening insights emerging from my experience in the NAB FX trading scandal was the group dynamics that supported, condoned and sustained the behaviour. Group norms emerged that were clearly unethical. People, be they those working on the FX trading desk or around it, appeared to tolerate and, at times, embrace those norms, some more willingly than others.There were examples of seemingly decent, well-meaning people making decisions and engaging in behaviour that, no doubt, surprised those who knew them closely. In addition, I experienced frsthand how extraordinarily difcult it is to raise concerns and challenge group norms. The FX trading desk was beyond reproach. Those who did speak up invariably sufered consequences. After the losses were exposed, I heard numerous stories about others who similarly attempted to raise concerns. These eforts were either ignored or fell on deaf ears. And, more often than not, there were costs for these individuals. The previous chapters outlined some of the factors that can come together to enable and sustain these dynamics. Conficts of interest, high-powered incentive schemes and a failure to apply accountability on the many occasions when it was clearly called for all (no doubt) contributed. In addition, the impressive (albeit

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fctitious) proftability of the trading desk, in an environment where proft was lauded, shielded it from criticism or questioning. But on refection, it seems clear that other factors also played a role. Two in particular seemed undeniable. The frst was the role of leadership. In some cases, through their actions, choices and decisions, leaders openly endorsed and encouraged questionable behaviour. In other cases, leaders provided endorsement unwittingly – their failure to act in the face of evidence that suggested something was amiss (acts of omission) spoke just as loudly as any act of commission. The other factor, as mentioned above, was how difcult it was to speak up and challenge the prevailing norms. Once established, group norms appear to have broad support and endorsement. Those who harbour concerns can feel isolated. But as this chapter will explain, good governance within institutions demands that people can speak up when they witness wrongdoing. If, for whatever reason, employees feel that they are unable to escalate concerns or are not taken seriously when they do, the most likely outcome is that the key governance forums within institutions will be caught blissfully unaware as minor indiscretions quickly spiral into ethical failure. Groups are a ubiquitous feature of all large institutions. Be it the board, the executive or teams across the organisation, it is rare that decisions are made by individuals unilaterally. For this reason, an understanding of ethical failure requires us to try to explain why a group of people, working together, can collectively condone, endorse or turn a blind eye to unethical behaviour. How does this happen? Surely, when a group of people become aware of wrongdoing, the likelihood that it will be addressed should increase? If not, why? This chapter explores these questions. We begin with leadership and the role it plays in promoting unethical behaviour in groups. Leadership The role leadership plays in driving the behaviour of individuals, be they in small teams or across entire institutions, is taken as a given.Terms like “tone from the top” are bandied around as though they are a primary cause of and solution for ethical failure.And there appears to be evidence aplenty connecting unethical leadership to inferior conduct. But is it reliable? Unfortunately, much of the research that explores the relationship between ethical leadership and wrongdoing within an institution has shortcomings that

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makes drawing any direct link between the two constructs problematic. One such shortcoming is that the research typically uses survey-based instruments to measure constructs such as “ethical leadership” and “unethical behaviour”. Given our desire to create the perception that we are principled and virtuous, there is a risk of response bias in such research. But beyond this, any correlation that might exist between these constructs does not necessarily imply causation.That is, if responses to a survey produce low scores on the “ethical leadership” scale and high scores on the “unethical behaviour” scale, it could be that unethical leadership abets misconduct within the institution. However, it could also be the case that the institution is corrupt and has attracted unethical leaders to its ranks. Or alternatively, there are other factors promoting both unethical leadership and misconduct. To investigate whether a causal relationship exists between leadership and (dis)honest behaviour, a carefully crafted experiment would be required. Broadly speaking, the design of the experiment would need to: a. Make use of a task that provides participants with the potential to beneft from dishonesty. b. Place participants into groups and randomly assign one of the group members to the role of leader. c. Provide the leaders of some groups (the experimental conditions) with the ability to infuence the behaviour of their followers. An experiment that adopts this type of approach was conducted by d’Adda et al. (2017). The task they used to assess the level of dishonesty was a modifed version of the Fischbacher and Föllmi-Heusi (2013) die rolling task. Instead of payments to participants being based on the number they reported, payments were based on the number they reported relative to the average outcome reported for the group. To achieve this payof profle, the rewards for participants were drawn from a pool of funds that changed in size.The size of the pool was maximised when the average reported outcome across all participants was 3.5 (this being the expected average outcome when a large group of individuals roll a fair die). From here, the size of the incentive pool decreased linearly as the average reported outcome increased, reaching its minimum when the average reported outcome was six. Therefore, despite this altered payof profle, d’Adda et al. (2017) retained the confict of interest that is at the heart of the original Fischbacher and Föllmi-Heusi

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(2013) experimental design. By reporting honestly, participants would maximise the size of the total incentive pool. However, a participant could increase their personal payof by maximising the diference between their reported outcome and the average outcome, something that could be achieved by reporting dishonestly. In the frst stage of the experiment, d’Adda et al. (2017) had every participant (a total of 320) complete one round of this modifed version of the die rolling task individually. Following this,“frms” were created by randomly assigning the participants into groups of four. Each frm contained three “workers” and a leader.Workers were required to privately roll a die and self-report the outcome.The role played by the leaders meanwhile difered across the following two dimensions: the ability to make public statements and the ability to provide incentives to workers. By manipulating the presence or absence of these two key channels through which leaders could infuence the behaviour of workers, the following four experimental conditions were created: • “Leader inactive”: in this baseline condition, leaders could neither make public statements nor provide incentives. • “Leader active”: leaders could both make public statements and provide incentives. • “Leader statements only”: leaders could only make public statements. • “Leader incentives only”: leaders could only provide incentives. In the two conditions where the incentive channel was not available to leaders (“leader inactive” and “leader statements only”), all group members – the leader and the three workers – each received 25 per cent of the frm’s profts. In the “leader active” and “leader incentives only” conditions, the leader was once again guaranteed 25 per cent of the frm’s proft but workers were only guaranteed ten per cent each. The remaining 45 per cent was the leader’s “bonus pool”.This could be distributed to workers at the leader’s discretion. As outlined above, the size of the incentive pool from which profts were drawn was maximised when the average reported die roll across all frms in each condition was 3.5 (there were 20 frms in each condition). However, an individual frm’s profts were determined by comparing the average reported die roll of a frm’s workers relative to this overall average.Therefore, a proft-maximising leader would want workers in their frm to report the highest outcome, even if doing so required dishonesty. An “ethical” leader meanwhile would want their workers to report honestly hoping that by doing so, the size of the incentive pool would be maximised.

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The results demonstrated that leaders used both incentives and public statements to encourage dishonest reporting, with both methods being efective at eliciting dishonesty from the workers in the frm. However, public statements made by leaders that encouraged misreporting were most efective in the condition where leaders were also given the ability to control incentives (the “leader active” condition). Furthermore, in conditions where leaders could control the distribution of incentives, how they were distributed in a previous round (each frm completed ten rounds of the die rolling task) strongly infuenced future reporting by workers. That is workers, who due to the transparency of the experimental design were able to observe what behaviours leaders rewarded, subsequently increased misreporting when it was rewarded. This fnding shows that incentives do not just infuence the behaviour of those directly benefting from them, but also the behaviour of those observing the signals incentives provide. To examine the behaviour of leaders, d’Adda et al. (2017) divided the cohort of leaders into “honest” and “dishonest” leaders. To do this, they assumed that a participant who reported a six when they completed the die rolling task individually in the frst stage of the experiment was dishonest. There are some shortcomings associated with this sorting approach.To begin with, some participants who reported a six would have done so honestly. In addition, some of the participants who were assigned to the “honest” cohort may have misreported (for example, they may have rolled a one and reported a number between two and fve). However, given that more than twice as many sixes were reported than what would be expected in the frst stage of the experiment, the most likely outcome was that there was a large degree of dishonesty among these participants. This sorting mechanism was used to create the following three experimental groups: • “Leader active (dishonest)”: the 19 participants who (a) reported rolling a six in the frst stage of the experiment, (b) were appointed to leadership roles and (c) were in conditions that allowed them to make use of incentives or public statements. • “Leader active (other)”: the remaining 41 leaders who were in conditions that allowed them to make use of incentives and public statements but did not report rolling a six in the frst stage of the experiment. • “Inactive leader”: identical to the original baseline condition containing the 20 frms whose leaders were passive.

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Figure 4.1: In the experiment conducted by d’Adda et al. (2017), groups led by participants who had behaved dishonestly when completing the die rolling task individually consistently reported higher outcomes.

As Figure 4.1 illustrates, frms led by leaders classifed as leader active (dishonest) consistently reported higher outcomes across all ten rounds of the experiment.The average reported outcome for these frms was 4.82. This compared to 4.54 for frms led by leaders classifed as leader active (other) and 4.28 for those frms in the baseline condition (inactive leader).The percentage of die rolls reported as a six increased from 34 per cent in the inactive leader condition to 53 per cent in frms led by those classifed as leader active (dishonest). Finally, those classifed as dishonest leaders displayed a greater tendency to use incentives and public statements to encourage dishonesty among their workers. Of course, the d’Adda et al. (2017) research only considers how leaders infuence the behaviour of people in small teams. It does not tell us how the (un)ethical actions of an individual leading a large institution infuences the behaviour of those multiple layers below them in the hierarchy.To be sure, a rogue CEO or executive is a recipe for disaster in any institution. However, what the research by d’Adda et  al. (2017) also demonstrates is that leadership at all levels is important. It is possible to have a situation where a large institution is being led by an ethical CEO and a rogue

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manager located somewhere in the bowels of the organisation can bring the whole enterprise undone. Unfortunately, in Australia, our most senior politicians have in recent times presided over declining standards among their own ranks (refer to Box 4.1). We would need to be careful in drawing direct links, but perhaps it is no coincidence that Australia’s score in the Transparency International Corruption Perception Index has dropped a full 12 points since 2012, seeing its global ranking fall from seventh to eighteenth (Brown, 2022). More concerningly, I fear that the decline in standards among our political class has compromised the ability of our public institutions to develop efective legislation and subsequently enforce it, the abandonment of some key recommendations emerging from the Royal Commission providing examples of this. Box 4.1 Unethical leadership among Australia’s political class In recent times, the most senior members of Australia’s former coalition Liberal-National Government engaged in behaviour that at best could be described as highly unethical. Although there are numerous examples one could point to (Ireland, 2021), two of the more fagrant have been dubbed the “sports rorts” and “car park rorts” scandals.The result of such conduct, as this box illustrates, is substandard and compromised public policy. The “sports rorts” scandal emerged in the shadows of the Royal Commission. It involved the use of money allocated from the federal budget to fund the Community Sport Infrastructure Grant Program. Sports Australia, an arm of the Australian Sports Commission, was responsible for administering the program which totalled AUD 102.5 million. In a review of the program conducted by the Australian National Audit Ofce (ANAO), it was found that Sports Australia’s assessment of applications was largely in accordance with the published guidelines (Australian National Audit Ofce, 2020). However, in parallel with the Sports Australia assessment process, the ofce of the Minister for Sport undertook its own assessment process, and according to the ANAO report (p. 32): The Minister’s Ofce drew upon considerations other than those identifed in the program guidelines, such as the location of projects, and also applied considerations that were inconsistent with the published

