CBA's result is an ominous sign

Strip away all the write downs, fanfare and market reactions, and the Commonwealth Bank 2017-2018 results gives us our first peep at what banking is going to be like in the future.

That's assuming there is no serious deterioration of the current position. But, before I detail that, let me relate the experience of a property buyer being funded by one of the big four banks, because it graphically illustrates the credit squeeze currently in operation.

This person has a residential house with a mortgage and the property has been rising in value and looks like rising further, because it is in a regional growth area.

The person also bought two regional residential properties – one of which has income that covers interest plus other expenses and the other one is mildly negative. The loans were not “interest only”, so principal was being repaid.

Back in March/April bank officials said that there was plenty of borrowing capacity in the person's bank “loan bin” should the person want to buy another property.  At that stage a suitable one was not available. But now one has emerged, so our investor went back to the bank looking for the April loan offer to be repeated.

The banker's eyes narrowed and he shook his head vigorously. “No, a thousand times no!”, he thundered. Under today's rules the bank would not have funded the second investment property, and if my friend was to sell one of the investment properties the bank would not fund another property to replace it.

This experience is being duplicated around the land from all the major banks. We are looking at a massive tightening of housing credit, and that tightening has become more severe in recent months, which means that a wide range of residential property prices can't rise and are more likely to fall. There will always be pockets of good demand in selected areas.

In particular, I am noticing in Sydney that cheaper one-bedroom units are suddenly attracting demand. Properties that are selling between $600,000 and $800,000 can often be funded, but as the value rises it gets tougher and tougher unless you have very high income or substantial assets.

But in this credit squeeze most banks are concentrating on income levels rather than assets, which can be very frustrating.

Bank revenues on the decline

So, we come to the Commonwealth Bank and look at the second half-year, because that is when the squeeze started. In the current year the squeeze will be tighter and, of course, cover a full 12 months. In the second half-year the Commonwealth Bank's net interest income declined by 2 per cent; loan growth was subdued at 1 per cent and the net interest margin was lower. Costs rose 2 per cent, while impairment losses continue to be low.

Looked at a different way, retail banking revenue was down 3 per cent while institutional revenue was down 11 per cent. This is an underlining trend and it will apply to all the major banks. It doesn't mean the banks are going fall over, but their profit growth will be at best subdued and, if anything serious goes wrong, profits will fall.

The banks know they must invest in new technologies to lower their cost base, but they are also being forced to invest in all sorts of governance procedures to stop them from making mistakes.

I find it hard to believe that in this environment banks can increase dividends. Indeed, given the aggression coming from the Royal Commission and the regulators I thought it was provocative for the Commonwealth Bank to raise its dividend, albeit by a small amount. And there is also one other major event to take place. Both the Commonwealth and the NAB are going to exit their MLC and Colonial businesses respectively.

I think there will be some big book value losses in that area. The ANZ is making a similar move but has nowhere near the investment level, and Westpac is going to try and keep some of its wealth management operations, but I suspect the pressure from the Royal Commission means it too will exit.

So, we are going to have our big banks return to being banks again, but that comes at a time when they are being forced into a credit squeeze and being subjected to a level of government intervention not seen in recent times.

The ASIC “corporate cops” will be no push over and will seek information on a vast scale. All this will be a cost and the loan approval delays will add to the credit squeeze. The banks have made too many mistakes for the “corporate cops” to be push overs. And we are now talking about charging bank executives with criminal offences that carry jail terms. I fear this will create a panic that will add to the credit squeeze.  

Ill-fated forays into insurance

And when it comes to mistakes there has been none bigger than what has happened to the great life offices – AMP, Colonial and MLC. AMP is of course a separate public company; Colonial was bought by the Commonwealth Bank, and MLC by NAB. Each of these businesses had a series of fundamental flaws, that were not recognised.

The first is that they built their businesses on the basis of high commissions. Their armies of sales people are now called advisers or some other title, but their jobs had their origins in the old insurance sales people who enjoyed large commissions. In the days gone by those commissions didn't matter, because the premiums were tax deductible.

The rules changed and the three big life offices responded by moving their commission structures to fee-for-service operations. The trouble was that, in practice, they were still commissions because there wasn't much servicing being offered, so they were charging for the services not provided.

They were absolutely ripe for a Royal Commission to uncover all of this. It's true the model was being disbanded, but the three life offices were too slow in making the change and vulnerable to the Royal Commission, particularly as there had not been full disclosure. The existing fee structures will now be dismantled quickly, which will reduce revenue and cause substantial back payments.

Under the new rules, if an adviser gives bad or inappropriate advice, both the company that contracts the adviser and the adviser personally can be liable for the total loss. This means that the sales structure of these enterprises carries an extreme risk to the parent company. And, finally, the Royal Commission is not at all happy that products produced by AMP, Colonial and MLC are marketed by the captive advisers.

Just how this will pan out in the next year or two is hard to determine, but the big fall in AMP shares is a clear reflection that the market believes these enterprises are worth substantially less than they were a year ago. It is quite possible that they will be split up into various components.

Meanwhile, it is now clear that the decisions by Commonwealth Bank and NAB to buy these huge enterprises were simply wrong. They didn't have the skills to run them and they were inheriting a culture that in the current environment (as distinct from the past) is poisonous.