The recommendations of the final report by the Royal Commission into Financial Services were far more benign than the market feared. And that’s seen an immediate bounce in bank share prices. Can shareholders now relax?
The market’s reaction to the release of the final report by the Royal Commission showed that it can often hate uncertainty more than the outcome and tends to focus on the worst-case scenario.
While the final report was damning about the cultures within the banks, as well as how predatory practices were incentivised by remuneration structures, the final recommendations are unlikely to impact the sustainable profitability of the banks to the degree that the market had factored into share prices.
Importantly for the broader economy, there were no recommendations that are likely to further tighten credit availability for either households or businesses. That doesn’t mean credit will flow more freely either, with great scrutiny of expenses by the banks likely to continue slowing the approval process and permanently reducing debt limits.
The bad practices that were highlighted by the Royal Commission were driven by financial incentive. Therefore, ending such practices will have some financial impact. With the banks having already moved to address a lot of these issues, the impact will to some extent already be reflected in earnings forecasts.
The fines and remediation to come will no doubt be substantial. However, they will (hopefully for shareholders and customers alike) represent one off charges. As such they should be looked at in isolation in comparison to the overall market value of the bank rather than as a percentage impact on earnings.
Impact on commissions and mortgage brokers
The recommended ban on commissions for mortgage brokers is actually a win for the major banks. The mortgage brokers provide a very important distribution channel for the smaller banks and non-bank financial institutions (NBFIs) to gain access to customers and compete against the major banks. Mortgage broker originated mortgages had been growing share of overall originations for many years.
Most consumers view mortgage brokers as a free service. While this is not actually the case, with the cost borne by the lenders and effectively passed on to all borrowers through higher rates, if mortgage brokers are forced to charge fees directly to the borrower, it is likely to materially reduce demand for their services, with borrowers more inclined to look for lenders themselves. This increases the value of the major bank branch networks as a key sales and marketing channel, increasing the competitive advantage of the major banks.
The benefit of this change will not be the same for all of the majors. National Australia Bank (ASX:NAB) had the least reliance on mortgage brokers for originations at around 35 per cent of new mortgages written in FY2018. As such it is likely to benefit most from a reduced use of brokers by borrowers. At the other end of the spectrum, the Australia and New Zealand Banking Group (ASX:ANZ) generated 55 per cent of its new loans from brokers in FY2018 and as such is a lot more reliant on the broker channel to drive its mortgage market share. But all of the majors are below the overall industry average of 59 per cent for mortgage broker share of originations.
In line with the recommendations from the recent Productivity Commission Report that also looked at the issue of conflicted remuneration for mortgage brokers, the Government’s response indicates that it would not look to remove upfront commissions to mortgage brokers (other than restricting them to being based on the amount drawn down rather than the loan limit) due to the impact on competition. Trailing commission would be banned from July 2020, and upfront commissions would be reassessed in three years time.
A pending election….
But the Government’s view on this is likely to prove irrelevant given the high probability of a change in Government at the May Federal election. Labor announced that it would implement all of the recommendations from the report, despite not knowing what they were. On the basis of this sort of quality decision making I have a few houses I would like to sell Bill Shorten sight unseen, but leaving that aside, it appears the mortgage broking industry will probably be the most negatively impacted by the changes recommended in the final report.
The removal of conflicted remuneration and fee structures from the vertically integrated financial advice businesses operated by the banks falls well short of the feared forced break up of these structures.
The requirement to provide regular and more explicit information to customers regarding fees is also likely to create greater pricing pressure on advice and platforms.
The recommendations will change the economics of these businesses to some degree but the financial impact is likely to be largely immaterial in the context of the overall group earnings.
This is most significant for Westpac (ASX:WBC) as it is the only major that is looking to retain its wealth management operations going forward, and as such its share price will see a greatest benefit from the reduction in the risk premium being applied to the banks.
For ANZ, the recommendations themselves are unlikely to impede the sale of its wealth management business to IOOF, but there remain questions about the constraints that will be placed on IOOF given recent findings and rulings by regulators. The sale of the wealth management business is an important part of the capital management investment case for ANZ.
The singling out of the CEO and Chairman of NAB might see leadership change as a result of public and political pressure. This is likely to weigh a little on NAB’s share price but given the bank’s poor execution over a number of years, the bank has tended to trade at a discount for the quality of its management anyway. Forced change could actually be a positive for the share price if the right people are brought in as replacements.
Overall, the recommendations fell well short of what was feared by the market and factored into bank share prices. As a result, we are seeing bank share prices bounce materially upon resolution of this risk.
But this is not the end of the regulatory uncertainty for the banks with the campaign leading into the coming May Federal election likely to include a bank bashing competition between the two major parties.