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guidelines. It was this assessment process that predominantly informed the Minister’s funding decisions, rather than Sport Australia’s process. More damning was that one of the “considerations” the minister’s ofce incorporated into the assessment criteria was whether the projects were based in marginal electorates or in electorates being targeted by the coalition government in the 2019 federal election.The decisions that drew particular ire were those made in April 2019, just weeks prior to the election. In this funding round, 73 per cent (or 167) of the approved projects were not recommended by Sports Australia. A subsequent investigation by the Department of Prime Minister and Cabinet, which was not made public, found that the then Minister for Sport (the Hon. Bridget McKenzie) breached her ministerial standards as she failed to disclose a confict of interest (she was a member of a gun club that received funding under the program). She subsequently resigned her position as Minister for Agriculture and Deputy Leader of the Nationals Party, but was reappointed to the ministry less than 18 months later. Shortly after news of the scandal became public in January 2020, the Prime Minister was, at that early stage, standing by Ms McKenzie. Dr Simon Longstaf, a prominent and respected Australian ethicist, wrote an article for the Australian Financial Review in which he stated (Longstaf, 2020): The question now is this: do Senator McKenzie’s colleagues – including the Prime Minister – endorse this approach? If so, then let’s hope that the whole nation laughs out loud the next time a Coalition Minister attacks “union corruption”, throws a bank executive under the bus, or invokes the concept of integrity when criticising others. Wind the clock forward 18 months and it felt like déjà vu. Same author, same masthead (Longstaf, 2021): In fact, from all of what I have heard of Birmingham [Federal Minister for Finance Simon Birmingham] – and his character – I still cannot believe the words he uttered on Sunday are truly his. For there he was, on national television, efectively arguing that a political bribe is not a bribe if it works!

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Let’s not beat around the bush here. The use of public money (or power) for private political purposes is corrupt. It is formally defned as “political corruption” and is every bit as wrong as personal corruption. The only diference is that the payof, from political corruption, is in the form of power rather than money. The incident Dr Longstaf was referring to on this occasion was the so-called “car park rorts” scandal that involved the biased selection of commuter car parks for upgrading as part of the Australian Government’s Urban Congestion Fund (UCF).The objective of the UCF, established as part of the 2018–2019 Federal Budget, was to improve the safety and efciency of trafc movement in urban areas. Under the initiative, between January and July 2019, funding was provided to upgrade 47 commuter car parks. According to a review conducted by ANAO, of these 47 projects (Australian National Audit Ofce, 2021): • Forty (85 per cent) were selected in the period leading up to the 2019 federal election. • Thirty-seven (77 per cent) were located in electoral seats held by the Liberal-National Coalition Government. • Thirty-eight (81 per cent) were given efect by the written agreement of the Prime Minister in response to a written request from a variety of government ministers. The ANAO concluded (p. 38): The department’s [Department of Infrastructure] approach to identifying and selecting commuter car park projects for funding commitment was not appropriate. It was not designed to be open or transparent. The department did not engage with state governments and councils, which increased the risk that selected projects would not deliver the desired outcomes at the expected cost to the Australian Government. Departmental advice did not contain an assessment against the investment principles or policy objectives and it was not demonstrated that projects were selected on merit.The distribution of projects selected refected the

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geographic and political profle of those given the opportunity by the government to identify candidates for funding consideration. These incidents, and others, have intensifed calls for the creation of a federal integrity commission, a signifcant gap in Australia’s national integrity institutional arrangements (Ng, 2020). Without such a body, the conduct above, which does not reach the threshold of being criminal or illegal, is not investigated. It is more likely the case that given there is no avenue through which it can be brought to the public’s attention and investigated, other instances of unethical conduct is not seeing the light of day. A key policy of the recently elected Labor Government is to “legislate a powerful, transparent and independent National Anti-Corruption Commission by the end of 2022” (Australian Labor Party, n.d.).We shall wait and see. Group norms The idea that individuals, when immersed in a group, can behave in ways that they privately disagree with, is not new. It is arguably most famously illustrated by Hans Christian Andersen in his folktale, The Emperor’s New Clothes (Andersen, 2008).The vain emperor, known to spend lavishly on clothing, was deceived by two con artists posing as tailors. They had the emperor believe that the clothes they had ftted for him were magnifcent but invisible. As he paraded before his subjects, nobody stood prepared to inform the emperor that he was naked – the collective silence caused everyone to suppress what they could clearly see before their very eyes. In 1924, Floyd Allport coined the term “pluralistic ignorance” to describe a situation where privately members of a group reject behaviour they are collectively engaging in. As Allport (1924) theorised, the failure of any member to make their private views public creates the perception that the behaviour is widely endorsed and condoned. Analogously, economist Timur Kuran uses the term “public preference falsifcation” to describe a situation where an individual, due to social pressures, expresses a public opinion that is contrary to their own, true, privately held view (Kuran, 1995). In recent times, economists have turned their mind to determining whether this group dynamic can be demonstrated experimentally. A typical research design involves placing participants in groups and assigning them a “type”. The incentives

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are structured in a way that participants can increase their earnings by reporting their type in a way that conforms to the type reported by the majority of group members. The type assigned to each individual shifts over successive rounds leaving participants in a quandary: Do they report their type honestly or, to maximise their earnings, conform to the “majority view” of the group and report their type dishonestly? Such a paradigm was employed by Dufy and Lafky (2021) in an experiment where groups of twelve participants transitioned from “X-types” to “Y-types” over 20 rounds. At the end of each round, participants were required to report whether they were an “X-type” or “Y-type” which determined their reward. The incentives were structured in a way where in addition to being rewarded for honesty, participants were also rewarded based on how many other participants in their group reported similarly to them. Although all participants began as “X-types”, the transition process ensured that at some point over the 20 rounds they all became “Y-types”. In some conditions, the rate of transition was known. In others, there was a degree of ambiguity. In addition, the incentives were also varied across conditions. Although the amount received for reporting honestly did not change, the reward for reporting similarly to other group members was higher in some conditions versus others. Dufy and Lafky (2021) found evidence of preference falsifcation, especially when the incentives encouraged high levels of conformity to how other group members reported. In two instances, groups failed to arrive at an outcome where all participants reported themselves as Y-types in the fnal round, despite all of them having transitioned. On one occasion, a group had all members report as X-types in the fnal round. Alas, if there is an incentive to do so, people will be dishonest to conform with a group.And as Hans Christian illustrated, those incentive do not necessarily need to be monetary – being the sole defector in an environment where the need to toe the party line is strong is a daunting prospect for many (if not most) of us. These types of dynamics help explain why, as is often the case in ethical failures, people who are party to the wrongdoing fail to appreciate how nefarious the conduct they are associated with actually is. Rather, narratives develop among groups involved in the conduct that work to justify and rationalise the behaviour, downplaying its severity. As described in Chapter One, the fee-for-no-service scandal provides an example of this. In the Royal Commission’s fnal report, Commissioner Hayne described how a “narrative” developed that portrayed the incident not as an ethical failure, but as “a series of careless mistakes capable of being swept aside as ‘processing errors’” (p. 138, Royal Commission, 2019).

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These types of narratives are destructive within institutions. They work to condone and normalise unethical behaviour. And they need to be challenged. But as anyone who has been in an institution where a narrative emerges that normalises unethical conduct will tell you, it is extraordinarily difcult to speak up and challenge.This is especially so when the narrative is supported and endorsed by the most senior leaders.When group dynamics deteriorate, whistleblowing is inevitably a casualty. As will be described in the following section, this comes at a signifcant cost to any institution. But before proceeding, the word “culture” has yet to be used in this book. This may be perplexing for some readers as many of the topics discussed in this chapter – “ethical leadership”,“group norms” and “whistleblowing” – are constructs typically associated with culture.The omission of the word is by design. My belief is that the construct of culture is too extraordinarily complex to properly defne. However it might be defned, it manifests when all of the various institutional arrangements discussed in this book (and many others) coalesce to create environments within institutions that guide the decisions, actions and choices of employees. It is what emerges from these decisions, actions and choices that we label “culture”. Box 4.2 provides a perspective on culture that captures this idea.

