Banking royal commission: Will banks in the dock always work?

Nor, it is claimed, were the boards and senior executives of large financial firms initially aware that their governance, remuneration and "cultural" strategies were leading to systematic wrongdoings by their staff.

The question then is how are these types of wrongdoings to be brought to light and dealt with? Outside independent investigation (such as by journalists following up tips from consumers or competitors who had suspected some wrongdoing), investigations by financial regulators, or self-reporting by institutions or whistle-blowers among their staff, are the main avenues.

Grey areas

Arguably, institutions may be more willing to self-report (and dob in other miscreant firms) once wrongdoing is recognised by senior management if negotiated settlements rather than court prosecution is a consequence. Particularly where the behaviour is in the grey area of "maybe not compliant" with regulation or community standards, senior management may respond to potentially higher penalties by non-disclosure in the hope of non-exposure.

The second reason is that financial regulation ranges between "black-letter law" and "principles based" regulation. In the former case, acceptable and unacceptable behaviour are clearly distinguished and prosecutions can be readily launched (if deemed more appropriate than reaching some form of negotiated settlement).

Principles-based regulation has the advantage of allowing financial firms the flexibility to decide on the way in which they will act consistent with achieving the objectives of the regulation. But determining whether some form of conduct is consistent with the objectives of the regulation is more problematic. And the regulator and regulated firm may have different views on this!

Consequently, negotiation between regulator and the regulated firm to achieve behavioural changes deemed required by the regulator, and to impose some penalty where past behaviour was clearly inappropriate, seems more appropriate than court actions. Courts are good at dealing with issues which are black and white, less so when there are many shades of grey.

Uncertain results

The third reason is that prosecution can be extremely expensive in terms of resource costs (for both parties) relative to the alternative approach of negotiated settlements and enforcement actions. And potential outcomes can be uncertain and different from what the regulator and the regulated firm might otherwise agree on (as the recent Westpac rate-fixing case shows). Speed of resolution is also an important issue.

None of this is to say that the past approach of Australian financial regulators, involving relatively few court actions, has been the right one. It also seems apparent that the approach adopted has not involved as much transparency and publicity as might be desired to achieve a better general deterrence effect.

But there is the risk of the pendulum swinging too far in the opposite direction. Finding the right balance between the "heavy handed" court-based and the more "softly-softly" negotiated settlement approach, and determining the best modus operandi for each are the challenges facing our financial regulators.

Kevin Davis is professor of finance at the University of Melbourne and research director at the Australian Centre for Financial Studies, Monash University