We continue to challenge the effectiveness of the underlying culture in banks – Director General Derville Rowland

Speech by Derville Rowland, Director General Financial Conduct, to the UCD Behavioural Science Research Group, University College Dublin

Good Morning Professor Delaney, Ladies and Gentlemen. Thank you very much for the invitation to address the UCD Behavioural Science Research Group.

I want to talk to you this morning about the work of the Financial Conduct Pillar of the Central Bank of Ireland and how insights from Behavioural Economics are helping us build our Consumer Protection capabilities and influence a culture of compliance in the Financial Services Industry.

But first let me tell you a story.

When I was working in the UK, a young woman decided to try to buy her first home. As she left the office for a meeting with a mortgage broker, a very experienced colleague told her that no matter what she did, not to buy an endowment mortgage.

By the time she had finished listening to the mortgage broker’s sales pitch and succumbing to the pressure tactics, she walked away with the very thing she had been told not to buy.

An endowment mortgage worked like this: The borrower paid only the interest on the capital. This reduced the monthly payments when compared with a traditional repayment mortgage. The borrower also paid a sum in to an investment fund wrapped inside a life insurance policy.

The investment fund was predicted to grow at unrealistic rates that would pay off the mortgage on maturity and perhaps even deliver a surplus lump sum. The life insurance policy came with tax breaks.

The promise was that you could repay your mortgage, generate a surplus and save tax in the process. Of course, what actually happened was a widespread mis-selling scandal because the promise and the reality did not match.

These investments did not perform in line with the sales projections. The result was that many borrowers could not pay off the mortgage when they retired because there was a substantial shortfall in the return.

Providers of endowment policies – usually insurance companies – often paid commission to the intermediaries who sold these policies. This gave rise to criticisms that some sales of endowment policies were in the interests of the advisers who sold them rather than of the clients who bought them.¹

So she fell for the sales pitch and bought - or was sold - a long term financial product that was not best suited to her needs.

Unfortunately, it is a familiar story.

Ten years ago, the international financial crisis was in part caused by the sale of unsuitable products, namely inappropriate mortgage loans, including sub-prime loans, and the subsequent sale to investors of bundles of those unsuitable loans. Credit rating agencies labelled the bundled loans as high investment grade - until the borrowers began defaulting, causing uncertainty and ultimately panic that left investors nursing very big losses and families losing their homes.

Other recent examples of misbehaviour by financial institutions include:

• UK employees being advised to switch out of index-linked pensions in to less attractive private sector pensions
• The mis-selling of Payment Protection Insurance in the UK and Ireland
• The manipulation of the London Interbank Offered Rate (LIBOR)
• Instances where foreign banks were facilitating money laundering
• The recent Wells Fargo issue in the U.S. where the bank was opening accounts in customers’ names without their knowledge
• The tracker mortgage scandal here in Ireland

The Central Bank’s Mission

The Central Bank’s mission is to safeguard stability and to protect consumers. One of the ways we do that is through the regulation of the behaviour of firms and the people who work in them. Trust and confidence in financial services and the system of regulation is vital.

Our vision for a financial services system underpinned by a strong culture of compliance, with firms and the people working in those firms acting in the best interests of their customers, is backed up by comprehensive and enforceable legislation, rigorous supervision, a credible threat of enforcement including powers of redress when consumers have suffered detriment.

To give you an idea of the scale of the task, we regulate more than 10,000 firms providing financial services in Ireland and overseas.

We operate an assertive risk based approach to supervision which means the higher the risks, the higher the intensity and intrusiveness of the attention we pay those firms in our supervisory work.

The Financial Conduct Pillar

The Central Bank of Ireland last year restructured financial regulation in order to lend further support to its dual mission of safeguarding stability and protecting consumers. In September, I was appointed to the role of Director General, Financial Conduct.

The newly established Financial Conduct Pillar is responsible for the regulation and supervision of firms’ consumer and investor protection obligations and the orderly operation of financial markets.

We expect those firms to comply with the legislation and with the codes and standards that we set.

We have an important gatekeeping role to ensure that senior management in our financial institutions comply with our fit and proper regime, that legal and regulatory breaches are investigated and sanctions are administered.

Our assertive risk-based supervision of those firms and individuals is backed up by a credible threat of enforcement.

The Central Bank has concluded more than 115 enforcement cases under its Administrative Sanctions Procedure and imposed over €61 million in fines. There have been prohibitions and disqualifications of individuals, while about 40 people withdrew their applications for senior roles following robust challenge from us.

