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Morningstar | Financial Services Royal Commission Poses Plenty of Questions, but Provides few Answers

The interim report issued by the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry is long on questions and short on recommendations, but we expect this to reverse when the final report is released Feb. 1, 2019. The government will respond to the final report recommendations before the next election scheduled for May 2019 and we are concerned government policy changes could damage the longer-term outlook for the wide-moat major banks. The interim report doesn't materially change our view on Australia’s highly profitable major bank oligopoly, but it is clearly not a positive. We see increasing headwinds to lending growth as tighter credit standards start to bite, fees and charges will be more heavily scrutinised, and operating expenses will increase due to tougher regulatory and compliance requirements.

We expect regulators will more aggressively seek legal remedies for breaches of the law, rather than the previously preferred negotiated settlement. In a tough environment for the unloved major banks, earnings and share price catalysts are hard to find and we expect further uncertainty and negativity to continue for the next six months at least. At current prices, Westpac, Commonwealth Bank, and National Australia Bank are most undervalued, trading 22%, 16% and 15%, respectively below our valuations. ANZ Bank is trading 18% below our valuation. We are comfortable with our modest earnings growth forecasts, with EPS expected to grow an average of 2.4% per year to fiscal 2022.

As expected, the interim report presented a scathing critique of conduct shown by financial services entities. We agree this conduct is totally unacceptable, and rightly has drawn widespread political and public condemnation. The report bluntly concludes that unfettered greed and the unrelenting pursuit of profit maximisation “at the expense of basic standards of honesty” are behind the bad behaviour with the interests of customers a distant last.

Despite the financial services industry being a key enabler of Australia’s capitalist market economy, it is clear the industry has overstepped the fine line between profit and fairness. We have long argued the banking system is critical to the health of the Australian economy and the fact the Australian economy has not had a recession in 26 years is a clear sign of a robust economy and efficiently functioning banking system. But, the pendulum has over time swung too much to the benefit of bank shareholders and staff with little regard to the rights of millions of customers. Dealing with customers honestly and with respect became optional with “staff measured and rewarded by reference to profit and sales.”

The report conclusions were pretty much expected following six harrowing months of hearings into consumer lending, financial advice, small and medium enterprise lending, agricultural lending, and financial services provided to remote and regional communities. The findings concerning the superannuation and insurance sectors will be included in the final report. The seventh round of hearings will focus on policy issues arising from the first six rounds. Major bank CEOs will take the stand during round seven, starting Nov. 19, 2018, following testimonies to the semiannual Federal Government Economics Committee hearings in Canberra.

A key takeaway from the Royal Commission interim report is criticism of the regulators, Australian Securities and Investments Commission, or ASIC, and the Australian Prudential regulation Authority, or APRA. Commissioner Kenneth Hayne noted “the conduct regulator, ASIC, rarely went to court to seek public denunciation of and punishment for misconduct. The prudential regulator, APRA, never went to court.” Commissioner Hayne calls out the regulators as part of the problem, and lax enforcement was partly to blame for the bank’s bad behaviour. Too often punishment was inconsequential, particularly compared with the major banks' massive profits.

We liked the Commissioner’s conclusion that there is not necessarily a problem with the regulatory system per se, but rather enforcement of existing laws. “Much more often than not, the conduct now condemned was contrary to the law” and “the law already requires entities to ‘do all things necessary to ensure’ that the services they are licensed to provide are provided ‘efficiently, honestly and fairly.’” The Commissioner points out introducing new laws would only “add an extra layer of legal complexity to an already complex regulatory regime.”

The key negative from the Royal Commission is the implementation of tighter lending standards, particularly for home loans, credit cards and auto loans. Despite an outlook for tighter regulatory and compliance requirements, the biggest risk for the major banks is the potential for stricter lending criteria to cause a credit squeeze, in turn triggering an economic downturn and leading to weakness in borrower demand. For now, though, the Australian banks are well supported by strong economic fundamentals as global and domestic economic conditions improve. Despite robust fundamentals, major bank share prices are well down from 12-month highs with Australia and New Zealand Banking Group down 11%, Commonwealth Bank of Australia down 16%, National Australia Bank down 17%, and Westpac down 19%.

Major bank lending standards for home loans have been progressively and steadily tightening during the past three years but have intensified in the past nine months. Lending growth is slowing with home loan growth of 5.4% for the 12 months to Aug. 31, 2018 down from 6.6% for the 12 months to Aug. 31, 2017, with residential investment lending bearing the brunt of the decline. We expect total housing credit growth to fall to the 4%-4.5% range, but if average house prices continue to fall, the rate of annual credit growth could approach 2%-4%. Credit growth for residential investment properties declined to just 1.5% year-on-year growth at Aug. 31, 2018 compared with about 5% in Aug. 31, 2017.