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Shareholders celebrate Royal Commission recommendations

06052018_Royal_Commission

Shareholders celebrate Royal Commission recommendations

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.

In short

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.

The Montgomery Funds own shares in National Australia Bank and Westpac. This article was prepared 05 February with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these stocks you should seek financial advice.

INVEST WITH MONTGOMERY

Stuart is the Portfolio Manager of The Montgomery [Private] Fund. Stuart joined Montgomery in 2015 after spending 19 years in research roles with JP Morgan in Australia and in New York. Stuart was appointed Executive Director at JP Morgan in 2005 and for 8 years was Deputy Head of Research. Prior to this he worked as an analyst in the Australian Equities team at Bankers Trust Asset Management for 3 years. Stuart is a CFA® charterholder.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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5 Comments

  1. Sensational stuff Stuart, I knew I’d learn more by the end of this discussion than at the beginning, and I did.

  2. The NAB Q1 results have been swamped by the fallout from the Royal Commission.

    So can you please help me with this, as either me or the market is missing something.

    CET1 Capital came in at 10.0%, Q1 last year, 10.2%. This time around, the ‘Expect to meet…’ line is missing as well.

    This should mean dividend cuts or capital raisings before the end of this year.

    Odds are I’m missing something.

    • Hi Phil,
      NAB is the most borderline of the major banks in terms of meeting the higher requirements of APRA’s unquestionably strong requirements by 1 Jan 2020. However, something to bear in mind regarding the 31 December 2018 CET1 ratio having fallen to 10.0% from 10.2%. The December quarter includes the payment of the final dividend from FY18. This dividend reflects the earnings and excess capital generation from the 6 months to 30 September. The 31 December 2018 CET1 ratio only benefits from 3 months of capital generation from earnings, so dividend paid was larger than the earnings generated and the amount of CET1 capital tends to fall in the first quarter of the financial year. In the March quarter, the CET1 capital base will benefit from another 3 months of earnings/capital generation, but there is no offsetting dividend payment, so the CET1 ratio will jump back up. The same pattern will occur in the third and fourth quarter due to the timing of the payment of the interim dividend.

      Having said this, NAB has the higher dividend payout ratio of the major banks. With new management coming in, along with board renewal, it is likely that the dividend policy will be one of the things that will be re-assessed.

      I hope this helps

      • Thanks for that, Stuart.

        I agree with you quarter by quarter.

        However my comparison was with Q1 last year, which also had the dividend payment in it.

        My forecast remains NAB dividend cuts or capital raising until I’m forced to change my opinion based on facts I’m currently overlooking.

        You heard it here first!

      • This is going to get a little complicated and I apologise for that. The mechanics behind the movement in the quarter reflect the movement in risk weighted assets and change in CET1 capital. This issue in comparing the 1Q18 CET1 ratio with the figure in 1Q19 is the movement in risk weighted assets. In 1Q18, risk weighted assets fell 1.44% relatively to 30 September 2017. This is why the CET1 ratio increased in 1Q18 to 10.2% despite CET1 capital remaining roughly flat over the quarter. In 1Q19, risk weighted assets increased 3.3% by the end of the quarter (relative to 30 September 2018). Net CET1 capital generation was actually better in 1Q19 than in 1Q18 with an increased of around 1.2% vs flat in the prior year.

        The question is why did risk weighted assets increase so significantly this year and why did they decline last year. The increase this year is function of loan book growth during the quarter (particularly in business lending), whereas as in 1Q18, the loan book was flat with business loan book shrinking by the end of the quarter. The risk within the book also fell with the average risk weighting declining last year.

        The improved growth in the loan book contributed around half of the increase in risk weighted assets in the current quarter. The other half was was to to an increase in the risk overlay applied to certain off balance sheet exposures (unspecified). So it was a bit of a reevaluation of risk in the business. Hopefully this is a one off step up in risk assets and won’t continue to grow and act as a drag on CET1 ratio improvement.

        If you look at the history of quarter CET1 ratio movements, 1Q18 was a bit of an anomaly in that is actually increased relative to the CET1 ratio at the end of 4Q17 (as previously discussed, the CET1 ratio normally declines in 1Q and 3Q each year because the of the timing of the dividend). This is a function of the reduction in risk weighted assets, which is unusual given we normally assume banks grow their loan book over time. So comparing the CET1 Ratio at the end of 1Q19 with the ratio at the end of 1Q18 is probably a bit misleading (I note the CET1 ratio was 9.5% at the end of 1Q17 having fallen from 9.8% at the end of the previous quarter).

        Having said all this, I agree that meeting the minimum 10.5% CET1 ratio requirement by this time next year will be very tight, particularly as management is flagging a delay in the sale of MLC to FY20. Given what is required is a one time step up in capital, a permanent reduction in the dividend payout ratio might not be required, rather it could be achieved through asset sales, reducing the risk in the loan book (mix shift) by exiting higher risk weight loans, a reduction in markets and interest rate risk on the bank book, or an equity raising (either by underwriting a DRP or increasing the discount, or undertaking a placement).

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