The Royal Commission’s (RC) final report was incrementally positive for the major banks because there were no unexpected, material or adverse outcomes and the core business of taking deposits and making loans was untouched. This explains Tuesday’s powerful relief rally, which was also driven by short-covering. Short interest in banks had risen in previous weeks ahead of the final report.
Wisely, and probably under some pressure from the regulator and government, the report did not recommend any further tightening of bank lending standards, where banks moved ahead of the Commission’s recommendations and are now under public pressure from APRA and government to lend more liberally. The Commissioner continues to think benchmarks for living costs are not the same as verifying the customer’s actual costs. However, he said the ASIC vs. Westpac proceedings on this matter should determine whether there is “some deficiency in the law’s requirements,” so the RC has not recommended any change to relevant legislation. Despite this, banks probably won’t relax their lending standards near-term.
The RC also did not recommend major structural change, for example to WBC’s ownership of both advice and platforms, and many of the actual recommendations were expected. The four areas of focus (access to banking services; roles and responsibilities of intermediaries; responsible lending; regulation and the regulators) were widely known.
But even though there were no major surprises, some of the recommendations will still restrain revenue and add to costs, as they address the imbalance between sales, profits and customer service. In short, the old model of maximum sales incentives is over. The recommendations will increase compliance costs and thus the cost of doing business, inflate remediation charges and reduce revenue in selected product areas. Remuneration models will have to change to increasingly incorporate customer outcomes, which in the short term is likely to result in lower returns but in the long term makes the industry more sustainable.
The removal of trailing commissions paid to mortgage brokers would add around 1% to earnings. However, the response of government and the broking and banking industries make it too early to conclude lenders also won’t pay brokers upfront commissions given concerns about sending smaller brokers out of business and reducing competition. The medium-term effects on market share, the volume/margin tradeoff for banks, and borrower churn will depend on how brokers react to their new ‘best interests’ obligation and the removal of trail commissions, the rate of front book discounting, and customers’ adoption of open banking.
Litigation, refunds, remediation and fines are still likely. The final report concludes says those responsible for misconduct should compensate those harmed and be held to account. While difficult to quantify, refunds and remediation will be a recurring cost into FY20 given the RC identified cases of criminal or civil misconduct and the banks want to restore community trust. We have seen estimates of $2.5bn of further charges by the end of FY20.
So banks enjoyed a relief rally earlier this week. Now the RC’s final report has been released the debate about bank earnings will move on to the economy, house prices, capital, bad debts, lending growth, retail bank pricing and interest margins. The RBA downgraded its economic growth outlook on Tuesday and there will be more detailed forecasts in tomorrow’s Statement on Monetary Policy. CBA reported its 1H19 result yesterday and NAB gives a 1Q19 trading update tomorrow. We are doing extensive valuation modelling and expect to make any necessary change to the portfolios’ bank positions soon.