Box 4.2 A game theoretic perspective on corporate culture In Box 2.1, the principal-agent problem was described.The reader will recall that the relationship between the principal and agent creates moral hazard because there are heterogeneous preferences and information asymmetries between the two parties. When economists model the interaction between the principal and agent game theoretically, collective optimal outcomes are achieved when the agent is honest and the principal chooses not to expend resources on monitoring. However, the benefts from dishonesty loom large for the agent, making the optimal outcome unstable.Therefore, it is common for the dominant outcome to be one where the agent shirks and the principal monitors. The reader will also recall that institutions can be represented as a cascade of principal-agent relationships – shareholders engage a board, the board appoints a CEO, the CEO employs managers, managers hire employees and so on.This

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representation allows us to theoretically model all of the relationships between an employee and their leader within institutions game theoretically. In such a model, the employee could be provided with the choice between trusting or not trusting their leader.The leader meanwhile can choose between exploiting their employees or treating them fairly. Like the principal-agent problem, although optimal outcomes are obtained when employees trust their leader and leaders do not exploit employees, this outcome is unstable – the benefts derived from employee exploitation, even in the mildest forms, loom large for the leader. Box 2.1 also describes how the contract is one of the tools used to try and address the moral hazard created by the principal-agent problem. Similarly, it is also used to manage the relationship between a leader and employee. In theory the employment contract, appropriately structured, will prescribe exactly what is required of the leader and employee to ensure that when they interact, the optimal outcome is the result (fair treatment and trust). However, when the task is complex and the conditions under which the leader and employee interact are dynamic, it is not possible to construct the perfect contract that provides instruction under all possible scenarios (contracts are inevitably imperfect). Culture is ultimately what emerges from all of the countless interactions between employees and their leaders across an institution. Given contracts are imperfect, economists, despite what many are led to believe, see a role for culture. Specifcally, can culture fll the gap where contracts are not able to provide the required guidance in the countless leader-employee interactions? That is, can culture encourage decisions from the leader and employee that deliver optimal outcomes? Or, with reference to the model described above, can culture promote decisions that make fairness and trust between the leader and employee the “cultural norm”? Kreps (1990) proposes that a good metaphor for cultural norms is the idea of “focal points”, frst developed by Schelling (1963). Focal points are the equilibria that are most prominent in games where individuals must coordinate behaviour. The well-known example Schelling (1963) used to illustrate the concept was where two friends agree to rendezvous in New York City without agreeing on a meeting point. In this example, there are a multitude of potential locations where each of the two friends could decide

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to show up. However, in tests of the game, Schelling (1963) found that Grand Central Station appeared frequently as an optimal outcome – it is a focal point. Within institutions, there are also multiple equilibria. Is it possible to cultivate cultural norms that make fairness, trust and (dare I say it) honesty focal points? One of the most common ways institutions attempt to do this is by articulating their purpose, values and principles and communicating these to their employees. All employees would be familiar with these statements. Although the wording might change between institutions, typically there are many common themes. For example, you would be hard pressed not to fnd a statement in an institution’s values elucidating the primacy of customers (for example, “We care about the customer” or “We put our customers frst”). However, when these statements are not supported by the prevailing institutional arrangements, confusion and dissonance within institutions is bound to arise.With the passage of time, the focal points that emerge among the plethora of potential equilibria may not be those that are outlined in the institution’s purpose, values and principles. For example, the institution’s values may claim that “We put our customer frst”, but how is this claim to be interpreted when, despite multiple examples of customers being treated poorly, executives are still handsomely rewarded? Or conficts of interest exist that make it difcult to prioritise the customer? What is the predominant focal point in this scenario? Readers who have made it this far will know the answer to these questions. The focal points that emerge will be determined by the prevailing institutional arrangements. The utterances within the institution’s purpose, values and principles will, in the example developed by Schelling (1963), be some obscure intersection in Upper Manhattan. It is the behaviour that is supported and sustained by the institutional arrangements that will become the Grand Central Station of the institution. Whistleblowing Since being established in 1998, Australia’s prudential regulator – APRA – has only twice conducted a review of an ADI and subsequently made the fndings public. The most recent, as has already been referenced, was of the CBA after it was alleged to have made multiple breaches of the Anti-Money Laundering and Counter-Terrorism

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Financing Act 2006 (Cth) (this being one of a series of ethical failures that was the catalyst for the review). Prior to this, APRA conducted a review of the NAB following the FX trading scandal. As is always the case with reviews of this nature, although there are some similarities in the fndings, there are also some notable diferences. In this instance, one key diference was how news travelled to each institution’s key governance body, the board. In their review of the NAB, APRA stated (p. 49, Australian Prudential Regulation Authority, 2004): Our investigation has shown that, while the structure of the governance model within the bank appears appropriate, the established escalation channels in existence for executive management to elevate issues to the Board and Board committees were generally inefective. In the review of the CBA, the independent panel APRA engaged to complete the review stated (p. 19, Australian Prudential Regulation Authority, 2018): Evidence reviewed by the Inquiry did not identify a systemic issue in messaging to the Board or its Committees. However, instances were observed where messaging has over-emphasised positive aspects and progress, and de-emphasised more negative elements of risk issues and incidents. In the case of the NAB, it was a clear failure in creating an environment where people felt comfortable speaking up and raising concerns. It is little wonder that it required an incident of signifcant magnitude before whistleblowers were listened to. However, the experience at CBA is one that is far more common when postmortems of ethical failures within institutions are conducted. Bad news does reach the board, but it is buried in lengthy board papers. Or it is presented in a way so subtle that it is imperceptible. Or, as what appears to have been the case at CBA, it is sugar-coated and wrapped in lolly paper. Both scenarios, although diferent, are obviously less than ideal.They are particularly less than ideal given the nature of the wrongdoing that was exposed at the Royal Commission. For reasons that will be described in the fnal section of this chapter, the most efective bulwark to “conduct risk” (as it has come to be known) is creating an environment within institutions where people not only feel that they can raise concerns, but when they do are listened to, respected and have their concerns

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appropriately addressed. Without such an environment, whistleblowing becomes a challenging, thankless task. Being survey based, much of the research into whistleblowing sufers from the same shortcomings associated with the research into ethical leadership.The research that elicits information from actual whistleblowers, while providing information about the personality of whistleblowers and the context they found themselves in, does not contain a control group. Meanwhile, research that creates hypothetical scenarios and asks participants about their whistleblowing intentions invites response bias. It is easy to claim in a survey when nothing is at stake that you will be “ethical” and do the right thing (as most people do). Put yourself in a real-world scenario where whistleblowing is an option and it can suddenly become very unappealing. An experiment conducted by Reuben and Stephenson (2013) addressed some of these methodological issues. They employed a modifed version of the Fischbacher and Föllmi-Heusi (2013) die rolling task where participants, working in groups of three, could maximise their individual monetary rewards by misreporting. However, as their actual and reported outcome in the task was made known to other members of the group, the experiment allowed for participants to blow the whistle on dishonest conduct and prompt a review by a “central authority” (the experimenter). To assess how whistleblowers were treated, the experiment allowed for the possibility of participants being excluded from groups. At certain points in the experiment, a member of each group was randomly removed. In one condition, these excluded participants were assigned to other groups. In another, the excluded participant could only join a group if their inclusion was unanimously endorsed by the two other members. Given participants could earn more when there were three people in their group, there was an incentive to welcome excluded participants. However, given the details of an excluded participant’s past behaviour were made public, Reuben and Stephenson (2013) could determine whether a history of whistleblowing worked to put those who spoke up out of favour. This experimental design has many parallels with real-world settings. For example, aside from some jurisdictions such as the U.S. where, under some circumstances, whistleblowers are provided with lucrative bounties (U.S. Securities and Exchange Commission, n.d.), there were no incentives for reporting wrongdoing. Also, dishonesty in the whistleblower game was highly proftable but heavily sanctioned if discovered (ofending participants were fned three times the amount they overstated their earnings by). Furthermore, the central authority did not monitor participants but relied on civically minded individuals to expose those who chose to

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behave dishonestly.And fnally, there were potential ramifcations for whistleblowers (namely, ostracism). Whistleblowing behaviour was, perhaps not surprisingly, low. When dishonesty was witnessed in a group, reviews by the “central authority” were only requested on 25 per cent of occasions. When reviews were requested, it tended to coincide with egregious dishonesty where participants overstated actual outcomes by large amounts. Dishonest participants were less likely to request a review, and as a corollary to this fnding, whistleblowing was less likely when there was an absence of honest individuals to witness dishonesty. And this takes us to a key fnding of the experiment – in conditions where the return of excluded participants had to be approved by group members, honest participants were shunned. Excluded participants were “vetoed” (rejected) on 70 per cent of occasions if they had previously requested that their group be reviewed. For those who had never reported dishonesty, the rejection rate fell to 48 per cent. In addition, the spectre of being ostracised impacted on whistleblowing behaviour. In the condition where excluded participants were assured assignment to another group, 32 per cent of participants who witnessed dishonesty requested a review. This fell to 17 per cent when group membership had to be endorsed post exclusion. Similarly, the proportion of participants who never requested a review rose from 28 per cent when group membership was assured to 53 per cent when group membership required endorsement. In a more recent experiment exploring whistleblower behaviour conducted by Butler et al. (2020), participants were placed in “frms” containing two “employees” and one “manager”. Employees were provided with the opportunity to report managers who acted dishonestly to infate earnings for both themselves and their employees. The incentives were adjusted across conditions so that in some cases, employees received a reward for whistleblowing while in others they incurred a cost (the former being twice as large as the latter). In addition, other participants played the role of “members of the public” and incurred a loss when managers behaved dishonestly. How did these various arrangements infuence whistleblowing behaviour? A prominent fnding was that the presence of rewards substantially increased the proportion of employees who chose to report manager dishonesty. More interesting was how the presence of rewards for whistleblowing interacted with “social judgement” from members of the public. Social judgement was more likely to encourage whistleblowing if employees knew that members of the public were

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aware of how they were adversely impacted by manager dishonesty. If members of the public were not aware of the costs they were incurring from manager malefcence, the presence of social judgement worked to hinder whistleblowing by employees. This led to one of the key fndings from the research undertaken by Butler et al. (2020) – in short,“social judgement” from “members of the public” can act as both an enabler and inhibitor to whistleblowing (p. 613): In particular, when the negative externalities caused by fraud are not visible to the public, the possibility of social judgment, through expectations of social disapproval, tends to decrease employees’ willingness to blow the whistle, whereas when negative externalities are visible to the public, social judgment generally increases whistleblowing, possibly because whistleblowers expect to receive messages of social approval. Overall, the red carpet does not tend to be rolled out for whistleblowers. What’s more, the ostracism that accompanies whistleblowing not only reduces the likelihood that people will speak up, but it results in greater dishonesty among those who do not fall victim to the fltering process and remain within our institutions. As much as I would like to think otherwise, it could be the case that my experience was somewhat unique. Whistling While They Work (WWTW), a research project led by Professor A. J. Brown from Grifth University, seems to provide support for this conclusion.As Box 4.3 outlines, it paints a sobering picture of the outcomes for whistleblowers in Australia and New Zealand. Box 4.3 The Whistling While They Work research project WWTW was a frst of its kind survey-based research project. It sought to better understand the prevalence of whistleblowing in Australia and New Zealand and, more importantly, the outcomes for individuals who had blown the whistle on workplace wrongdoing. The anonymous survey was open to every public and private sector organisation across Australia and New Zealand. Over an 18-month period, 17,778 responses were received from employees working in participating institutions. Preliminary fndings from the project were published in a series of working papers in late 2018 (Brown, 2018).

