Feature Stories | Dec 14 2017
This article was first published for subscribers on December 6 and is now open for general readership.
A Royal Commission is a clear negative for Australian banks but “lesser of the evils” positives dull the impact and bank valuations have already been de-rated.
– Scope and time frame limited
– Cost to banks unknown
– Valuations already de-rated
– CBA loses its premium
By Greg Peel
At first, the Coalition government dismissed the notion put up by Labor that, given a string of indiscretions, a Royal Commission should be held into the Australian banking industry. The government had a strong argument – the banks had already been subjected to multiple reviews post-GFC and many were still ongoing. What more could a Royal Commission achieve?
Indeed, as at present day, no less than 51 substantial reviews, investigations and inquires have been launched since the financial crisis and 12 of those are still ongoing.
But when the Coalition began to sink in the polls, it was decided a bank levy would sooth the baying mob. Then along came Commonwealth Bank’s ((CBA)) Austrac fiasco.
As infighting and policy stagnation further eroded the Coalition’s popularity, Labor’s call for a Royal Commission helped the Opposition to a clear lead in the polls. When toppling Abbott, Turnbull had pointed to the run of negative polls. Those had come back to haunt the prime minister. Furthermore, Nationals senators were now threatening to cross the floor should Labor propose the right bill.
Turnbull announced a government inquiry, hoping this would head off the floor-crossing threat, and again appease the baying masses. All along, Turnbull likely assumed the banks would be thankful for his persistence in trying to avoid a full-on Royal Commission. If so, he was wrong.
The four banks wrote a collective letter to the Treasurer asking for “the government to act to ensure a properly constituted inquiry into the financial services sector is established to put an end to the uncertainty and restore trust, respect and confidence”. At least Turnbull had an excuse for his about-face in announcing the Royal Commission – the banks themselves had requested one.
The Commission is expected to cost Australian tax payers $75m. Estimates vary on just how much it is going to cost the banks to comply with the Commission’s requests.
Bell Potter suggests a “conservative” $150m per major. UBS suggests $50-100m. Citi offers $1.0-1.25bn in total for all of the majors, Macquarie Group ((MQG)) and the two regionals Bank of Queensland ((BOQ)) and Bendigo & Adelaide Bank ((BEN)).
Whatever the number ends up being, there is no argument there will be a cost. But as Bell Potter points out, $150m represents roughly 1% of major bank profit forecasts for 2018. “A small price to pay for sector confidence and the privilege of holding a bank licence”.
The next problem is that the Commission’s scope of inquiry includes not just commercial banking but super funds (ex-SMSF), wealth managers, insurers and non-bank lenders as well. Those banks who have already divested of their insurance and/or wealth management businesses will be feeling relieved they have done so. Those banks yet to move, if that is their intention, will likely have to postpone until the Commission is completed.
Who would buy with such a sword dangling overhead?
Another issue is one of simple distraction. In recent times the banks have variously been restructuring, upgrading systems, instigating cost-cutting programs and so forth. The Commission will require a great deal of attention from bank executives, constraining their capacity to pursue other agendas.
The big uncertainty is, of course, what will the Commission find? And having so found, what will be the cost to the banks in related fines or other penalties, compensation and possible class actions stemming from such findings, and possible constraints on the way banks can operate going forward?
These questions cannot be answered ahead of time.
The first positive has already been demonstrated by the banks themselves. Good or bad, the Commission will end the uncertainty. At least the banks will know where they stand, as will bank investors.
The second, major, positive is that the Commission has been called by the Coalition government and thus the government will lay down the terms of reference. While the scope is broad given all of banking, wealth management, and insurance is included, it does not include vertical integration (that a bank should be able to own wealth management/insurance etc businesses at all), the taxpayer guarantee (by the government of deposits with banks up to a certain amount) executive remuneration, and the industry regulators to boot, as Labor has called for.
The actual terms of reference are yet to be announced, but the government has assured there won’t be any overlap with current ongoing inquires. Vertical integration is currently being investigated by the Productivity Commission. Austrac is investigating CBA with regard money laundering and ASIC with regard corporate governance, while ASIC is also running the inquiry into BBSW rigging.
The government intends for the Commission to “consider misconduct and any conduct falling below community standards and expectations. Issues such as culture, governance and remuneration will be considered insofar as they were the causes of this misconduct”.
The third significant positive is that the Commission only has one year – beginning from its establishment next February, with an interim report to be presented in September. This is a short timeframe for a Royal Commission – some of them go on and on for years – and it is in the banks’ favour if the Commissioner does not have the time to turn over every single rock. It also means only one year of uncertainty.
The main risk is that the Commission finds more skeletons in the cupboard than are already known, and bank managements were also unaware of, otherwise why would they call for a Commission themselves? CBA supposedly did not know criminals and terrorists were using their ATMs.
There is a risk the ultimate cost of any reparations, from fines to compensation, is far greater than anyone fears. But analysts are in the difficult position of having to ascribe a value to a completely unforecastable outcome.
There is a risk Labor wins the next federal election. However, the next election must be held for the Senate before May 2019 and the Commission’s findings are due February 2019. Would Labor instigate another Royal Commission to cover the much wider scope it would like to see investigated?
