EUR 850.00 For Business Accounts Only

Morningstar | Royal Commission Final Report a Positive for the Major Banks, AMP, and IOOF. No Change to FVEs

The final report of the Hayne Royal Commission released late Feb. 4, 2019 included no major surprises and is a net positive for Australia’s besieged major banks. Key recommendations are far less Draconian than expected. The government has stated all recommendations will be acted on and the opposition Labor party has confirmed all recommendations will be implemented. Importantly, despite severe reputational damage, in our view, the major banks have navigated through the Royal Commission with dominant market positions undiminished, pricing power firmly in place, and wide economic moats intact. We maintain our fair value estimates for Westpac Banking Corporation, National Australia Bank, Australia and New Zealand Banking Group, and Commonwealth Bank of Australia.

A lot of negativity had already been priced into bank share prices, with prices on average down approximately 15% during the previous 12 months as the continual stream of damaging and disturbing revelations were scrutinised in painstaking detail by Commissioner Hayne and his very capable assisting QCs. The market has reacted positively to the report with major bank share prices up strongly today, Feb. 5 with Westpac up most at 8% and Commonwealth Bank the lowest at approximately 5% as expectations of adverse outcomes and short positions unwind.

We also plan to maintain our fair value estimates for narrow-moat IOOF and AMP. Both firms will benefit from the commission’s recommendation to not break up their vertically integrated advice businesses, which was a key piece of uncertainty heading into the final report. But these wealth managers also face uncertainty surrounding the timing of eliminated grandfathered commissions, possible follow-up investigations, remediation expenses and related fees, and overall reputational risk that will likely lead to an outflow of advisors, reduction in assets under management, and greater regulatory scrutiny and costs.

Westpac Bank is our preferred major bank and looks to have come out of the Royal Commission better than peers. The bank has not been referred to regulators for further misconduct investigation. The lack of forced structural separation of the vertical integration model is a positive for Westpac and we expect the bank to continue reporting relatively clean financial results, high returns on equity, and sustainable dividends. Prior to the release of the final report, Westpac’s share price was down 21% on the previous year. Recommendations made should also accelerate the end of grandfathered and trailing commissions and improve the level of trust in Australia’s large financial institutions, by removing conflicts of interest and improving transparency.

Trust and service must be key parts of corporate landscape and we expect the Royal Commission, both the final report recommendations and the cringeworthy process of questioning witnesses, will deliver better customer outcomes, particularly a culture of accountability and compliance. Despite coming off reasonably in good financial shape, reputations and customer trust have been trashed and we believe government acceptance of all 76 recommendations will have a long lasting positive impact on Australia’s critical financial services industry. We think the industry understands the overriding importance of putting customers first with “customers before profit.” Changes to culture and remuneration will remove conflicts of interest and should deliver better customer outcomes.

The two financial system regulators, Australian Prudential regulation Authority, or APRA, and Australian Securities and Investments Commission, or ASIC, came under intense criticism for not applying existing laws and regulations as forthright as the community expected. A new regulator to oversee the existing regulatory “twin peaks” seems inefficient to us and we question the effectiveness of this costly initiative. However, we do believe the two regulators will far more aggressively implement laws and regulations when dealing with financial service entities and we see the financial system benefiting from regulators that will be “fit for purpose.” The two regulators will receive a boost to funding and are expected to better police laws and regulations.

Despite expectations by some investors for far tougher recommendations, the Royal Commission recognised the importance of ensuring proposed changes to industry structure do not unduly impact the broader economy due to the critical role the financial services industry plays, particularly in the health of the economy.

There were no recommendations for criminal proceedings against individual executives, but the report recommended criminal charges against three unnamed financial institutions, likely to be National Australia Bank, Commonwealth Bank, and AMP. The Royal Commission referred 15 cases to regulators for further investigation that could lead to civil or criminal proceedings. Commissioner Hayne launched a scathing attack on National Australia Bank’s Chairman Dr Ken Henry and CEO Andrew Thorburn. We expect both will probably depart the organisation in the short term.

