RC Poses More Questions For Financial Sector

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Rather than a set of recommendations, the interim report from the Financial Services Royal Commission has presented a list of questions for the financial sector, extending the period of uncertainty.

-Incentives for profit the main cause for concern of Hayne Royal Commission
-Debate likely to continue regarding the required level of separation in wealth management
-AMP likely to be the biggest loser from RC-instigated changes in wealth management
 

By Eva Brocklehurst

After the hue and cry of the proceedings, the interim report from the Royal Commission into Misconduct in Banking, Superannuation and Financial Services appears softer than many in the financial markets expected.

Commissioner Kenneth Hayne has presented questions for the financial sector for further discussion at later hearings, which extends the period of uncertainty over recommendations until the final report is delivered. The Commissioner has noted changes are already underway in the industry. Most of the major banks are in the process of reducing their footprint in wealth management.

Credit Suisse observes Westpac ((WBC)) will become the only major bank owning a platform and no bank will own an asset manager. ANZ Bank's ((ANZ)) exit of wealth management is the most advanced while Westpac has gradually reduced its holding in Pendal Group ((PDL)) over the last few years to around 10%, and plans to exit its remaining position at some point in the future.

Nevertheless, the interim report has highlighted major concerns around culture, incentives, conflicts of interest and regulation. The report covered consumer and small-medium enterprise lending as well as financial advice but did not cover insurance and superannuation.

Greed was the overriding issue, as incentives for profit were largely the cause of transgressions and regulators received blame for not pursuing transgressors more thoroughly.

Vertical Integration

Specifically, JPMorgan suggests the main risks lie with the Royal Commission requiring the financial services industry to prove why vertical integration should be allowed. The Commission noted that some clients have ended up paying higher platform fees because of a reduction in competition.

Furthermore, while banks may be leaving wealth management this does not necessarily reduce vertical integration, Credit Suisse points out. Two of the planned spin-offs – CFS, owned by Commonwealth Bank ((CBA)), and MLC, owned by National Australia Bank ((NAB)) – will operate across the value chain in advice, platform and asset management. From a technical point of view, these divestments do little to reduce vertical integration.

The Commission did not signal a desire for an outright ban on vertical integration and Credit Suisse suspects there will be continuing debates about the level of separation required in wealth management. If vertically integrated business models persist, costs are expected to rise. Dealer groups are also expected to provide greater choice of platform to advisers through less conflicted arrangements.

The broker believes IOOF ((IFL)) has an operating model which is an example of a less-conflicted vertically integrated model, where advisers can choose between platforms and use their own in-house platform. However, the company's advice practice is expected to face a new challenge, as price reductions from BT Panorama (Westpac) eliminate revenue share for dealer groups under the new pricing structures.

Grandfathering

The Commission also questions whether stronger probity tests are needed for advisers to move clients into aligned products, and grandfathered commissions and commissions on life insurance also came under scrutiny.

Credit Suisse observes the main impact of ceasing such commissions will be increased product switching, which could mean higher flows into contemporary products, and this could benefit Netwealth ((NWL)) and HUB24 ((HUB)).

Shaw and Partners considers the biggest loser is likely to be AMP ((AMP)) as its business model is based on vertical integration and grandfathered commissions, and allows for a substantial risk of conflicted advice.

The broker estimates, the sooner grandfathered commissions are terminated, the quicker the higher-margin wealth management products become lower-margin new products issued by another provider and, the sooner intermediaries are not allowed to sell AMP products, the less the company is worth.

All up, JPMorgan believes all wealth managers face significant risk until these questions are resolved and, while IOOF has not received the same attention as AMP during the hearings, this is not necessarily because there are no issues with its business.

Credit Suisse believes HUB24 will attract significant flows in coming years because of its superior offering and a shift to specialist platform providers, however, there is increased risk from broader price competition and greater scrutiny of superannuation fees. The broker has a Neutral rating on the stock but considers it offers better value than Netwealth (Underperform) as it trades on a similar multiple yet offers higher earnings growth.

While Netwealth is making the most of the opportunities from the disruption in the wealth management industry, the broker believes it is constrained by low rates of switching and increased competition.

Credit Suisse also increases Magellan Financial ((MFG)) estimates because of a strong performance in its funds over the September quarter, upgrading the stock to Outperform, with its conviction driven mostly by valuation and an opportunity for re-rating in the short term.

Regulation

The Commissioner is also asking whether there should be more adversarial action by regulators in response to financial misdemeanours. Shaw and Partners suspects the potential for further damage to banks is likely to come from a “wounded" Australian Securities and Investments Commission (ASIC) with a point to prove, while fines and penalties are likely to be higher.

The Commission also questions whether new laws would ignore the fact that most of the complaints it confronted involved transgressions of existing laws, and could be dealt with by firmer enforcement.

Bailieu Holst expects the outcome may be larger fines for misconduct, prosecutions and higher operating/compliance costs. While banks have already substantially modified their approach to lending Shaw and Partners also suggests executives may find an unwelcome adverse impact on remuneration.

There will be another hearing in November when submissions will be sought before the final report is released in February. A key issue is whether costs from a more adversarial process and zero tolerance for errors will be offset by better outcomes for consumers. JPMorgan suspects wealth stocks will not show any recovery until there is clarity on the final findings and government policy.

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