The bigger risk is that an early election is forced one way or another, perhaps if the Coalition loses its majority, or called by the prime minister ahead of a string of state elections late next year and early 2019. On current polls Labor would win, and do so before the Commission’s cut-off date.
Royal Commissions aside, Labor policies include limiting negative gearing, reducing capital gains tax relief, limiting family trusts and raising personal tax rates, all of which would be negative for the banks.
Bank analysts suggest the bulk of the risk of a Royal Commission was already being priced in by the market before the Commission was confirmed. And share prices have done nothing but fall ever since.
Sector valuation is not as low as seen in the two troughs this year – June and September – but headed back in that direction. It’s been a choppy ride.
One the one hand Australian banks have tried to follow US banks up on expectations of higher interest rates, they have benefitted from mortgage repricing, and there was relief when APRA’s “unquestionably strong” capital requirements provided no need for capital raisings. But on the other hand, tighter lending restrictions, the bank levy, Austrac, and now the Royal Commission have kept knocking the banks back down every time they try to get up.
The best bank analysts can offer at this stage, given the unknowns, is that downside should be limited by both the de-rating process that has already occurred and by the positives as listed above regarding the terms of reference and time frame of the inquiry, as noted above.
And in their darkest hour, bank share prices still tend to find a bottom when yields exceed 6% (before full franking).
Losers and Losers
Given the Royal Commission has been called to appease the baying mob, Macquarie believes the predominate focus will be on consumer and small business customers and relevant offerings. While all banks are losers in this context, ANZ Bank ((ANZ)) may be a relative beneficiary given its overweight position in institutional business.
Credit Suisse suggests the Coalition-led Commission could be incrementally more negative for banks with an agri-business skew, being National Bank ((NAB)) followed by ANZ in the majors, along with Bendelaide and Suncorp ((SUN)).
Were Labor to be leading the Commission, it would be incrementally more negative for banks with a wealth skew, being Westpac ((WBC)).
But it’s all speculation. Understandably, analysts have not made major changes to their valuations or recommendations as a result of the Commission announcement. Since FNArena's last bank update, post the November result season, The ratio of Buy/Hold/Sell recommendations amongst the eight stockbrokers in the FNArena database has shifted to 9/20/3 from 10/18/4. Back then the Big Four share prices added up to $172.26, as of yesterday's close it was $167.89. The consensus target price sum has fallen to $172.68 from $174.98.
The Trouble with CBA
For so many years, CBA was afforded a premium by the market over the other three majors. Size was one issue, but while ANZ and NAB are indeed smaller the gap to Westpac ((WBC)) is much narrower, yet still a premium was applied.
For so many years, bank analysts have called that premium unjustifiable in its extent. For so many years, it has made no difference.
But things have changed. While all the majors have been caught up in some scandal or another over the years, with recent alleged BBSW collusion involving all four, no bank has been found to have as many skeletons in the cupboard than CBA. This year the bank’s CEO was forced to resign. ASIC is now investigating the bank’s culture and governance. There’s little doubt the Austrac revelations were the straw that broke the camel’s back and got us to where we are now – with a Royal Commission.
The cost to CBA of any penalties associated with Austrac is yet to be known. But the impact on sentiment towards the bank is obvious. The premium has been eroded.
Skeletons aside, Morgan Stanley suggests CBA’s consistent strategy and execution have been key reasons for the premium rating but now the bank faces a period of uncertainty. A survey conducted by Morgan Stanley suggests CBA customers with a higher level of savings are more likely to switch banks, and are less likely to recommend CBA following the Austrac affair.
At the same time, notes the broker, political and regulatory scrutiny is likely to weigh on returns in retail banking.
Crunching actual numbers, Morgan Stanley points out that CBA’s earnings growth has exceeded the other majors since FY07, but below-peer growth is now expected over the next few years as the mortgage bull market ends. The bank has enjoyed a return on net tangible asset gap to peers, but that is also narrowing, and an increase in mortgage risk weights looks likely to weigh on future capital generation.
CBA once boasted a balance sheet and business mix advantage, but that has narrowed. Morgan Stanley notes CBA’s capital position is around peer average, and analysis of lending exposures suggests the bank is no less vulnerable to an increase in loan loss rates (bad debts) than Westpac or NAB.
CBA still holds a funding advantage, but the difference is far less significant than it was a decade ago, the broker notes.
Finally, CBA continues to have a greater skew to retail shareholders than the other majors (which would be a result of privatisation and suggests more “bottom draw” long term investors than institutions that reweight portfolios regularly), but that difference has decreased to around 8% from around 14% in 2007.
The bottom line is Morgan Stanley has identified, through extensive analysis, four points of difference that once justified CBA’s PE premium but no longer hold water, or at least are heading back in the wrong direction: franchise strength, stronger growth, higher returns and excess capital; stronger balance sheet and lower risk profile; tighter share register.
No surprise Morgan Stanley has an Underweight rating on CBA. Currently MS is the only broker in the FNArena database to have a Sell or equivalent rating, but as the table above shows, no broker is prepared to rate the bank a Buy. A total of nine Buy ratings are afforded the other three banks from eight brokers.
At $71.00, MS also offers the lowest target price compared to a consensus $78.59. Next lowest is Credit Suisse (Neutral) on $75.00, while Deutsche Bank and UBS both suggest $83.00 but both have Hold ratings.
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