An Australian Royal Commission into Misconduct in the Banking, Superannuation and Financial Services industry has started to hear evidence. The so-called Hayne interim report into banking misconduct won’t be issued until 30 September though, unlike previous reports into the banking system, this inquiry is in the full public glare and, with more than 3,000 submissions, we can expect Justice Hayne to highlight further evidence of mis-selling, misconduct and mistreating clients. He is also likely to make several recommendations on sales practices and the potential separation of wealth management and banking. Most of all, the onus will be on responsible lending practices, with some potential for credit growth to be further constrained. As a result, investors in bank shares are interested in potential implications for balance sheet growth and margins for the banks.
The Hayne review is divided into three broad areas – consumer lending, wealth management and business lending. The key focus seems to be on mis-selling, fees, foreclosures and potential excessive extension of credit.
So far, evidence has been gathered on residential mortgage selling practices, incentives for mortgage brokers, transparency on mortgage rates and selling practices for add-on products such as insurance. This month, Hayne will question the banks on wealth management, life insurance and general financial advice. He will then turn to business lending, particularly in the rural and agribusiness market where foreclosures have had a high profile in the media.
Justice Hayne. Source: AFR. A key thread of Hayne’s focus is financial planners who, under Australia’s Future of Financial Advice Reforms, can no longer collect commissions and so Hayne is asking similar questions about the banks.
What could happen next?
Unlike previous banking and financial sector inquiries, this investigation is highly transparent, with a media room and the public dissemination of documents. For instance, on the first day of the hearing, the banking Royal Commission heard evidence about an alleged bribery ring involving National Australia Bank staff from multiple branches; how they forged documents, faked pay slips and Medicare cards, and paid bribes in cash to secure loans, as staff responded to an incentive program to sign up new customers[1]. In reply, National Australia Bank CEO, Andrew Thorburn, outlined the actions the bank has put in place to address mis-selling and poor documentation.
The Commission seems to be using this public inquiry as an opportunity to air dirty laundry and find common threads for new policy implications. The mortgage broker network appears to be in the sights of Hayne with a potential new regulation to ensure lending is in the best interests of borrowers and not mortgage brokers and banks. It may also be that Hayne pushes for banks to divest mortgage brokers (for instance CBA owns Aussie Home Loans, and Westpac owns RAMS Home Loans, both large mortgage brokers). Mortgage brokers were originally left out of the review, but Hayne decided to include them, reflecting their importance in the lending channel with more than half of new home loans sold through brokers. In part, most of the ground seems to have already been covered with ASIC and the Sedgwick reviews both looking at remuneration and volume-based incentives.
The insurance, wealth and superannuation industry is under review this month, where the role of trustees and their independence is being questioned. There is a focus on the nature of investments and whether they are fit for purpose. Bank sector life insurance units are also under fire for automatically enrolling some members in income protection, death or other insurance, potentially providing excessive insurance cover and additional fees for the life insurance companies. Incidences of some banks stalling on payouts and using genetic testing and medical records could also be reviewed, providing insights on how Australia may deal with risk analysis advances in medical diagnostics.
The final strand of inquiry is expected to be on bank lending to small businesses and agribusinesses. In the submissions, there is some alleged mistreatment of these borrowers, with an Australian parliamentary committee saying that banks may have behaved “in ways that are unethical, unreasonable and lacking transparency”. Various practices of changing loan terms are likely to come under scrutiny with ANZ’s purchase of the Landmark loan book a focus of some commentators.
With such public exposure, there is nowhere to hide in terms of historic grievances and the nature of lending and some banking practices. However, much of this is old ground with various parliamentary reviews, industry reviews and legislation on financial advice already changing the way banks sell.
Nevertheless, Credit Suisse has estimated that the cost of participation in the inquiry could be $100mn per bank, with remediation of past misconduct a multiple of this through potential forced divestments of some wealth and life insurance business lines, a change in the bank/mortgage broker model, and greater transparency on mortgage rates potentially impacting margins. It seems likely that higher regulation of selling practices, with a shift to more guidelines on responsible lending, is a minimum likely outcome.
The AFR reported that the Commission’s standard of judging banks against community expectations could yet see some surprises in Hayne’s Interim Report.
History suggests New Zealand regulators will be watching this space carefully.
From an investment perspective, the implications of the Royal Commission inquiry are less clear. The Australian banking sector has underperformed the broader market for three years. In the last three years, the bank index has returned -3.4% p.a. while the overall Australian market has returned 16.4% p.a. This performance gap has seen a major de-rating of the banks’ valuations. Today, the banks’ relative value is about 30% lower than the average of the last 15 years according to Credit Suisse estimates.
Figure 1: Performance of the Bank Sector share prices and the Australian equity market
Source: Bloomberg
This underperformance, particularly since the terms of the inquiry were mooted over a year ago is significant and suggests that some of the potentially negative news may already be in the price. However, the information flow from the Commission may yet peak with disclosures around wealth management and superannuation. It is our opinion, however, that unlike other inquiries, the public nature of the Commission may provide more insights during the journey, rather than at the final point of report’s delivery.
We are monitoring closely the small downgrades to earnings and the slippage in dividend expectations for the banks. We think that analysts may be yet to fully factor in some downside influences, but as we move through the next few months of the Commission’s line of questioning, together with broader influences of the trends in the housing market, global interest rate trends and competition for deposits will be another key factor to monitor.
Broadly speaking we think banks will need to continue to focus on costs, efficiencies, capital allocation and the introduction of financial technology, in light of proposed further changes in risk-weighted capital exposures.
The near-term drivers for bank share price performance seem unlikely to come from asset growth, net interest rate margins or regulatory relief.
[1] https://www.theguardian.com/australia-news/2018/mar/13/banking-royal-commission-public-hearings-open-on-litany-of-misconduct
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