Tracker Mortgage Examination

We protect consumers by setting regulations governing the conduct for financial services firms. These cover how products should be sold, the information that should be provided and how complaints should be dealt with. The days of caveat emptor – or buyer beware – are long gone. As Regulators we insist on transparency, which means clear information being provided to help consumers make informed decisions. We intervene where we have a concern that there may be a widespread case of consumer detriment.

The Tracker Mortgage Examination is a case in point.

Our ground-breaking Consumer Protection Code, which dates back to 2006, is quite directional and states how we expect lenders to behave. We have been able to hold the lenders to account in large part due to violations of our regulatory codes rather than contractual breaches.

Since 2010, the Central Bank of Ireland has identified and pursued tracker mortgage-related issues with lenders. As new issues continued to emerge, we decided in December 2015 that a system-wide review was necessary, to ensure that all lenders were acting in their customers’ best interests as the Code required.

It’s clear from the scale of the wrongdoing that we uncovered during the Examination that customer interests were not sufficiently protected or prioritised. In particular, lenders failed to be transparent with consumers who switched from tracker mortgages to fixed rate products about what would happen at the end of the fixed rate period.

To end of December, the Central Bank has forced lenders to pay out €316m to affected customers, with more to follow as the rest of the 33,700 customers who were denied tracker products or charged the wrong rates receive redress and compensation.

The main lenders have now made combined provisions of about €900m in respect of the Examination, broken down as approximately €600m for redress and compensation and €300m for costs.

But we haven’t finished yet. We will ensure that lenders continue to identify all customers affected by their unacceptable failings and pay appropriate redress and compensation to consumers who were wrongly denied their tracker mortgages and who suffered serious detriment as a result – up to and including the loss of their homes in the most severe cases.

We are conscious, of course, that no amount of redress and compensation will ever adequately compensate customers for the trauma of losing their homes.
We are currently conducting enforcement investigations into four lenders with more expected to follow. In our enforcement investigations, the Central Bank will consider all possible angles, including potential individual culpability.

Of course, prevention is better than cure. And we are increasingly turning to the discipline of behavioural economics to help inform us where we need to intervene to protect consumers and investors.

Behavioural Economics

As behavioural economists, you understand all too well that consumers are likely to make costly mistakes when they are confused by descriptions of products which force them to think about too many things at once.

This can also happen when products are developed, promoted or sold in a way which is too complex or which exploits behavioural biases.

The Central Bank has partly funded laboratory based experiments carried out by the Economic and Social Research Institute (ESRI) which sought to answer the question at what point products become too complex for consumers to choose accurately between the good ones and the bad ones.

The research² found that consumer performance was significantly impaired when faced with increased complexity. When consumers were faced with taking two or more simultaneous factors into account, their ability to distinguish good and bad deals was diminished.

The researchers also examined how consumers choose a personal loan which involves making decisions about the term of the loan, the Annual Percentage Rate of interest (APR), the monthly repayment and the financial cost.³

They found that consumers were prone to making mistakes when choosing loans and that consumer choice can be significantly influenced by how information is presented.
Insights from behavioural economics point to ways that regulators can strengthen regulatory requirements to ensure firms help consumers make better choices.

For example, a “high cost loan” warning was found to reduce the chances that consumers opted for loans with high APRs. Providing consumers with a specific table of example loans before they made their choices also helped them to make more consistent decisions.

The Central Bank of Ireland requires such warnings be provided for moneylender loans.
Behavioural economics is also of interest to companies seeking to sell more products. We are live to the risks this poses to consumers.

For example, we are currently working with the ESRI on a desk-based review of global behavioural economics literature to provide demonstrable examples of firms knowingly taking advantage of consumer behaviours and biases. This will then be used to educate ourselves and the firms we regulate – highlighting practices that should not be used when designing or selling products to consumers.

To date, the research covers multiple, cross-sectoral products including but not limited to, mutual funds, structured deposits, mortgages, loans, credit cards and insurance. For example, the research highlights there is strong “extrapolation bias’’ when it comes to the purchase of mutual funds, where past performance is used overtly as a guide to indicate future performance. We have also found issues relating to teaser rates and hidden fees on credit cards with companies taking advantage of some consumers who were not fully informed about such fees. We plan to publish this research later this year.