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The respondents were asked whether they had experienced or observed wrongdoing in their organisations. Of the 17,778 respondents, 5,509 (or 31.0 per cent) stated that they had experienced or observed some type of wrongdoing in their current organisation and a further 1,881 (or 10.6 per cent) in their previous organisation. These fgures were relatively similar across both private and public sector institutions, suggesting that, at some stage in your career, there is a good chance you will witness some form of wrongdoing. Best to brace yourself for it. If we focus on the segment of the sample that had experienced or observed wrongdoing in their current organisation, of these 3,785 (or 68.7 per cent) reported the wrongdoing. These reporters nominated themselves as either “employees” (2,607 respondents), “managers” (771 respondents; these respondents had formal responsibility for managing or supervising staf) or “governance professionals” (406 respondents; these were employees working in support functions of the organisation such as internal audit, risk, human resources, fnance or legal).This break-up is illustrated in Figure 4.2. For the survey respondents employed in the public sector, the top fve reasons provided for not reporting observed wrongdoing were (a) “I didn’t think anything would be done about it”, (b) “I didn’t think the organisation would protect me”, (c) “I didn’t think my identity would be kept secret”, (d) “I didn’t trust the person I had to report to” and (e) “I was afraid the wrongdoer(s) would take action against me”. Although similar results were not provided for private sector respondents, these fndings are consistent with previous whistleblower research. Namely, the primary reasons people refrain from speaking up is fear and futility – people fear that there will be consequences associated with raising concerns or that doing so is ultimately futile because nothing will be done. For those who did identify as whistleblowers, the vast majority (over 80 per cent) used internal channels (managers and other internal staf) to report wrongdoing. Less than two per cent used external channels (regulators, politicians or the media) while the remainder used a combination of the two, typically resorting to external channels when internal channels had failed them. Meanwhile, the research categorised the wrongdoing reported by whistleblowers into the following three types:

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Figure 4.2:  Of the 17,778 people who responded to the WWTW survey research project, 5,509 stated that they had experienced or observed wrongdoing in their current organisation and of these, 3,785 reported the wrongdoing (graph A). Of those who reported wrongdoing, 2,607 were employees, 771 were managers, while the remaining 406 were governance professionals (graph B).

• “Public interest wrongdoing” (wrongdoing that affects more than the personal or private interests of the whistleblower). • “Personal or workplace grievances” (wrongdoing that personally affects the whistleblower). • “Mixed” (a combination of public interest wrongdoing and personal or workplace grievances). The majority of whistleblower complaints (45.0 per cent) were mixed, meaning that disclosures contained information regarding multiple issues. Just over 18.0 per cent focused on public interest wrongdoing while the balance (37.0 per cent) related to personal or workplace grievances. This distribution is important as we turn our mind to one of the most important questions explored by the WWTW research project: How did whistleblowers fare? An analysis of the responses for individuals who had reported wrongdoing in either their current or previous organisations found that 42.1 per cent of them reported having experienced detrimental treatment from either their managers, colleagues or both. As Figure 4.3 illustrates, when these results were

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Figure 4.3: The WWTW research project found that whistleblowers were more likely to report that they had experienced detrimental treatment from management, their colleagues or both if (a) they were employees as opposed to managers or governance professionals (graph A) and (b) they were making mixed reports rather than making reports which focused on a specifc issue (graph B).

analysed through the prism of the whistleblower’s position in an organisation and the type of wrongdoing that was reported, the results found that whistleblowers were more likely to have experienced detriment when: • They were employees (as opposed to managers or governance professionals). • They reported mixed wrongdoing (as opposed to public interest wrongdoing or personal or workplace grievances). The most common forms of detriment experienced by whistleblowers were stress, reductions in work performance and, perhaps not surprisingly given the results of the research conducted by Reuben and Stephenson (2013) discussed above, isolation or ostracism. The research also found that whistleblowers were more likely to experience a positive outcome when their organisations (a) conducted a risk assessment when a disclosure was made or (b) provided advice to whistleblowers. These fndings provide some promising avenues for institutions that are serious about protecting those who raise concerns and (once again) point to the importance of institutional arrangements. 122

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The role of public institutions Whether public institutions should be meddling in the group dynamics of institutions has been a source of much debate. Given the territory covered in the book thus far, one can understand why. A plausible argument could be made that if public institutions focus on passing efective legislation and duly enforcing it, appropriate group dynamics should emerge. However, to understand why this is an area governments and regulators have (for better or worse) devoted increasing attention to, a brief history of how risk management has evolved in the fnancial services industry is required. Although fnancial institutions have always been aware that risk is inherent in their activities, it was not until the last decade of the twentieth century that risk functions started becoming commonplace within institutions. Legend has it that the “chief risk ofcer”, the role charged with the responsibility of overseeing an institution’s risk function and overall management of risk, frst appeared in 1993 (Chief risk ofcer, n.d.). In these formative years, given they are far easier to identify and quantify, risk functions developed approaches to measuring and managing fnancial risks. One can more easily assess an institution’s exposure to credit risk, market risk, liquidity risk and other fnancial risks and provide the board with comfort that the institution is operating within acceptable tolerance levels. However, the global fnancial crisis was a rude awakening for the world of risk management.The risks that caused the crisis did not ft neatly into existing risk categories. After a period of introspection, risk professionals developed terms like “conduct risk” and “risk culture” to describe the non-fnancial risks that were said to be at the heart of the global fnancial crisis.These risks only grew in prominence given the role they played in many of the more signifcant ethical failures in the fnancial services industry subsequent to the global fnancial crisis (most notably the LIBOR scandal) and the majority (perhaps all) of the ethical failures that were examined by the Royal Commission. The challenge for risk professionals is that unlike traditional fnancial risks, conduct risk and risk culture are far less straightforward to quantify and measure. Given the above backdrop, regulators globally have invested considerable resources into understanding, regulating and at times assessing risk culture. In Australia, the prudential regulator, APRA, frst signalled its intention to focus more heavily on risk culture following the global fnancial crisis. After conducting a review of its prudential frameworks, one of the outcomes was the release of Prudential Standard CPS 220 (Risk Management). This came into efect in January 2015 and, among

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other things, requires the board of an APRA-regulated institution to form (p. 3, Australian Prudential Regulation Authority, 2017): a view of the risk culture in the institution, and the extent to which that culture supports the ability of the institution to operate consistently within its risk appetite, identify any desirable changes to the risk culture and ensures the institution takes steps to address those changes. The Royal Commission has only intensifed APRA’s focus on risk culture. In one of his recommendations, Commissioner Hayne asked that APRA ensures its supervisory activities work to encourage the development of cultures in institutions that mitigate conduct risk. In response, APRA published an information paper in November 2019 outlining its new, expansive approach to supervising the governance, culture, remuneration and accountability practices of institutions (Australian Prudential Regulation Authority, 2019). In this paper,APRA announced it would be looking to complete industry wide risk culture assessments and administered a pilot survey to ten general insurers in early 2021 (Australian Prudential Regulation Authority, 2021). Although I am not averse to survey-based culture assessments, one must also be cognisant of their limitations. Properly designed and administered, they can reveal potential issues and pockets within institutions where employees hold genuine concerns and may be fnding it difcult to bring these to light. However, apart from the obvious issue of response bias, it can be very difcult (if not impossible) to identify from a survey alone what the institutional arrangements are that drive the attitudes and behaviours of employees.Without a proper understanding of these, using initiatives like improved communication from leaders, training programs or “nudges” to drive “culture change” can be a fool’s errand. Given the discussion in this chapter, arguably the most notable legislative reform in Australia over recent years that targets group dynamics is the Treasury Laws Amendment (Enhancing Whistleblower Protections) Act 2019 (Cth) which passed parliament in February 2019. This reform, for the frst time in Australia, provides a single piece of legislation that vastly improves protection for whistleblowers in the private sector.The catalyst for the reform was a parliamentary inquiry into whistleblower protection which made a total of 35 recommendations in its fnal report, 16 of which were implemented (Commonwealth of Australia, 2017). It is surprising that this legislation, and the important role of whistleblowing more generally, was not given any attention at the Royal Commission.

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A variety of mechanisms in the legislation work to strengthen protections for whistleblowers working in Australia’s private sector.These include providing a broad defnition of (a) the group of people who are eligible for protection if they make a disclosure, (b) the types of wrongdoing that constitute a disclosable matter, (c) the people to who a whistleblower can make a disclosure to and (d) the type of reprisals that are considered to constitute detriment to a whistleblower. The legislation also increases penalties for institutions who fail to safeguard the identity of whistleblowers and provides provisions for compensating whistleblowers who have experienced detriment. In an address delivered to the Third Australian Whistleblower Symposium, ASIC Commissioner Sean Hughes discussed how the number of disclosures made to ASIC since the above reforms were introduced has markedly increased (Hughes, 2021). In the fnancial year prior to the introduction of the new legislation, whistleblower disclosures to ASIC totalled 278. In the two fnancial years that followed, disclosures increased to 644 and 817 respectively. As Mr Hughes acknowledged, “many factors will have contributed to this 194 per cent increase in the number of reports to ASIC” – we cannot unequivocally conclude that the legislation was solely responsible for this trend. However, there is a clear correlation between the legislative reforms and the number of disclosures. A further reform (albeit in this case not implemented) that was not considered by the Royal Commission but is also designed to increase the likelihood that information regarding misconduct reaches an institution’s board is the appointment of a principal integrity ofcer (PIO). Although this idea is employed in many other jurisdictions (admittedly to varying degrees of efectiveness), it was frst proposed as a potential institutional arrangement in Australia by the Productivity Commission. In their inquiry into competition in Australia’s fnancial services industry, the Productivity Commission believed a PIO was one way the issues associated with conficted remuneration could be surfaced (p. 274, Australian Government Productivity Commission, 2018): Regulation should impose on all ADIs – as a condition of their banking licence – the appointment of a Principal Integrity Ofcer (PIO) to act as the source of internal (and, if necessary, external) accountability for payments [incentives] that could compromise consumer best interests. To be efective, the Productivity Commission frst proposed that the PIO should report directly to the chair and provide the board with regular reporting without

