Royal Commission into Banks

This week Robert Swift digs into the recently announced Royal Commission.

Today the Australian government announced there would be a Royal Commission established to investigate the banking industry. This was done on receipt, by Treasury, of a letter from ‘the big 4’ requesting such, in order to ‘restore faith in the financial system’.
 
There will be many comments available on this imminently so ours will be short. We will also mostly ignore the apparent ‘wordsmithing’ whereby the request from the big 4 was to “restore faith in the financial system” rather than investigate the big 4 specifically. That is, “the system is good, we just need folks to be educated” rather than “maybe the system isn’t so healthy; please help us fix it”
 
Banks have been unpopular in Australia (and elsewhere) for justifiable and unjustifiable reasons. It is not clear that Australian banks have been less well behaved than banks in other countries. It seems that banks are unpopular when they transgress with retail clients or the smaller end of town? Wells Fargo in the USA for example has had problems with mis-selling and over zealous account openings, and it has become the banking pariah, rather than the large investment banks which facilitated a number of ‘grand schemes’ which dwarf the WFC account opening scandal. Greece’s entry into the Euro for example, was facilitated by a sleight of hand on a gargantuan scale by a global investment bank. This has cost far more than any account opening or financial planning ineptitude for retail customers done by CBA or WFC!

Since they have only been as badly behaved with equivalent cultural ‘problems’ as banks elsewhere why then is there a Royal Commission and what damage will be done?

It is a political gesture for a marginal government to appear to listen to the people. It is another ‘populist’ gesture much as the UK referendum was or even the Trump victory. Folks are pretty unhappy and rightfully so.

To get the banks to request the inquiry reduces the impact of the accusation of a ’U turn’ by the government and is a clever manoeuvre.

However a Royal Commission is NOT the best avenue to deal with the banking system and the problems of culture and poor behaviour at the big 4. Ironically a Royal Commission remit SHOULD be established and focus instead on the idea of breaking the oligopoly of the big 4. Somewhere along the line the Australian mantra of “4 pillars” became only 4 rather than at least 4. The problem of concentrated power lies in the decisions of the Rudd government to let Westpac take over St George, and for CBA to then buy Bank West. Four with a few small competitors became four with two of the more viable competitors subsumed. To have an industry which is price competitive needs competition and of that there is now too little. It is also clear that bank owned platforms with bank owned asset managers and tied planner networks is hardly the stuff of competition and low fees for the retail consumer. It is not all the fault of the Rudd government but they sure were nudged into acquiescing to what the big banks wanted.

A Royal Commission is designed to work when there is one major systemic issue and for which bilateral policy change can be agreed.

Inadequate banking competition and the overly powerful banks control of super fund administration in Australia, would be a valid target for a Royal Commission but it appears that this is not the requested objective.

Consequently we guess that this Commission will just be a sniping exercise where tabloid headlines of ‘scandalous policy and unsavoury behaviour’  will be the norm.

Here are our considerations if the toxic cultural norms, inadequate skills and bad incentives are to be improved:-

1. The best way to deal with poor behaviour is for the owners of the business, the shareholders, to get engaged before the event. ESG or Environmental, Social, and Governance, issues are all investment considerations, and yet we find that rarely are boards engaged by activist investors to effect change before something happens – at least not yet. Were the warning signs not there at CBA for some time as the Storm Financial scandal broke? Hindsight is a great thing but if ESG is an approach you highlight as part of your process then maybe there should have been more change required after Storm? I think the regulator might have been a little slow here too? People respond to incentives and staff are the same. Consequently shareholders should investigate management incentives and understand better the behaviours they produce. We understand it is difficult. We know some powerful UK based shareholder friends, who owned a decent slug of the Royal Bank of Scotland, and they were constantly telling the Chairman that Fred Goodwin was not a CEO who was building a sustainable and solid business. They got nowhere even though they were right. Engagement can be a thankless task but at least they tried before he blew up the bank and cost shareholders and tax payers a lot of money.
2. It is all about culture. Make the staff targets revenue based and you will get very different behaviour from imposing a target that is client retention based – for example. This Australian banking ‘problem’ is about behaviour, business culture and the true qualifications of executives to run retail and wealth management businesses. Business culture and the true level of management experience and skill should not be a Royal Commission remit.
3. Shareholders find it hard to vote with their feet if the company is too powerful and too large in their benchmark. Not owning CBA when it comprises over 10% of your benchmark assigned by the pension consultant is a tough and risky call to make for any fund manager. “Small is beautiful” in that the shareholders can afford to disinvest from a company they believe has a toxic culture and / or is a bad business.  We think that government should use the Royal Commission to investigate breaking up the banks; and that more funds here should invest internationally using a global equity index which acknowledges the plentiful supply of well run banks offshore. This would make Australian banks less influential.
4. In an age of Fintech it is not clear that reducing the size and scope of the banks would raise the cost of borrowing in the economy – a claim you can be sure the banks will make if it ever is threatened!  In short it may be a good thing to reduce the grip of the banks, but their written request was to “restore faith in the financial system”, not investigate and change the system! 
5. This will be embarrassing for and potentially emasculate, the financial regulators. Or they could come back “badder and bolder” and heap a whole load more regulation and pointless oversight onto listed companies. We don’t know but as ever more regulations don’t appear to change behaviours. Someone somewhere is always breaking the law. If you make more laws, more laws will be broken. It’s not about the number of laws but the principles and ethics in which the business is immersed; and then how you respond IF you do break a law. Again we don’t see how a Royal Commission can help with ameliorating poor behaviour.

Our response in conclusion? Prepare for a year of revelations and rumours and heightened volatility in Australian banks. Look elsewhere, especially internationally, for diversification.