As the Commission did not recommend the wholesale break-up of vertically integrated business models, both AMP and IOOF should continue to benefit from their distributional reach, which we expect will be difficult to overcome for competitors in the medium term. Nevertheless, ASIC has indicated it will be regulating vertically integrated business models more proactively which will likely reduce the competitive advantage of these models. In all, we maintain both companies’ narrow-moat ratings but reiterate each company’s poor stewardship rating. While we had already incorporated most of the Royal Commission’s suggestions into our financial projections, we will provide further updates over the coming week as additional details are revealed.

The elimination of grandfathered commissions for advisors was largely telegraphed, and we had already included this development in our financial projections for AMP. We expect the most substantial impact from this change will be to the number of advisors, as the removal of this lucrative earnings stream combined with stronger educational requirements will likely spur an accelerated departure for many from the industry. As a result, we forecast a 1% to 1.5% in cash outflows in AMP retail assets under management over the next couple of years. However, we also see market growth of assets under management as a mitigating factor, averaging about 5% return. And, given the repeal of grandfathered commission will not occur until 2021 under the government’s plan, this impact will be slightly delayed versus our current assumptions (although the upcoming federal election, in which the opposition Labor party holds a polling lead, adds some uncertainty to this final timing).

We think the bigger risk remains the reputational damage fallout from the Royal Commission for AMP and IOOF. We expect ASIC and APRA will more proactively regulate these firms, adding to operating expenses and potentially reducing profit margins even more than we currently project going forward. IOOF also faces continued uncertainty regarding the successor fund transfer part of its planned acquisition of ANZ Bank’s One Path Pensions and Investment, or P&I, business, which was recently delayed until later this calendar year. At this point, following the share rebounds for both companies in the wake of the Commission’s final report, we don’t see suitable margin of safety for investment in either firm.

Key losers include mortgage brokers with significant proposed changes around broker remuneration. In our view, the Royal Commission’s recommendations on mortgage broker remuneration, tougher licensing requirements and the requirement mortgage brokers act in the best interest of clients, damage Mortgage Choice’s the business model to such an extent we put the stock under review, with a cut to our fair value estimate likely. The firm’s stock price is down more than 25% today following release of the recommendations, with the firm’s official response understandably broad and general. The proposed changes are a serious blow to the mortgage broker’s profitability.

The Royal Commission made 76 recommendations, and we see the most significant applying to the mortgage broking industry with the proposed banning of lender paid commissions, replacing these with borrower paid fees. Mortgage broker commissions are to banned over a period of two to three years, first by banning trail commissions on all new loans and then on upfront commissions. There is some uncertainty on the banning of upfront commissions with the Coalition indicating a period of review to assess the likely impact on competition in the mortgage market.

Another widely expected recommendation is for mortgage brokers to act in the best interests of borrowers, not surprising with the Royal Commission recommending mortgage brokers should operate under the same laws and regulations as financial advisors. We think it likely the major banks will move ahead of the three-year phase out period and remove broker commissions sooner, further damaging the viability of mortgage brokers.
The Treasurer stated from July 1, 2020, the government would ban trail commissions for new loans and limit upfront commissions to the amount drawn down not the loan approval amount. Trail commission on existing loans is unaffected by the proposed changes.

The next steps are getting proposed law changes through parliament but there is insufficient “sitting” time to get legislative changes through both houses of parliament before the expected election in May. We understand the Senate has just five sitting days scheduled and the house of representatives just 10 days before mid-May. It will take many months to get a clearer picture of how the government of the day and regulators will implement the recommendations, assuming successful passage through both houses of parliament.

The Royal Commission has done a good job in reducing the ripple effects to other areas of the economy and the government clearly understands the need to balance tighter lending standards with the need to avoid a credit crunch that could damage the broader economy. The government of the day must balance the interests of consumers with the requirement for the banks to make strong profits. A profitable banking industry is needed to maintain the stability of the financial system and the strength of the broader economy. We all need strongly profitable banks as the banks are major employers, the largest corporate tax payers in Australia, and the banks need to make money to support Australians' investments and savings, particularly retirement savings.