Brent Sheather: Watching the detectives

Populating boards with bankers potentially sends messages to management. Photo / 123RF

Brent Sheather is an Authorised Financial Adviser and a personal finance and investments writer.

A few weeks ago we looked at the bad behaviour of the banking sector overseas and noted that whilst in the 1930's the criminals robbed banks today they seem to run the banks. That's progress for you.

Complicating matters further is the fact that in NZ the Government has seen fit to populate more than half of the board of the NZ financial police (the Financial Markets Authority) with past and present bankers.

This is, as we will see, in sharp contrast to the make-up of the comparable institution in the US, the Securities Exchange Commission.

The decision which the NZ Government has taken to dominate the Board of the FMA with bankers means that there is potential for industry to capture regulation and let's be honest having bankers regulating bankers doesn't engender confidence.

The old adage of "putting the foxes in charge of the hen house" springs to mind.

Populating the board with bankers potentially sends messages to management.

A recent FMA report said a number of times that fund fees need to be fair but was very careful never to define what "fair" meant.

It's very easy to see this comment from a cynical perspective ie the FMA management is confident enough to "talk the talk" but perhaps feels that it doesn't have the political support to "walk the walk".

In the UK a few years back the Chief Executive of the financial regulatory authority there didn't appreciate the influence of the finance sector on Government, tried to implement some genuine changes to safeguard retail investors' interests and in the process annoyed the banks.

Subsequently his employment contract wasn't renewed and his demise was widely reported as payback from the banks.

That was a low point for British politics - now they have a new prime minister who better appreciates the political ramifications of widespread inequality.

Perhaps if the FMA defined "fair" properly they might risk the same outcome as the poor fellow at the UK FCA because as we showed a few weeks ago a very large proportion of the managed funds available locally could reasonably be described as having fees that are unfair.

Now the FMA executives will no doubt completely reject this speculation and quite rightly argue that they are people with high levels of integrity and that none of these issues impact their performance.

I'm sure that Rob Everett and his team are great people and doing a great job managing all those conflicts expertly but the mistake of populating the FMA board with bankers is not of their making and it wouldn't even be appropriate for them to comment.

The buck stops with the NZ Government. Directors are appointed by the Government not the FMA staff and appointing bankers to regulate bankers is a conflict obvious even to an idiot.

I spoke to Dr Andy Schmulow, Senior Lecturer at the University of Western Australia, who has been a vocal critic of the regulatory scene in Australia. He made the point that there are two types of companies in the world - banks and everything else.

The thing that differentiates banks is that if ANZ goes bust it will, through contagion and a loss of confidence, most likely send Westpac and the other banks bust and subsequently engender a major economic breakdown.

In contrast if Coles goes bust Woolworths won't.

Given the importance of the banking sector to the economy and the widely documented bad behaviour of bankers it is critical that the banking sector be regulated aggressively.

Reducing the systemic risk of the banking sector necessarily means downsizing the banks and reducing profitability.

Given this situation bankers regulating bankers is not a good idea.

Dr Schmulow also highlighted the problem of the revolving door between the finance sector and regulatory bodies. This is as much an issue locally as it is overseas.

In the US Senator Elizabeth Warren recently co-sponsored the Financial Services Conflict of Interest Act, prohibiting former private sector employees from receiving bonuses from their employers for entering government service.

The reason that politicians like Mr Goldsmith and his predecessors roll out for putting the foxes in charge of the hen house is that "we need people who understand banking".

Contrast this naïve approach with the view of Senator Elizabeth Warren, former Harvard Law Professor and bane of the finance industry, who said the other day that "the finance guys argue that if you are never in the club you can't understand it.

But I think they have it backwards.

Not being in the club means not drinking the Kool-Aid". She is referring here to Tom Wolfe's book "The Electric Kool-Aid Acid Test" written back in the 70's which I read at the time. The Kool-Aid had LSD in it.

One other obvious reason to refute the "we need people who understand banking" excuse is that if the products and services offered to the public ie, the end user of the finance industry, are so complex that only bankers can understand them then they are obviously unsuitable products.

The other well-rehearsed response from Government to the suggestion that bankers regulating bankers is not a great deal for consumer is to say "we have policies to manage conflicts of interest".

That really doesn't stand up to any careful analysis let alone comparison with best practice overseas. A good example of an unmanageable conflict is the fact that a director of the FMA is very closely associated with a fund whose total expenses in one year were 3.4% and that included a patently unfair performance fee.

How on earth could one "manage" this conflict. Best practice is not to manage conflicts. It is to eliminate them, which brings us to the make-up of the SEC Board.

Looking at the SEC Board, which is appointed by the President of the USA, we can see that none of the three commissioners have worked in the finance sector, let alone are currently employed by the firms they are regulating.

Typically commissioners have legal or economic backgrounds and are distinguished academics.

The Chairman, Mary Jo White, for example "has decades of experience as a Federal prosecutor and, as the US attorney for New York, prosecuted complex securities and financial institution frauds".

In contrast to NZ no SEC director is also a director of Wells Fargo, Merrill Lynch or JP Morgan. Contrast this with the FMA Board where some five members of the nine member board are past or current bankers. Senator Warren would have a fit.

I emailed Paul Goldsmith, the Minister in charge of the FMA, and who just last month appointed yet another banker to the FMA board, asking why the public of NZ should not be concerned about bankers regulating bankers.

He said "Given FMA's role as a financial markets conduct regulator, it is important the Board is made up of people with a wide range of experience in the financial services industry. The FMA has strict policies to manage any potential conflicts of interests around its board and governance arrangements once members have been appointed." Oh dear.

The rise of populism and resulting irrational behaviour in the UK (Brexit) and the USA (Trumpism) should serve as a warning to the NZ Government. If the wider public suspect, rightly or wrongly, that the system is rigged and its institutions corrupt society as a whole loses.

The Financial Times talked about solipsism a month or so ago whereby there is widespread mistrust. John Authers wrote "economies are founded on trust.

Credit comes from the Latin word for trust but trust is fragile and under attack. Scepticism thus becomes solipsism, the fear that nothing is true. That scares me particularly when it is directed at institutions that rely on trust for their survival."

In a recent speech the Chief Executive of the FMA made the point that the public's confidence in financial institutions was low. Full marks there however it follows that if confidence is to be restored in the banks then the public need to have confidence in the FMA and that means its governance needs to be consistent with best practice not to mention common sense.

Refreshing the FMA's directorship should be Goldsmith's priority.

There are a few appropriate people on the FMA board but bankers regulating bankers is not a good look. If nothing gets done NZ always has the option of refreshing the Government.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.