We are also undertaking research focussing on the connection between household financial decisions and behavioural factors. This research will show how behavioural traits correlate with significant mortgage decisions such as the decision to refinance one’s mortgage, the decision to switch mortgage provider or indeed the decision about the type of mortgage to take on when purchasing a home.

As we learn more about what drives their behaviour, we will seek to strengthen the regulatory protections for consumers to ensure that firms do not exploit them unfairly.
We are already proposing measures aimed at helping consumers make savings on their mortgage repayments and to facilitate mortgage switching by making better quality information available so that consumers understand where they may find cheaper or more suitable mortgage products.

You will have seen also that we are proposing stricter rules on how brokers can be paid commission by the firms whose products they sell. We consider it unacceptable to allow inducements that give rise to conflicts of interest, such as ones linked to the size of a mortgage or loan.

In 2006, we banned lenders from offering consumers unsolicited credit. We weren’t happy with the then practice of lenders increasing consumers’ credit limits without their request.

The “Gordon Gekko’’ Effect

We are also gaining insights from behavioural economics in terms of how we can influence, for the better, culture and behaviour in the financial services industry.

It is more than 30 years since actor Michael Douglas delivered an award-winning performance as corporate raider Gordon Gekko in the 1987 film Wall Street where he famously said:

“Greed, for lack of a better word, is good.’’

A recent paper published by the Federal Reserve Bank of New York noted that Gekko - the villain of the movie - had counter-intuitively inspired many young people to go in to the financial services industry.

Gekko’s character was based on one Ivan Boesky - the same Boesky who was convicted of insider trading and was sentenced to a term of imprisonment.

The author of the paper, Professor Andrew W. Lo, used the term “the Gekko effect’⁴ to argue that some corporate cultures may transmit negative values to their members in ways that make financial malfeasance significantly more likely.

He suggested that key behaviours can guard against the spread of a destructive culture such as a willingness to admit mistakes, the refusal to respect unjust authority, the ability to consider the future rather than the immediate present, and the individual values of honesty, responsibility and independence of thought.

“These behaviours may sound hackneyed, but they are no more hackneyed than the instructions to cover one’s mouth while coughing or to wash one’s hands regularly to prevent the spread of communicable diseases,’’⁵ he wrote.

He is not alone in taking this view. A paper published by the Financial Conduct Authority (FCA) in the UK notes that people behave differently when they are in groups meaning that rule breaking depends on the culture and social norms within firms. It argues that wrongdoing can be reduced by promoting a positive culture of compliance. Firms can do this through their tone of communication, training and the expectations they set for their staff, as well as by ensuring that staff have the right incentives, combatting negative ideologies and publicising examples of good behaviour.⁶

The authors of that paper have a message for regulators. Visible punishments are more effective at maintaining deterrence as they raise the expected costs of wrongdoing; that punishments on individuals tend to be more effective for those conducting business than punishments at the level of the firm; and that regulators have a key role in reinforcing the importance of individual morality and responsibility in decision-making – an approach being applied by the Financial Conduct Authority in the UK for Senior Managers.

I couldn’t agree more.

In our recent response to a Law Reform Commission paper⁷ the Central Bank recommended that reforms strengthening the accountability of senior personnel in regulated entities be adopted in this jurisdiction. This would help assign responsibility to individuals in a regulatory context and decrease their ability to claim that the blame for wrongdoing lay elsewhere.

We also recommended the extension of the period for which individuals can be suspended from senior positions in regulated firms as part of the fitness and probity regime.

And we indicated our support for the creation of a dedicated division within an existing criminal agency to investigate white collar crime. This reform would allow for more effective investigation and prosecution of white collar offences.

Culture and Behaviour Review at Lending Institutions

We continue to challenge the effectiveness of the underlying culture in banks. Starting in April, we will undertake behaviour and culture assessments at each of the five main lenders – AIB, Bank of Ireland, Ulster Bank, PTSB and KBC - and will report our findings to the Minister for Finance later this year.

This assessment will be underpinned by the Central Bank’s enhanced Consumer Protection Risk Assessment model which helps us determine how financial firms identify and manage consumer risks, including the risk that a firm’s culture does not promote and support the protection of consumers.

We are working with the Dutch Central Bank, recognised leaders in the supervision of behaviour and culture, who will support us in the inspections. The Dutch Central Bank employs a framework which has been used in the assessment of nearly 100 firms in the Netherlands and across Europe. The Dutch framework utilises the skill set of organisational psychologists to assess the underlying behaviours which drive organisational cultures.