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“alteration or scrutiny from management” (p. 275).These arrangements aim to avoid situations where information regarding wrongdoing either never reaches the board or, if it does, arrives in a manner that sugar coats or downplays the seriousness of the issue. As the previous chapter illustrated, even the individuals within institutions who are supposed to remain independent and speak truth to power (for example, the CRO) can become captured and fail to do so. There were further arrangements the Productivity Commission proposed should be put in place to preserve the independence of the PIO. Most notably, the PIO should be required to approach the regulator when they feel that the board, despite being aware of conduct issues within their institution, are not responding appropriately. As described in their report, the Productivity Commission referred to this as a “fail-safe obligation” that would deal with situations where “inaction” persists (p. 275, Australian Government Productivity Commission, 2018): The fail-safe obligation is vital. It is clear from successive recent reviews, that even where risk and audit processes of a bank may have reported a heightened risk of failure to comply with regulation, inaction can persist. Altering the mind-set that says this is acceptable when it comes to customers will be an important way to revive consumer confdence in banks, as well as ensure a regulator may have a window of the subject that they clearly lack today. Of course, there would be other arrangements that would be required to safeguard the independence of the PIO. This would include appointing an individual of unquestionable integrity, limiting the tenor of the appointment to fxed terms (potentially three to four years), and, for obvious reasons, restricting remuneration to a fxed base salary.And although the PIO is an institutional arrangement that was proposed by the Productivity Commission, there is nothing stopping a private institution voluntarily putting the arrangement in place. Indeed, as with the majority of issues associated with suboptimal group dynamics, they are best dealt with internally rather than through regulatory intervention. If the latter is required, leaders within institutions have failed. Lessons for leaders This chapter has illustrated some of the ways in which being a member of a group can cause us to compromise our moral standards. When it is encouraged by group

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norms and required for group membership, people can engage in dishonest conduct (or turn a blind eye to it). This is especially the case when leaders endorse and promote dishonesty, knowingly or otherwise. And in groups where this dynamic has taken hold, speaking up can be extraordinarily difcult.The challenges posed by suboptimal group dynamics are in many ways some of the most signifcant given the nature of the risks that underpin the wrongdoing exposed at the Royal Commission. As mentioned earlier, non-fnancial or conduct risk (as it has become to be known), is, relative to more traditional fnancial risks, difcult to identify and quantify. The most reliable indicator of a conduct risk issue is after an incident has occurred. Obviously, post hoc measures are not ideal for the boards of institutions and it is therefore not surprising that they can be caught unawares.The information required to warn directors of a pending conduct risk issue either never reaches the board (à la FX trading scandal at the NAB) or arrives in a format that does not properly alert them to the gravity of the issue. For these reasons, arguably the best bulwark to the types of ethical failures showcased at the Royal Commission is a speak up culture. Institutional arrangements must encourage the surfacing of minor conduct issues before they degenerate and require a whistleblower to lift the lid on a full-blown scandal. Employees within institutions must feel comfortable raising concerns. Furthermore, when they do, their concerns must be given due consideration and appropriately addressed. As this chapter has demonstrated, creating an environment where this is a reality is far easier said than done. However, it should be a key focus for institutions and their leaders. In large institutions, a variety of channels should be available to employees through which they can raise concerns. Importantly, the channels should be credible and provide employees with confdence that their concerns will be addressed. Ideally, managers at all levels of the institution will create the conditions where people feel comfortable approaching them in the frst instance. But when this fails (as it will), other avenues should exist. These can include formal whistleblower channels, respected ethics champions or role models and, should they exist, a PIO. Most importantly, leaders must recognise that failing group dynamics have, as their root cause, defcient institutional arrangements. It is all very well to establish standards in an institution through codes, oaths or other such artefacts. But if conficts of interest make honouring these standards difcult, or leaders behave in a way that is at odds with these standards and are not held accountable when they do, or the remuneration arrangements reward those who behave with impropriety, then dysfunctional group dynamics will be an inevitable outcome.At this point, the path towards ethical failure is paved.

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Note 1 The Inner Ring by CS Lewis © copyright 1949 CS Lewis Pte Ltd. References Allport, F. H. (1924). Social psychology. Houghton-Mifin. Andersen, H. C. (2008). Andersen’s fairy tales. https://www.gutenberg.org/ fles/1597/1597-h/1597-h.htm#link2H_4_0001. Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth). https://www. legislation.gov.au/Details/C2021C00243. Australian Government Productivity Commission. (2018). Competition in the Australian fnancial system (Report No. 89). https://www.pc.gov.au/inquiries/ completed/fnancial-system/report/fnancial-system.pdf. Australian Labor Party. (n.d.). Fighting corruption: National Anti-Corruption Commission. https://www.alp.org.au/policies/fghting-corruption. Australian National Audit Ofce. (2020). Award of funding under the Community Sport Infrastructure Program. https://www.anao.gov.au/work/performance-audit/ award-funding-under-the-community-sport-infrastructure-program. Australian National Audit Ofce. (2021). Administration of commuter car park projects within the Urban Congestion Fund. https://www.anao.gov.au/sites/default/fles/ Auditor-General_Report_2020-21_47.pdf. Australian Prudential Regulation Authority. (2004, March 23). Report into irregular currency options trading at the National Australia Bank. Australian Prudential Regulation Authority. (2017, July 1). Prudential standard CPS 220 risk management. https://www.apra.gov.au/sites/default/fles/PrudentialStandard-CPS-220-Risk-Management-%28July-2017%29.pdf. Australian Prudential Regulation Authority. (2018, April 30). Prudential inquiry into the Commonwealth Bank of Australia. https://www.apra.gov.au/sites/default/fles/ CBA-Prudential-Inquiry_Final-Report_30042018.pdf. Australian Prudential Regulation Authority. (2019, November 19). Information paper: Transforming governance, culture, remuneration and accountability: APRA’s approach. https://www.apra.gov.au/sites/default/files/Transforming%20governance% 2C%20culture%2C%20remuneration%20and%20accountability%20-%20 APRA%E2%80%99s%20approach.pdf. Australian Prudential Regulation Authority. (2021, October 14). Transforming risk culture: Observations from APRA’s pilot survey. https://www.apra.gov.au/ transforming-risk-culture-observations-from-apra%E2%80%99s-pilot-survey.

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Brown, A. J. (Ed.). (2018). Whistleblowing: New rules, new policies, new vision. Grifth University. Brown,A. J. (2022, January 25).Australia and Norway were once tied in global anticorruption rankings. Now, we’re heading in opposite directions. The Conversation. https://theconversation.com/australia-and-norway-were-once-tied-in-globalanti-corruption-rankings-now-were-heading-in-opposite-directions-174966. Butler, J.V., Serra, D., & Spagnolo, G. (2020). Motivating whistleblowers. Management Science, 66(2), 605–621. https://doi.org/10.1287/mnsc.2018.3240. Chief risk ofcer. (n.d.). In Wikipedia. https://en.wikipedia.org/wiki/Chief_risk_ofcer. Commonwealth of Australia. (2017). Parliamentary Joint Committee on Corporations and Financial Services:Whistleblower protections. https://www.aph.gov.au/Parliamentary_ Business/Committees/Joint/Cor porations_and_Financial_Ser vices/ WhistleblowerProtections/Report. d’Adda, G., Darai, D., Pavanini, N., & Weber, R. A. (2017). Do leaders afect ethical conduct? Journal of the European Economic Association, 15(6), 1177–1213. https:// doi.org/10.1093/jeea/jvw027. Dufy, J., & Lafky, J. (2021). Social conformity under evolving private preferences. Games and Economic Behavior, 128, 104–124. https://doi.org/10.1016/j. geb.2021.04.005. Fischbacher, U., & Föllmi-Heusi, F. (2013). Lies in disguise: An experimental study on cheating. Journal of the European Economic Association, 11(3), 525–547. https:// doi.org/10.1111/jeea.12014. Hughes, S. (2021, November 11). Whistleblower policies and the compliance gap [Speech transcript]. https://asic.gov.au/about-asic/news-centre/speeches/ whistleblower-policies-and-the-compliance-gap/. Ireland, J. (2021). Questions about cabinet. Inside Story. https://insidestory.org.au/ questions-about-cabinet/. Kreps, D. M. (1990). Corporate culture and economic theory. In J. E. Alt & K. A. Shepsle (Eds.), Perspectives on positive political economy (pp. 90–142). Cambridge University Press. https://doi.org/10.1017/CBO9780511571657.006. Kuran,T. (1995). Private truths, public lies:The social consequences of preference falsifcation. Harvard University Press. Lewis, C. S. (1949). The weight of glory and other addresses. Macmillan Company. Longstaf, S. (2020, January 20).Why McKenzie must resign or be sacked. Australian Financial Review. https://www.afr.com/politics/federal/why-mckenzie-mustresign-or-be-sacked-20200119-p53sp2.

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Longstaf, S. (2021, July 8). Car park rorts rot the body politic. Australian Financial Review. https://www.afr.com/politics/federal/car-park-rorts-rot-the-body-politic20210707-p587r7. Ng, Y. (2020). As the government drags its heels, a better model for a federal integrity commission has emerged. The Conversation. https://theconversation. com/as-the-government-drags-its-heels-a-better-model-for-a-federal-integritycommission-has-emerged-148796. Reuben, E., & Stephenson, M. (2013). Nobody likes a rat: On the willingness to report lies and the consequences thereof. Journal of Economic Behavior and Organization, 93, 384–391. https://doi.org/10.1016/j.jebo.2013.03.028. Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. (2019). Final report (Vol. I). https://www.royalcommission.gov. au/sites/default/fles/2019-02/fsrc-volume-1-fnal-report.pdf. Schelling,T. C. (1963). The strategy of confict. Harvard University Press. Treasury Laws Amendment (Enhancing Whistleblower Protections) Act 2019 (Cth). https:// www.legislation.gov.au/Details/C2019A00010. U.S. Securities and Exchange Commission. (n.d.). Ofce of the Whistleblower. https:// www.sec.gov/whistleblower.

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Evils difused throughout the human race can only be dealt with by trade-ofs, through artifcial devices which themselves produce other unfortunate side efects. A confict of visions: Ideological origins of political struggles (p. 155, Sowell, 2002) In August 2018, more than 14 years after the FX trading scandal at the NAB hit the headlines, I received a message through my personal website from one of the four traders that was subsequently gaoled for their role in the incident. I cannot recall the last time I had any sort of contact with this individual, sufce to say it was prior to me becoming a “whistleblower”. The message, in its entirety, is reproduced below: you’ve got to get another line of work mate, everyone now knows that everyone in corporate life lies…pretending to be outraged about it is just getting old… I’ll let others judge what this says, if anything, about the individual’s character.What struck me, however, was that they had a point (and a good one at that).The message was sent at the height of the Royal Commission when there was a seemingly endless stream of headlines about bankers behaving badly. To think that, 14 years after the FX trading scandal, one of the protagonists could make a credible claim that unethical behaviour (or lying as they put it) is normalised in corporate life is a blight on so many of us involved in the fnancial services industry. But in addition, they raise a more important point that takes us back to the questions I raised in the introduction of the book:What if this is as good as it gets?

