How to deal with a bank culture gone bad

Waiting for a royal commission isn't enough. John Addis explains how investors can protect themselves against shocks from Australia's big four banks.

‘Working in the bank is like living in a parallel universe. Within the four walls are posters of selected employees expressing how great and pleased they are working for the bank. You are constantly surrounded by images and sound bites of how the establishment supports positive cultures and attitudes and how customer service is the right ethos. All the while though in your everyday experience you come across victimisations, blame and yes, discriminations. If you should express any reservations about bank policy, you are marginalised. I guess I must be one of the bad apples.’*

Comment published in response to a Fairfax story, 7 May, 2016 (*Edited by author)

Nowhere is the culture of an organisation more important than in a big, systemically important bank. By definition, banks are highly leveraged. Unlike other businesses, which have many ways to fail, banks have only one.

Investors sniffing for clues of banks getting into trouble, as research director James Carlisle has been doing recently, watch impairment charges like a hawk. These are the debts the bank expects not to be repaid, and one theme of the recent results is that impairment charges for the Big four banks are increasing, largely due to write-offs of large corporate debts.

The figure is useful but not the whole story. In most businesses, errors come to light quickly. In a bank, they lie waiting on the sea floor, slowly gathering sand before darting to the surface in reporting season years later.

Bank loans to the likes of Dick Smith, McAleese and Arrium would have been written years ago. It’s possible – likely even - that the bank employee responsible for them has since moved on. Only now is that mistake being recognised. A bank’s internal culture – the way employees think about risk and the processes they follow to deal with it – is the best protection against bad debt problems.

Key Points

  • The sector would benefit from a royal commission

  • Worry about corporate bad debt more than mortgage debt

  • Three ways to manage the risk of poor bank risk management

It’s been two years since Commonwealth Bank’s financial planning scandal came to light (see The financial planning quagmire). Since then the bank has been accused of forcing BankWest customers into default, ignoring evidence of a $100m fraud by its own staff and, most recently, running an insurance business that systematically denies legitimate claims, even from customers on the verge of death, through shonky medical small print, file destruction and cherry-picked advice. It is now accused of sacking the senior medical staff member that bought the scandal to light. That’s quite a rap sheet for the ‘ethical bank’.

Profit first

A theme is emerging, a modus operandi in fact, that should have Commonwealth Bank shareholders concerned. The whistleblower at the centre of the Comminsure disgrace, Dr Benjamin Koh, says that the organisation puts ‘Profit first, everything else is second’. The issue is that the problems this attitude creates can take years to show up.

Commonwealth Bank chief executive Ian Narev denies the allegations, implicitly asking us to believe there is no pattern to these scandals, just a few bad apples (and a culture of sacking those that reveal who they are). The bank employee quoted above, and the three others that left similar comments on the Fairfax story, dispute this view, as does the Senate Inquiry into financial advice.

One of its many recommendations was to call for a Royal Commission into the sector. Two years later, Senator Mark Bishop, who sat on the committee said: ‘The financial misdemeanours are so numerous, the attitude of the banks so entrenched, the complainants have been so wronged. The only solution that will ensure financial justice is an independent, arm's length public examination of the whole banking saga.’

This would be a good outcome for everyone. As we saw during the GFC, the direct costs of bank failure are socialised. So is the personal cost of bank misbehavior, through higher healthcare charges, legal expenses and family breakdown. We all have a vested interest in a stable, risk averse banking sector.

Bank shareholders would also benefit. A Royal Commission could seek evidence of a bank’s internal culture that would not otherwise be exposed. Should it support Narev’s contention of a few bad apples, shareholders could rest easy. With greater confidence in the bank’s ability to avoid expensive scandals of the kind that have cost US and UK banks billions, a Royal Commission might salvage the banks’ tarnished reputations.

If, however, the evidence supported Dr Koh’s view, pressure on the banks to address problematic corporate culture would be irresistible. This, too, would be useful, even to banks. Changing corporate culture is notoriously difficult. The public exposure of further wrongdoing would make positive change more likely. Whilst the findings from a Royal Commission might further tarnish the banks in the short term, the action stemming from them could prevent further scandals.

If everyone’s a winner, why have the banks fought so hard against the recommendations? Good question, as is the one about the effect of generous political donations by the banks over the past few years.

Soft option

Unless Labor wins the forthcoming election a Royal Commission is now off the table. Instead, the Government is restoring the ASIC funding it cut in the 2014 budget to ensure ASIC remains ‘a tough cop on the beat’. Please, no giggling up the back. In a kind of next level Stockholm Syndrome, additional ASIC staff charged with policing the banks will be indirectly paid by them, via a special levy. Yeah, that’ll work.

Yesterday, Commonwealth Bank closed at $77.99, down 19% from its high of $95.80 in March last year. With a Buy price of $70, another 10% or so might see CBA join our Buy List. The same goes for our other preferred pick in the sector, Westpac. And indeed our Equity Income Portfolio recently topped up its holdings in each just above those Buy prices (although its weighting to the sector, at around 5%, remains well below our recommended maximum of 20% and the market’s weighting of around 25%).

Where does this leave members with bank shareholdings, especially those ruminating on a series of scandals that suggest banks might be accumulating future bad debts in the course of chasing short-term profit, at the expense of reputation, culture and risk management?

Without the cleansing light of a Royal Commission, we can only wonder whether the bodies exist and, if so, where they are buried. Senior management might tell CBA staff to ‘play nice’ but in a contest between heart-warming posters of satisfied customers and a bonus culture that implicitly encourages staff to stiff the client, I know which horse I’d back.

Investors are left with only one course of action. If banks are potentially sacrificing risk management and reputation for short-term profit, then the task of risk management falls to us.


We’re addressing the issue in three ways. First, our recommendation guides factor in far higher levels of bad debt. Impairments have been at all-time lows over the past few years, but our valuations are based on historical averages, around double their level in the first half, which had already seen a sharp jump for all but NAB. That offers some protection against a bad outcome.

So too does overall bank profitability and their apparent ability to escape almost any misdemeanour unscathed. A billion dollar fine might cause Commonwealth Bank some damage but, if recent history is any guide, the bank will determine the compensation it pays and fund the lawyers representing wronged clients. In the unlikely event ASIC finds some balls, the bank could withstand the fines, even those of a few billion.

Second, our favoured stocks in the sector dominate the home lending markets. That, too, offers some protection. It is usually corporate rather than mortgage debt that causes the big problems. By watching impairment charges closely and leaning towards CBA and Westpac, we’re reducing our exposure to bad corporate debt pushing impairments above the already high level embedded in our valuations. This doesn’t eliminate risk entirely but it does reduce it.

And finally, that old chestnut: Keep your overall exposure to the big four banks down to no more than 20% of your portfolio – or half that for more conservative investors. Despite the veneer or financial security that the banks display to the world, these are risky investments.

None of this is to say we’re predicting a bank failure, only to remind you that banking is cyclical and that risks need to be managed. Even if Ian Narev hasn’t fully comprehended that message, bank investors should.

Note: The Intelligent Investor Equity Income Portfolio owns shares in Westpac and Commonwealth Bank. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

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