You try taking incentives away from bankers, or babies. From the most tender age, humans respond to the incentives that are set for them. Incentive structures shape our behaviours in the most profound ways. Incentives come in many forms. Societies may threaten the deprivation of freedom, or even death, to prevent the worst of bad behaviours. Families and lovers may seek to influence those around them with displays of, or threats to withdraw, affection. And when it comes to the capitalist system, humans have demonstrated time and time again that they respond to that most blatant of incentives: money.

The incentive structures embedded in Australia’s largest financial institutions will come under the microscope again from today, as the second round of hearings of the Hayne royal commission kicks off. Last month’s initial hearings focused on incentives for misconduct in the sale of consumer products like home loans, credit cards and car loans. Loading Replay Replay video Play video Play video Multiple case studies revealed how the customers' best interests were undermined by misaligned incentives: sales bonuses structures for bankers, “introducer” payments for third parties and conflicted commission structures for mortgage brokers and car dealers. This week, Australia’s 25,000 financial planners and the quality of the advice they give to customers is in the spotlight.

Senior executives from Australia’s big banks will be hauled back to explain how their incentive structures failed to protect customer interests in recent high-profile cases of misconduct. About 2.3 million Australian adults receive financial advice from a financial planner each year, paying an average of about $2000. Unbeknownst to many Australians, the big four banks, plus AMP, control about half of the financial planning industry by revenue. In addition to their own branded networks, Commonwealth Bank owns Count Financial and Financial Wisdom, NAB owns GWM Adviser Services, Westpac owns Securitor Financial Group, ANZ owns Millennium 3 Financial Planning and AMP owns Charter Financial Planning.

A review released earlier this year by the corporate watchdog detailed how these banks' financial planners use “approved product lists”, offering customers a choice of both inhouse and external financial products, like super and insurance. Banks’ inhouse products comprise about 21 per cent of the products on these lists, but somehow end up receiving 68 per cent of the total funds that their customers invest. Funny that. Overall, the corporate watchdog concluded there are “inherent” conflicts of interest in such “vertical integration” structures – where a company manufacturers a product, while another part of its business purports to offer independent advice to consumers considering buying that type of product. The watchdog's review of customer files found that in 10 per cent of cases where clients were switched to an inhouse product “it was readily apparent that customers were likely to be significantly worse off as a result of following the advice” and that in a further 65 per cent of cases the review “did not demonstrate that the customer would be in a better position following the advice”.

No doubt these issues will dominate this fortnight's royal commission hearings. As the hearings roll on – with bank CEOs no doubt due to appear later in the year – it is increasingly clear that Australia's banking industry is beset by pernicious incentive structures which produce unacceptable outcomes for customers. And those bad incentives go all the way to the top. In a recent speech, the head of Australia’s banking regulator, Wayne Byres, compared the incentives faced by bank CEOs to that of pilots. “Pilots have no incentive to take off in an unsound plane. Pilots have no incentive to perform manoeuvres that stress the plane beyond its limits in pursuit of short-term thrills. Pilots, like everyone else on board, have no incentive to do anything other than land safely.”

Not so, says Byres, with the executives of Australia’s largest financial institutions. “The perception in the community is that in the financial sector, particularly at senior executive level, the carrots are large and the sticks are brittle. Not only are rewards generous, but there are seemingly few repercussions for poor outcomes. It’s in the industry’s interests that this perception changes.” A review of bank executive remuneration by the regulator found “considerable room for improvement”. While senior bank executives had been rewarded handsomely for banks’ good financial performance in recent years, Byres explained that “there has been limited evidence of material financial consequences for senior executives when risk outcomes have been poor in their area of responsibility”. Overall, Byres wants a shift away from rewarding bank executives with bonuses depending on their ability to generate short-term profits, and towards paying them for their ability to provide good risk management and customer outcomes. “To return to my earlier analogy, it’s too easy for financial pilots, unlike those who actually take to the sky, to walk away from the scene of an accident unscathed. That can do nothing other than jeopardise the establishment and maintenance of a sound risk culture."

Change is coming. The Turnbull government has announced a new regime, kicking off from July, whereby 60 per cent of bank CEO pay will be deferred for four years, in an attempt to ensure they remain accountable for the longer term outcomes of their tenure. It’s a good start. But the commission could go further by recommending a rebasing of executive performance “scorecards” to give less emphasis to financial outcomes and greater emphasis to risk management and customer outcomes. Byrnes wants banks to reform themselves. But shareholders present a major hurdle. When the Commonwealth Bank tried to shift to rewarding its former CEO Ian Narev more on customer outcome and less on profits, shareholders revolted and voted the move down. It’s yet another example where banks themselves – well aware of problems in their industry – are unable to change unilaterally.