DOI: 10.4324/9781003335368-6

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That is, what if ethical failure is the gift that keeps on giving, and the best we can do is accept that it happens and pick up the pieces when it occurs? Should people like me, who place so much efort into understanding ethical failure and helping institutions avoid it, give up trying and “get another line of work”? There has been sufcient evidence presented in this book to suggest there is considerable merit to these propositions. But surely we can do better than what has been dished up over the past two decades? Recall from the introduction that my objectives for writing the second edition of this book were twofold. The frst was to update the research cited and in doing so, provide a more reliable and valid explanation for the origins of ethical failure (and the associated lessons for leaders). To this end I have been more discerning when selecting the research that has been referenced. Although there will inevitably be trade-ofs associated with experiments conducted in a laboratory and one must display caution when translating the fndings to real-world settings, I am confdent that relative to the frst edition the research cited is far more reliable and, by extension, so too are the conclusions that have been drawn from it. The second, more important objective was to capture some of the enduring lessons for leaders that have emerged since the publication of the frst edition of the book, especially given what has transpired in the interim. One of the key lessons remains unchanged – we are all susceptible. Humans have the capacity to err. Granted, some of us can follow the righteous path, even when the temptation is great. But they are in the minority. The majority of us, even when the temptation is slight, can succumb to the less desirable aspects of our nature, especially when the arrangements are permissive and allow dishonesty to be disguised. From this truth emerges the central lesson in this book that was absent in the frst edition – the importance of institutional arrangements. Inappropriately structured, institutional arrangements can prey on our propensity for dishonesty and invite unethical conduct. As was described in Chapter One, institutional arrangements come in a wide variety of forms, from the governance, compliance, risk management, performance management and accountability frameworks that exist within institutions (and all of the policies, processes and systems that support these), to the regulations and legislations put in place by our public institutions (and the capacity of public institutions to enforce these). For the purposes of this book, the focus was on the institutional arrangements that played a central role in abetting many of the ethical failures in the Australian fnancial services industry (which acted as the case study). These included conficts of interest that, even with heightened transparency and disclosure, will always place

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the conficted party in a hopeless bind; incentive schemes that, despite having the ability to motivate efort, can encourage ethical compromise; a lack of accountability that, when combined with high-powered incentive schemes, send a powerful message that boundaries are there to be broken; and the dynamic that can emerge when humans work together in groups, enabling the normalisation of unethical conduct and the silencing of those who stand prepared to question it. If there is one key lesson leaders should take from this book it is this: If we are serious about building institutions that are more resilient to ethical failure, then we must focus obsessively on institutional arrangements. However, although we may know where our focus should be, this does not make the task easy. A primary reason for this is that, as we found, reforming institutional arrangements inevitably involves trade-ofs – the most well-designed reforms that attempt to address one issue will invariably invite others (some of them unintended). And furthermore, in developing reforms, there is (more often than not) a messy political process that can produce signifcant compromise. But this does not mean we should not try. Throughout this book, the above lessons have been captured, as have suggestions on how institutional arrangements could be, and in some cases have been, improved (using the research cited as the guide). In the following sections some further insights and lessons for leaders are provided, borrowing on the themes discussed in the frst edition of the book. It starts at the top The very top. In the Royal Commission’s fnal report, Commissioner Hayne made it quite clear where he felt responsibility for the wrongdoing resides (p. 4, Royal Commission, 2019): There can be no doubt that the primary responsibility for misconduct in the fnancial services industry lies with the entities concerned and those who managed and controlled those entities: their boards and senior management. In one respect, Commissioner Hayne is right – leaders of institutions need to be held accountable. As was described in Chapter Three, accountability is an important institutional arrangement. But in other respects, responsibility does not just sit with the leaders of the fnancial institutions – it stretches to our elected ofcials and leaders of our public institutions. There is no escaping this fact (something that, as will be illustrated below, Commissioner Hayne is acutely aware of).

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In Chapter Two, it was illustrated how, at times, the leaders of institutions are left in a bind and are not able to move unilaterally to address suboptimal institutional arrangements (refer to the evidence provided at the Royal Commission by the CBA CEO Matt Comyn regarding mortgage broker commissions).The detriment caused by doing so would outweigh any potential ethical dividend (those damn trade-ofs). Furthermore, in Chapter Three, it was illustrated that if public institutions are not seen as a credible threat and do not hold institutions and the leaders within them to account when they engage in wrongdoing, there is little incentive for institutions to invest in compliance and put the appropriate institutional arrangements in place. As mentioned in Chapter Three, to ensure they are doing all they can to encourage ethical behaviour within institutions, the leaders of our public institutions and our political class must (a) conduct themselves with the highest level of probity, (b) implement efective policy, legislation and regulation and (c) properly enforce breaches of the law (undertakings that are not mutually exclusive). The terms of reference for the Royal Commission only provided Commissioner Hayne with the powers to inquire into the last of these three responsibilities. However, he did not remain silent on the frst two. Furthermore, his comments demonstrate that he is highly attune to the important role played by our political class and public institutions. In a speech delivered to the Centre for Comparative Constitutional Studies Conference, six months after the Royal Commission fnal report was published, Commissioner Hayne addressed the question “What does the use of Royal Commissions tell us about how our existing governmental structures are working?” (Hayne, 2019). As mentioned in the Introduction, the Royal Commission into misconduct within the fnancial services industry, despite being the primary focus of this book, has not been the only Royal Commission that has caused public consternation and discontent in Australia in recent years. Among others, there have been similar inquiries into the aged care sector and responses to institutional child sexual abuse. What this reliance on Royal Commissions says about the state of Australia’s public institutions was not lost on Hayne: The increasingly frequent calls for Royal Commissions in this country cannot, and should not, be dismissed as some passing fad or fashion. Instead, we need to grapple closely with what these calls are telling us about the state of our democratic institutions.

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Hayne also commented about our inability “to conduct reasoned debates about policy matters” and the perception that decision making by the political class is not only “opaque” but too often “seen as skewed, if not captured, by the interests of those large and powerful enough to lobby governments behind closed doors” (Hayne, 2019). What Hayne is referring to here is the issue of policy capture, a topic discussed in Chapter Three.This can only be avoided by vigorously defending the independence of our public institutions, something that, among other things, requires them to be sufciently funded and resourced, but also properly policed and held to account. Once again, this demands appropriate institutional arrangements. If we expect politicians and senior public servants to conduct themselves with the highest levels of integrity, we require institutional arrangements that hold them accountable when they stray. If we expect politicians and legislators to create legislation that is efective and not unduly compromised by special interests, we require institutional arrangements that reduce the potential for infuence. And if we expect our regulators to enforce the law and hold institutions and the leaders within them accountable, we require institutional arrangements that safeguard their independence and provide them with the required resources. Transparency International Australia recently published a paper that provides a “blueprint” for Australia’s national integrity system (Transparency International Australia, 2020). Many of the arrangements it proposes target the very issues described above. These include four-year budget allocations for core integrity agencies to safeguard their independence; a federal integrity commission with the ability to investigate any conduct, including “grey-area” non-criminal corruption; an overhaul of the arrangements surrounding lobbying and undue infuence; and reinforcing parliamentary and ministerial standards. These types of institutional arrangements, despite targeting public institutions at the federal level, will go a long way towards enhancing integrity within private institutions. In the meantime, we must accept that our elected ofcials are human. As the examples provided in Box 4.1 illustrate, they too will err. And they are susceptible to capture in the process of developing reform.This book has provided examples of fnancial services reform being compromised due to the infuence of special interests. The Royal Commission has provided more. Although estimates of how many of Commissioner Hayne’s recommendations have been implemented vary (Zifer, 2021a), what is clear is that some have been abandoned. One was a recommendation that sought to overhaul mortgage broker commissions, the very arrangement that CBA CEO Matt Comyn acknowledged he could not address unilaterally when providing evidence at the Royal Commission.

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Commissioner Hayne recommended that the existing remuneration arrangements for mortgage brokers, that involve the lender paying them upfront and trail commissions, be replaced with a fee paid by the borrower. As he outlined, the objective would have been to eliminate the array of conficts of interest that currently afict mortgage brokers (p. 78, Royal Commission, 2019): The result would be that within a period of two to three years brokers would no longer receive conficted remuneration. No longer would the remuneration arrangements within the industry be such as can reasonably be expected to infuence the choice of lender, the amount to be borrowed, or the terms on which the amount is borrowed. By now, the astute reader would be asking “But what about the trade-ofs?” It is the right question to ask. Mortgage brokers are a key distribution channel for smaller lenders in Australia and this reform, inappropriately designed and implemented, would result in competition being compromised and market share becoming more concentrated with the major institutions (Kane, 2019). Commissioner Hayne was not ignorant to these trade-ofs and asked that his recommendation be implemented over a two-to-three-year period and monitored by a working group established by federal treasury. The working group would have had the power to adjust the proposed remuneration arrangement if adverse consequences emerged, ensuring the necessary safeguards would be put in place. Despite this, with the 2022 federal election looming, both sides of the political divide decided against pursuing any reform to mortgage broker remuneration arrangements, thus efectively abandoning Commissioner Hayne’s recommendation (Kehoe, 2022). It is quite clear that successful lobbying by industry groups played an important role in these decisions, especially when it came to the initial response shortly after the Royal Commission recommendations were handed down (Kehoe, 2019). At that point, after “consultation with the mortgage broking industry and smaller lenders”, the government delayed any decision by committing to conducting a review of mortgage broker remuneration arrangements in 2022 (Frydenberg, 2019). It should be acknowledged that systemic wrongdoing among mortgage brokers was not a theme that emerged in the Royal Commission. This, when coupled with the above trade-ofs, provides the basis for a plausible argument to be made defending the decision not to implement the recommendation. However, one should also not lose sight of the lessons that have emerged in this book and how