However, it is important to stress that the culture of a firm is the responsibility of that firm.

In particular, the members of the firm’s board should constantly be asking questions of themselves and their senior management teams. Such as what counts for promotions – high sales figures or high-quality interactions with consumers? Are the right products being sold to the right people? How do staff incentives and rewards influence product sales and consumer outcomes? Are the interests of customers and investors taken into account when decisions are made in the boardroom? Is the tone from the top signalling the right values to staff? Is diversity and inclusion being promoted at all levels of the firm to improve decision-making?

In short, the boards need to take the lead in ensuring that financial institutions do not focus on short term gain over the long term interests of the business, its customers and shareholders.

Change is possible

The regularity with which financial scandals have occurred both nationally and internationally and the apparent continued glamorisation of greed, as depicted in recent movies like Leonardo di Caprio’s Wolf of Wall Street, has made many people question whether the regulatory authorities can influence the behaviour and culture of the financial services industry.

But I am optimistic.

You only have to look around you to see how culture can be shifted and how regulation can improve lives.

Consider, for example, the decline in car fatalities in the United States over the last 40 years, despite the vast increase in the number of drivers and miles travelled. The decline was due to advances in the design of cars and roads; changes in regulatory culture, such as the enforcement of appropriate speed limits and changes in social culture such as the stigmatisation of driving under the influence of alcohol.⁸

In Ireland too, the Road Safety Authority has in recent years provided very strong leadership on the issue of road fatalities. The result has been a very big decline in deaths on our roads. For example, in 1981 there were 572 fatalities. Earlier this year, the Authority reported that 2017 saw a record low for road fatalities with the numbers falling to 158.⁹

There are other compelling examples which demonstrate how culture and attitudes can be changed for the better when strong leadership is provided. I am thinking, for instance, of how Ireland led the way with the introduction of the workplace smoking ban in 2004 which was subsequently widely adopted elsewhere. The ban, which has enjoyed a high level of compliance, is estimated to have saved 3,726 lives in its first ten years of operation, an achievement of which Ireland can justifiably be proud.¹⁰

Conclusion

The vast majority of those working in the financial services sector are people who want to do the right thing by their customers, their shareholders, their communities and the economy in which they and their families work and live.

I am confident that with the right leadership in financial services firms, they can build a financial services industry that will deliver better outcomes for consumers and investors.
Of course, I can’t promise you that when you go out to buy a mortgage or a car loan that you won’t ever encounter a pushy salesman or that there won’t ever be a bad apple working in the financial services sector.

But what I can promise you is that the Central Bank of Ireland is determined that our financial institutions put their customers’ interests at the centre of their decision-making.

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¹ http://researchbriefings.files.parliament.uk/documents/SN00570/SN00570.pdf

² Lunn, P.,  M. Bohacek, J. Somerville, Á. Ni Choisdealbha and F. Mc Gowan. (2016) ‘Price Lab: An Investigation of Consumers’ Capabilities with Complex Products’. https://centralbank.ie/docs/default-source/publications/consumer-protection-research/gns4-2-1-1-price-lab-online-vers.pdf?sfvrsn=6 (PDF 2.27MB)

³ Lunn, P., M.Bohacek and A. Rybicki (2016). ‘Price Lab: An Experimental Investigation of Personal Loan Choices’.  https://centralbank.ie/docs/default-source/publications/consumer-protection-research/gns4-2-1-1-loans-report-online- (PDF 2.6MB)vers.pdf?sfvrsn=6 (PDF 2.6MB)

⁴ The Gordon Gekko Effect: The Role of Culture in the Financial Industry by Andrew W Lo, FRBNY Economic Policy Review/ August 2016.

⁵ Ibid, p35

⁶ Iscenko, Z, Pickard C, Smart L and Vasas, Z, Behaviour and Compliance within Organisations, 2016, p3

⁷ Law Reform Commission Issues Paper “Regulatory Enforcement and Corporate Offences”

⁸ The Gordon Gekko Effect: The Role of Culture in the Financial Industry by Andrew W Lo, FRBNY Economic Policy Review/ August 2016

⁹ http://www.rsa.ie/en/Utility/News/2018/2017-sees-Record-Low-of-Road-Fatalities/

¹⁰ http://health.gov.ie/blog/speeches/minister-reilly-speech-at-rcpi-10th-anniversary-of-the-smoking-ban/