Banks escape the worst of Hayne pain
The Royal Commission's recommendations should have a minimal long-term impact for the banks, but prospects are more uncertain for wealth managers.
It was meant to be about the banks. It was their misdemeanours that stoked public fury and eventually led to the Royal Commission being established at the tail end of 2017. But in the end, they've got away almost scot-free - at least the institutions themselves, not so much their employees - and it's the wealth managers and mortgage brokers that will carry the can.
The fact is that the right laws are mostly already in place; they just need to be applied more rigorously. This may be one of the most lasting impacts of the Commission - fired up regulators looking for trouble. IOOF Holdings has already felt the wrath of APRA, in a manner that would have been unthinkable a year ago, and it won't be the last. But if the result is to restore public faith in the financial services industry, then Justice Hayne may have done it a favour.
No material impact for Big 4 banks
Wealth managers retain vertially integrated models ...
... but prospects uncertain
Tighter regulation isn't necessarily a problem for the individual companies. So long as it's a level-playing field, then the additional costs can be passed on to customers. And that's likely the other lasting impact - higher costs for consumers.
Still, fairness ought to be a given. At least that way you know where you stand and, as informed consumers, we can work on the costs from there. If fair services are too expensive to provide, then we'd rather do away with them entirely rather than be ripped off with unfair services.
Beyond shining a light on the worst (we hope) of the industry's excesses and giving regulators a kick up the backside, Justice Hayne's final report contained 76 detailed recommendations. All of them, bar one, have been adopted by the Government. More to the point, perhaps, all of them have been accepted by Labor.
Relief for Big 4
Some individuals may be referred for criminal prosecution, although Hayne did not identify potential culprits. Three of the major banks (excluding Westpac) may also face prosecution for the 'fee for no service' scandals. So they may be hit with some hefty fines to go along with their customer remediation (the bills for which may mount). But we're likely talking about a few billion dollars for banks with a combined equity of over $200bn - so the impact on value should be limited to a few per cent.
More important is their long-term competitive positioning, and here the impacts will be minimal - or even positive if the increased regulation serves to deter competition. Requiring borrowers to pay mortgage broking fees upfront will make life harder for smaller lenders that lack the majors' economies of scale and distribution clout. This is the one recommendation that the Government hasn't immediately adopted, so there's still some doubt over its implementation - although Labor has said it will support it. The report should also ease the concerns of debt providers, thereby reducing the banks' wholesale funding costs.
The recommendations for mortgage brokers also have grave implications for that industry, causing the share prices of Mortgage Choice and Australian Finance Group to fall by 25% and 34% respectively the day after the report was published. Given the uncertainties, we continue to have no investment interest in the sector.
So, the final report is mildly positive for the big banks - which is fortunate for them, because they're already fighting battles on many fronts, with lower growth, increased competition, higher regulatory burdens and the potential for technological disruption.
Fallouts and opportunities
The report may be benign for the sector, but Hayne's comment that he wasn't confident that 'the lessons of the past had been learned' by NAB chairman Ken Henry and chief executive Andrew Thorburn cost the pair their jobs (although Henry will stay on for the time being to help find a new chief executive).
This adds uncertainty for NAB, particularly as it comes in the middle of a tough cost-cutting program, but it should also help the bank rehabilitate its reputation.
No bank enhanced its reputation through the Royal Commission, but we'd argue that Westpac was the least damaged. There were doubts Westpac could keep its wealth management division. And there were also fears that its lending standards were weak.
Westpac can hold onto its wealth management businesses according to the final report, and its loans continue to perform well. Like much of the industry, Westpac uses a model - the Household Expense Measure (HEM) - to assess home loan sizes. It serves as an estimate where an applicant's expenses can't be accurately verified. Justice Hayne hasn't recommended stricter loan verification, although regulators have warned against overuse of the HEM.
After upgrading Westpac to Buy last October, its share price remains just below our $27 Buy price and we think it still provides a good opportunity to those who have low weightings in the sector. Note, however, that given the risks, we think that most members' should keep their weighting in the sector to 10% or below.
With the Royal Commission out of the way, attention now shifts to bank earnings. Commonwealth Bank's interim result pointed to a solid performance this year, albeit with little growth - which would be a good outcome given the risks posed by sharp falls in property prices and a slowing economy.
Westpac remains our only BUY recommendation among the banks, with a HOLD for Commonwealth Bank, NAB, and ANZ.
The Royal Commission has been more detrimental to AMP and IOOF Holdings, yet they have avoided the disaster scenario of being forced to break up their vertically integrated model - where they provide both product and advice. That model will now be subject to a review every five years, which sends a powerful message: they will need to be on their best behaviour.
They will also need to contend with a raft of changes, including greater disclosure of conflicts for advisers and stricter compliance standards. At the same time, grandfathered commissions will be banned from 2021.
Ironically, such changes reduce the attractions of the vertically integrated model as advisers will need to be more independent. That's less of a problem for IOOF where advisers have greater freedom to recommend external products and platforms.
In any case, the cost of providing advice will rise and business models will need to be refined. So we're keen to see what the new chief executives at AMP and IOOF (on an interim basis) have to say about strategy.
Rebuilding customer trust and handling potential class actions, customer remediation costs and court proceedings is a priority. The fear remains that many customers will walk away, though the fallout has been manageable to date.
That said, AMP recently downgraded earnings for 2018, and IOOF experienced net outflows (albeit minor) from its advice division in the six months to 31 December.
Wait for more detail
Relative to the banks, AMP and IOOF face a wider range of outcomes. These are riskier businesses than they once were and subject to greater competition such as from new platform providers, such as HUB24 and Netwealth.
IOOF's half-year result will be released on 19 February and we'll wait till then before considering any potential change to its recommendation or reinstituting its price guide. AVOID.
Likewise, for AMP. The company reports its full-year result on 14 February, and it'll be the first opportunity we get to hear from new chief executive Francesco De Ferrari. HOLD.
Note: Our Model Income Portfolio owns shares in CBA and Westpac.
Note: The Intelligent Investor Equity Income Fund owns shares in CBA and Westpac.
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