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they apply to mortgage broker commissions. Namely, institutional arrangements matter and in many cases, leaders within institutions are unable to appropriately shape them – our public institutions and elected ofcials are required to do the heavy lifting. Furthermore, trade-ofs are part and parcel of reforming institutional arrangements. Although managing trade-ofs will inevitably result in compromise, when this compromise puts in place (or maintains) institutional arrangements that beget unethical behaviour, it is consumers that invariably pay the price. What about purpose? Purpose is still important, but it is futile if not supported by the required institutional arrangements. The frst edition of this book placed a lot of emphasis on the importance of institutions articulating a social purpose and a code of ethics. Consider the following paragraph taken from the frst chapter (p. 37, Gentilin, 2016): As a starting point, in addition to establishing a virtuous purpose, all organisations need to establish a code of ethics or other similar document. Amongst other things, the code of ethics should articulate the core values and principles that guide the organisation as they pursue their purpose. Of course, as symbolic as this document may be, it is by no means a “silver bullet” – it is up to the employees of the organisation to bring the document to life. More to the point, it is up to the leaders, the organisation’s role models, to set the tone, and through their actions, choices and decisions, they must live and breathe the document. There is nothing here I disagree with. Leaders within institutions must establish a shared sense of purpose for their employees and an ethical framework that outlines the values and principles that will guide behaviour. To begin with, and as demonstrated in Chapter Two, such statements can elicit discretionary efort (albeit they may not be as efective as monetary incentives). In addition, an ethical framework establishes a foundation for the institution that not only defnes behavioural expectations, but also informs the structure and content of institutional arrangements. Furthermore, the role leaders play in bringing an institution’s purpose, values and principles to life is crucial. By acting as credible role models and ensuring their

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actions, choices and decisions are supportive of the standards their institution claims to endorse, they will go a long way towards encouraging ethical behaviour. But what is missing from the above passage is the critical role of institutional arrangements. Even the most well-intentioned leader (or employee) will fnd it difcult to behave in a way that is consistent with the most well-articulated code of ethics if the institutional arrangements are pulling them in the opposite direction.The dissonance is too great. This was vividly illustrated in the independent inquiry into the CBA commissioned by APRA. The panel leading the inquiry stated the following in their fnal report (p. 91, Australian Prudential Regulation Authority, 2018): The Panel acknowledges the steps that CBA has been taking to become a values-led organisation.The most signifcant is the Vision and Values initiative, launched in 2013 in partnership with The Ethics Centre. Since then, there has been signifcant work and ongoing communications around the vision (‘to excel at securing and enhancing the fnancial wellbeing of people, businesses, and communities’) and the corporate values (Integrity, Accountability, Collaboration, Excellence, and Service) … The Panel recognises that this work has had an impact on CBA’s culture. However, neither the vision nor the set of values are well embedded within CBA, evident throughout the data collected by the Inquiry. There is signifcant value in developing codes, charters and other such artefacts. But the pledges and commitments within them will lose their meaning if not supported by the appropriate institutional arrangements. Legislation too faces a similar plight. The requirement for fnancial advisers to act in the “best interest” of customers (introduced as part of the FoFA reforms) proved to be inefective in environments where the institutional arrangements encouraged behaviour that was the antithesis of what was expected under the best interest duty. As they say talk (or in this case, making statements) is cheap. Perhaps this sentiment is best captured by the words of Justice Lee in the case of Australian Securities & Investments Commission v AMP Financial Planning Pty Ltd (No. 2) (2020). In this case, fnancial advisers employed by AMP Financial Planning were found to have been using dubious sales practices to maximise their personal commissions (“churning” life insurance products). In handing down his fndings in the Australian Federal Court, Justice Lee stated:

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For generations, many successful fnancial institutions did not need “values statements” setting out bromides; nor was it thought necessary to have an array of compliance executives with highfalutin titles; those responsible simply ensured their employees or representatives dealt with customers in a manner refecting an instinctive institutional commitment to playing with a straight bat. I would argue that the ballast supporting this “instinctive institutional commitment to playing with a straight bat” were the prevailing institutional arrangements. Don’t forget ethical followership I cannot overemphasise the importance of employee voice. As discussed in Chapter Four, the nature of the wrongdoing that has beset the fnancial services industry since the global fnancial crisis does not lend itself to reliable, ex ante, predictive measures. Non-fnancial (or conduct) risk, as it has come to be known, is difcult to identify and quantify. Therefore, if the key governance forums within institutions would like to be made aware of a pending conduct issue prior to it hitting the headlines, it is essential that employees are not only able to raise concerns but are taken seriously when they do. There is no doubt that since the Royal Commission, institutions have invested considerably in the internal systems, processes and controls that underpin their governance, compliance, risk management, performance management and accountability frameworks. This bodes well for known conduct risk issues. For example, it is highly unlikely that we will see another fee-for-no-service scandal – institutional arrangements have been put in place that signifcantly reduce the likelihood of “lightening striking twice”. However, what the next conduct issue will be and where it will arise is an unknown.Therefore, existing institutional arrangements may not be sufcient to act as a bulwark. As per the discussion in Chapter Four, it is for this reason that institutions and the leaders within them must put in place arrangements that encourage speaking up. It is also why I remain a proponent of and employ initiatives like Giving Voice to Values, an approach to ethics education developed by Dr Mary Gentile (Gentile, 2010). More than most, I understand that speaking up can be a difcult and treacherous undertaking.Approaches like those developed by Dr Gentile can equip us with skills and techniques that can be used in these moments, ensuring that if we do choose

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to raise concerns we do so in a way that is not only more likely to be efective but, more importantly, mitigates the risk of personal detriment. Furthermore, the burden of ethical followership should not just be carried by people within institutions. Rather, it is a burden we all carry to some degree across various dimensions of our lives – who we choose to provide our custom to, the institutions we choose to work for and how we vote, just to name a few.The ethical life requires us all to constantly question our actions, choices and decisions. Granted, our ability to infuence institutional arrangements may not be as great as those in positions of power, but it does not mean we should shirk our responsibilities. All of our choices matter, no matter how seemingly inconsequential. Finally In many ways, this edition of the book is less idealistic than the frst.There are fewer soaring statements, fewer appeals to our virtues, and less optimism about ethical conduct becoming normalised within the fnancial services industry. I may have disappointed some readers with this change in tone. Unfortunately, this is what happens when idealism collides with the hard rocks of reality. The hard rocks of reality I speak of was the Royal Commission. It was damning and the fndings emerging from it demanded that I challenge my thinking. What the Royal Commission exposed was not the work of a handful of “rogue” employees (or leaders) failing in their ethical obligations. Rather, it exposed widespread, systemic ethical failure enabled and sustained by defcient institutional arrangements. We must accept as our starting point a fundamental truth about human nature – when the circumstances are favourable, it is predisposed to dishonesty. Having accepted this, the revelations provided by the Royal Commission are less surprising. Should we expect anything else when people are placed in environments where conficts of interest are pervasive, incentives are lucrative and accountability is rare? Understanding this makes the solution self-evident – what is required is an obsessive focus on institutional arrangements. However, as self-evident as it might be, the solution is not straightforward. Addressing defcient institutional arrangements can come with signifcant tradeofs and the risk of unintended consequences.The concept of some type of ethical utopia is a mirage – even if it did exist, the trade-ofs to make it a reality would be enormous. But as I mentioned at the beginning of this chapter, surely we can do better than what has been delivered over the past two decades, a period during

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which the institutional arrangements created trade-ofs that privileged the shareholders and employees of institutions over consumers. To be sure, the pendulum has swung, both in the lead up to and following the Royal Commission. Institutions began investing far more in risk, governance and compliance and addressing defcient institutional arrangements. Regulators, meanwhile, have felt empowered and pursued wrongdoing with some success (Zifer, 2021b). The stakeholders that appear to be most indiferent are our elected ofcials, be it through their failure to support some of the key recommendations emerging from the Royal Commission (of which the reform to mortgage broker commissions was only one example), or their tolerance for a decay in standards among their own ranks (as described in Box 4.1).The recent change in government should not be viewed as a panacea to these issues, as tests of this nature don’t tend to discriminate along party lines – they will continue to come. Time will tell how the pendulum swings in the ensuing years. This will be telling. If the frequency of ethical failure declines, be aware of decisions that have the potential to compromise institutional arrangements. Politicians, under the guise of fscal responsibility, may slash the resources provided to regulators. Boards, under pressure to enhance shareholder returns, may cut investment in risk, governance and compliance. And employees, who become less vigilant of wrongdoing, may fail to notice the gradual decay in standards within their institutions and begin turning a blind eye to dubious conduct. Institutional arrangements will be shaped in these defning moments (and many others). As Joseph Badaracco states, defning moments test, reveal and shape (Badaracco, 1997).They test how committed we are to creating institutional arrangements that are supportive of ethical conduct; they reveal what we are actually committed to; and they will shape institutional arrangements (and conduct outcomes) for years to come. Some of these moments will appear inconsequential when they arrive but arrive they will. How we respond will reveal how committed we are to ethics and integrity. References Australian Prudential Regulation Authority. (2018, April 30). Prudential inquiry into the Commonwealth Bank of Australia. https://www.apra.gov.au/sites/default/fles/ CBA-Prudential-Inquiry_Final-Report_30042018.pdf. Australian Securities and Investments Commission v AMP Financial Planning Pty Ltd (No 2) (2020). 377 ALR 55. https://jade.io/j/?a=outline&id=707689.

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Badaracco, J. L. (1997). Defning moments. Harvard Business Press. Frydenberg, J. (2019, March 12). Review of mortgage broking trail commissions [Press release]. https://ministers.treasury.gov.au/ministers/josh-frydenberg-2018/mediareleases/040-2019. Gentile, M. C. (2010). Giving voice to values: How to speak your mind when you know what’s right. Yale University Press. Gentilin, D. (2016). The origins of ethical failure: Lesson for leaders. Routledge. Hayne, K. M. (2019, August 9). On royal commissions [Speech transcript]. Centre for Comparative Constitutional Studies Conference. https://meanjin.com.au/blog/ on-royal-commissions/. Kane, A. (2019, February 20). Non-major warns of banning broker commissions. The Adviser. https://www.theadviser.com.au/broker/38815-non-major-warnsof-banning-broker-commissions. Kehoe, J. (2019, March 14). How Mark Bouris and mortgage brokers defeated Hayne. Australian Financial Review. https://www.afr.com/companies/fnancial-services/ how-mark-bouris-and-mortgage-brokers-defeated-hayne-20190313-h1cc28. Kehoe, J. (2022, March 18). Mortgage brokers escape Hayne crackdown on commissions. Australian Financial Review. https://www.afr.com/property/residential/ mortgage-brokers-escape-hayne-crackdown-on-commissions-20220318-p5a5xq. Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. (2019). Final report (Vol. I). https://www.royalcommission.gov. au/sites/default/fles/2019-02/fsrc-volume-1-fnal-report.pdf. Sowell, T. (2002). A confict of visions: Ideological origins of political struggles. Basic Books. Transparency International Australia. (2020, November). Australia’s national integrity system: The blueprint for action. https://transparency.org.au/wp-content/ uploads/2020/11/NIS_FULL_REPORT_Web.pdf. Zifer, D. (2021a, February 4). Banking royal commission recommendations founder, two years on. Australian Broadcasting Corporation. https://www.abc.net.au/news/ 2021-02-04/banking-royal-commission-hayne-final-report-two-yearson/13110938. Zifer, D. (2021b, December 9). ASIC launches last banking royal commission case, but almost half did not make it to court. Australian Broadcasting Corporation. https://www.abc.net.au/news/2021-12-09/banking-royal-commission-reportasic-court-action-customers/100686336.

