Royal Commission's interim report stokes investor fears
Buying opportunities remain as investors wait for the Royal Commission's recommendations
We'll have to wait till February 2019 for the Financial Services Royal Commission's (RC) proposals with Friday's interim report providing more questions than answers.
In the meantime, investors appear to be filling in the blanks with a list of worries. After a brief flurry following the interim report's publication, share prices in the banking and wealth management sectors have resumed their recent falls.
Large fines and compensation look certain; but, as long-term investors, we're more concerned about likely changes to industry profitability and structures.
It seems likely, for example, that banks will be forced to tighten up on their lending standards. This has the potential to reduce lending growth, while increasing costs as banks are required to look at affordability on an individual basis rather than relying on standardised templates.
In recent years, for example, the banks have been relying heavily on the Household Expenditure Measure (HEM) as a benchmark for affordability in lieu of individual expense verification. There are obvious drawbacks with this in terms of accuracy, but the HEM also tends to understate actual expenses. So a shift back towards individual assessment is likely to reduce loan amounts as well as increase costs.
That would have a direct impact on banks' profitability, but there may also be second order effects if tighter lending standards exacerbate an already fragile housing market. We'll be watching closely.
The risk of significant structural change appears greater for the wealth management industry than for the banks. In particular, the Royal Commission has highlighted the conflicts of interest within vertically integrated structures, where the same company provides investment products and advice about those products.
AMP and IOOF Holdings use this type of model, as do the wealth divisions of the major banks (although, with the exception of Westpac, they've already made the decision to sell their wealth businesses).
The Royal Commission seems certain (we would hope) to recommend much tighter regulation of these structures, but it's possible that it will recommend banning them entirely.
Such a move would reduce these businesses' ability to distribute their investment products, and thereby reduce their value - particularly the ones (like AMP) that rely most heavily on their advisers as a distribution channel.
However, we think an outright ban remains unlikely. There are good reasons to have advisers owned by large groups: it provides economies of scale to help with structures around education and compliance, reduces the number of entities for regulators to supervise and gives someone to sue when things go wrong.
Yet the risk remains, investors are nervous and share prices are down.
Such conditions can provide compelling opportunities. With hindsight we were too early to upgrade IOOF to Buy in April, but the value on offer is more compelling at current levels. The company is well managed, has a good track record and the acquisition of ANZ's wealth management division should be very positive in the long run.
All that has been overshadowed by a poor showing in August at the Royal Commission's fifth round of hearings on superannuation. The Commission's interim report only covers the first four rounds of hearings, so IOOF didn't get a mention and investors are nervous about what may appear in the final report. However, IOOF's transgressions appear to be a far cry from those of AMP and the major banks and it has mounted a strong defence.
No doubt there has been widespread wrongdoing in the industry and it's good to see the Royal Commission rooting it out. We hope and expect tighter regulation to come from it. But at the same time the economy needs strong banks and it needs a wealth management industry to direct our savings to suitable investments. We're keeping our eyes open for further opportunities.
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