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Note: Italic page numbers refer to figures and page numbers followed by “n” denote endnotes. Abeler, J. 22–24 accountability 71–73, 133; assignment 73; failure of self-regulation 81–88, 82; identification 73; lessons for leaders 97–98; liability 73; pivotal role of public institutions 85–88; principalagent problem 85–88; promote ethical behaviour 74, 74–81, 75, 77, 78, 79; role of public institutions 88–97, 90, 92, 94 accountability maps 96 accountability statements 96 accountable persons 64, 95, 96 Accounting Principles Board 59 accruals-based earnings management 54 ADIs see authorised deposit-taking institutions (ADIs) Allport, Floyd 111 ANAO see Australian National Audit Office (ANAO) Andersen, Hans Christian 112; The Emperor’s New Clothes 111 Anti-Money Laundering and Counter-Terrorism Financing Act 2006 2–3, 84, 97, 115–116

ANZ see Australia and New Zealand Banking Group (ANZ) APRA see Australian Prudential Regulation Authority (APRA) ASX see Australian Securities Exchange (ASX) Australia and New Zealand Banking Group (ANZ) 2 Australian Consumer Law 92, 92 Australian National Audit Office (ANAO) 108, 110 Australian Prudential Regulation Authority (APRA) 3, 49, 53, 65, 67, 83, 84, 115, 116, 124, 138 Australian Securities and Investments Commission (ASIC) 5, 30–31, 36 Australian Securities Exchange (ASX) 42 Australian Securities & Investments Commission v AMP Financial Planning Pty Ltd (No. 2) 138 Australian Transaction Reports and Analysis Centre (AUSTRAC) 3 authorised deposit-taking institutions (ADIs) 64, 95 Badaracco, Joseph 141 balanced scorecards 48–56, 52

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dishonesty 21, 22, 23, 24, 26, 27, 37, 74, 75, 77, 79, 79, 80, 118 Duffy, J. 112

Bandura, Albert 18 bank bill swap rate (BBSW) 2 Bank Executive Accountability Regime (BEAR) 63, 64, 95, 96 Bansal, P. 57, 58 Bartle, I. 81, 82 BBSW see bank bill swap rate (BBSW) BEAR see Bank Executive Accountability Regime (BEAR) Becker, G. S. 23 Behnk, S. 80 Bennett, B. 54–56 Bieberstein, F. von 76, 77 Braithwaite pyramid 92, 92 Butler, J. V. 118, 119

earnings management 52–56, 59 Edmans, A. 60–61 enforcement methods 92–93, 92; employed by ASIC’s enforcement teams 93–95, 94 ethical dilemmas 18–21 ethical failures: definition of 18–21 ethical followership 139–140 ethical leadership: relationship between wrongdoing and 103–104

car park rorts scandals 108, 110 CBA see Commonwealth Bank of Australia (CBA) chief risk officer (CRO) 84, 123 CommInsure 2, 83 Commonwealth Bank of Australia (CBA) 2, 3, 62–63, 82, 116 Commonwealth Electoral Act 1918 19 Community Sport Infrastructure Grant Program 108 Comyn, Matthew 45, 134, 135 conduct risk 116, 123, 124, 127, 139 conflicts of interest 29–32 contract theory 44 corporate culture 113–115 Corporations Act 2001 30, 31, 64 CPS 220 123 CPS 511 65 Crede, A. 76, 77 CRO see chief risk officer (CRO) d’Adda, G. 104–107, 107 DellaVigna, S. 46, 47, 47, 48 DeMarzo, P. M. 85, 86 die-rolling task 21, 23, 76, 77, 77, 79, 104–106, 107, 117

FAR see Financial Accountability Regime (FAR) FASB see Financial Accounting Standards Board (FASB) FAS 123-R 59–60 fee-for-no-service scandal 5, 29, 32–36, 112, 139 Financial Accountability Regime (FAR) 96 Financial Accounting Standards Board (FASB) 59 financial advisers 29–30, 35, 36 Financial Stability Board (FSB) 49, 50 Fischbacher, U. 21, 22, 23–25, 37, 74, 74, 76, 77, 77, 79, 104–105, 117 Flammer, C. 57, 58 Fochmann, M. 77, 78, 79, 80, 87 FoFA reforms see Future of Financial Advice (FoFA) reforms Föllmi-Heusi, F. 21, 22, 23–25, 37, 74, 74, 76, 77, 77, 79, 104–105, 117 FSB see Financial Stability Board (FSB) Future of Financial Advice (FoFA) reforms 33, 35, 63–64, 91 FX trading scandal see NAB FX trading scandal Gentile, Mary 139 global financial crisis 63, 123, 139

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Gneezy, U. 24, 74, 75, 75, 76 Grattan Institute 89, 90 Griffiths, K. 91 group dynamics 102–103; group norms 111–115; role of leadership 103–111, 107; role of public institutions 123–126; whistleblowing 115–122 group norms 102, 111–115

lessons for leaders: accountability 97–98; dishonesty 37; group dynamics 126–127; incentives 66–67 Levitt, S. D. 24 List, J. A. 24 London Interbank Offered Rate (LIBOR) scandal 2 Longstaff, Simon 109, 110 long-term incentives (LTIs) 57–61 LTIs see long-term incentives (LTIs)

Hayne, Kenneth 4, 6, 18, 20, 21, 31, 34–36, 45, 61, 84, 94–96, 112, 124, 133–136 Healy, P. M. 54 Holmström, B. 44, 49 Homer: The Odyssey 21 Homo economicus 24 Hughes, Sean 96, 125 Hummel, D. 8

Maedche, A. 8 McKinsey and Company 8 moral hazard 43 mortgage brokers 62–63, 136 Murphy, K. J. 62

imperfect contracts 43–45 incentives 25, 41–45; balanced scorecards 48–56, 52; effectiveness of 45–48, 47; role of public institutions 61–66 informativeness principle 44, 49 institutional arrangements 29, 30, 35–37, 132, 135, 137 Ioannidis, John 3 Jensen, M. C. 62 Kajackaite, A. 24 Kaplan, Robert 48, 49 Kell, Peter 33 Koh, Benjamin 2 Kohlberg, Lawrence 20 Kreps, D. M. 114 Kristal, A. S. 9, 10 Kuran, Timur 111 Ladika, T. 59, 60 Lafky, J. 112 leaders/leadership: relationship between (dis)honest behaviour and 104; role in group dynamics 103–111, 107

NAB FX trading scandal 1, 41, 72, 73, 97, 102, 131 National Australia Bank (NAB) 1, 2, 17, 72, 73 NEPA see Norwegian Environmental Protection Agency (NEPA) non-financial risk see conduct risk Norden, L. 54 Norton, David 48, 49 Norwegian Environmental Protection Agency (NEPA) 86, 87 nudging: defined as 7; for honesty 7–10 The Odyssey (Homer) 21 Open Science Collaboration (OSC) 6 Ortmann, Andreas 2, 3, 7, 44, 86 pluralistic ignorance 111 Pope, D. 46, 47, 47, 48 Prendergast, C. 44, 45, 49 PricewaterhouseCoopers (PWC) 17, 41, 72 principal-agent problem 82; accountability 85–88; corporate culture 113–115; incentives 43–45 principal integrity officer (PIO) 125–126 Productivity Commission 125–126

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Index

public institutions, role of: accountability 88–97, 90, 92, 94; group dynamics 123–126; incentives 61–66 public preference falsification 111, 112 purpose 137–139 PWC see PricewaterhouseCoopers (PWC) Ramsay, I. 92–93, 95 retail funds 35 Retraction Watch 10 Reuben, E. 117, 122 “right-versus-right” ethical dilemmas 20 “right-versus-wrong” ethical dilemmas 21 risk culture 123–124 Robb, George: White-collar crime in modern England 12 Royal Commission 2, 3, 4–6, 10, 18, 20, 61–63, 65, 67, 82–85, 91, 92, 94, 124, 126, 132 Sautner, Z. 59, 60 Schelling, T. C. 114, 115 self-regulating organisation (SRO) 85 self-regulation: failure of 81–88, 82 Senate Economics Reference Committee 5, 93 sender-receiver game 80 Sheedy, E. 50, 52 Shu, L. L. 8–10 Sidgwick, H.: Outlines of the History of Ethics 19 Simonsohn, U. 10 Singer, P. 19 six lines of defence (6LoD) 98 “smoothing” 18, 34 sports rorts scandal 108 Stephenson, M. 117, 122

Stoian, A. 54 Sunstein, Cass 7 Superannuation Guarantee (Administration) Act 1992 32 superannuation system 32 Telle, K. 86–88 Tergiman, C. 24, 25, 28, 28, 37 Thaler, Richard 7 three lines of defence (3LoD) 98 trade-offs 48, 61, 62, 67, 89, 91, 132, 133, 137, 140–141 Transparency International Australia 135 Transparency International Corruption Perception Index 108 Treasury Laws Amendment (Enhancing Whistleblower Protections) Act 2019 124 Treasury Laws Amendment (Strengthening Corporate and Financial Sector Penalties) Act 2019 96 Turnbull, Malcolm 3, 4 Urban Congestion Fund (UCF) 110 variable remuneration 45, 46, 53, 63–67, 83, 84, 98 Vass, P. 81, 82 Villeval, M. C. 24, 25, 28, 28, 37 Wealth Management Project 32 Webster, M. 92–93, 95 Westpac Banking Corporation (WBC) 2 whistleblowers 116, 119–122; protection in private sector 124, 125 whistleblowing, group dynamics 115–122 Whistling While They Work (WWTW) research project 119–122, 121, 122 Wood, D. 91

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