Royal Commission Report puts governance in the spotlight
Governance failings aired during the Royal Commission give us many lessons for assessing governance risks in the future, and also long-term opportunities.
The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry gives us many lessons for assessing governance risks in the future.
The final report is, in our view, balanced and supportive of businesses adapting and reorientating, without a dramatic change to the industry structure.
A positive market reaction confirmed our view that the market was assuming an adverse outcome, and the report also removes some uncertainty about remediation costs, business models and additional regulations which hung over holdings in our Australian equity portfolios (IOOF, AMP and the ‘Big Four’ banks NAB, Commonwealth Bank, Westpac and ANZ).
However, the financial services industry is not yet out of the woods, and the final report has highlighted the importance of governance analysis, as well as understanding which companies can adapt swiftly.
Here are what we view as the long-term opportunities and lessons we’ve learned from governance failings aired during the hearings.
Impact on the banks relatively modest
When the Royal Commission was announced in late 2017, we were underweight the Australian banks in both our Australian income and accumulation strategies. We were concerned about a slowdown in lending growth (due to restrictions on investor loans and tighter overall lending standards).
Both the hearings and final report confirmed heightened risk around culture, accountability and misconduct disclosures. Conduct penalties are likely to continue, however much had already been identified, and the amounts applied are likely to be manageable versus capital. Therefore, the direct impact of the final report on the banks, beyond more regulation and compliance, has been relatively modest.
Opportunities in streamlining costs
Changes to how mortgage brokers receive commissions is likely to benefit banks, but we already expect major banks will continue to be the dominant lenders for housing loans.
Conversely, a slowdown in housing credit is now ‘baked in’, as adaptation to existing responsible-lending laws flows through, and banks respond with heightened price competition.
Banks which can avoid major restructuring, move swiftly through remediation and focus on streamlining costs, should be best placed. This will be in a world of slower credit and fewer business line opportunities, as banks follow self-imposed divestment processes. ANZ remains a beneficiary, due to its early focus on costs.
Wealth management injured, but business models can adapt
Both our income and accumulation strategies have been impacted by their positioning in the wealth management sector over the past year.
We underestimated the degree of governance issues to be aired during the Royal Commission and subsequent business disruption, although the recommendation that vertical integration of platforms, advice and manufacturing would not be outlawed, was consistent with our view.
The recommendations for the wealth management industry allow IOOF and AMP’s business models to be reshaped, and their service offerings and digital platforms can be strengthened to ensure high standards of compliance and oversight. This should lead to better outcomes for customers and the organisations which provide advice.
We view the change in ‘tone at the top’ of IOOF, together with swift action on repairing its relationship with Australian Prudential Regulation Authority (APRA) and building a compliance-administration function fit for purpose as positive steps.
The recommendations will mean compliance costs will rise across all parts of the industry, so the scale of a business like IOOF will allow the company to adapt to these new demands, and in turn support advisors to change. While challenging to implement, the new expectations and requirements should be manageable.
Opportunity to strengthen value proposition
Despite short-term negative sentiment, there is opportunity for a stronger financial-advice proposition. IOOF has reiterated its commitment to advice despite its problems, noting the closer to the customer, the greater its ability to earn attractive margins. With major banks exiting advice, at some point this will be a competitive advantage.
Governance in the spotlight
The Royal Commission raised many questions from clients about how fund investors should measure and assess the ethics and culture of Australian financial institutions. There were governance issues that we (and other investors) were not aware of in the lead up to the Royal Commission, together with markers that could have been better identified.
Our main lesson through all of this has been the need for even greater proprietary governance analysis and decisive action.
Importance of engagement
Regular engagement with the boards of companies involved throughout the Royal Commission has helped us understand to what extent companies have identified material governance risks and how they are managing these – so that they do not impact future earnings and their plans for improvements. Our engagement can extend to lobbying for significant governance change; as we stated in the public domain regarding IOOF.
At the same time, we have built out an improved internal Governance Assessment rating framework, that should help us better identify the type of oversight failings which have surfaced (see our paper Six ways to assess if a board is competent and on our side for more detail).
The next steps
We need to factor any future implications to earnings into our Valuation and Quality measures, not just penalties for past transgressions.
While there will still be some significant conduct cases for Australian Securities and Investments Commission (ASIC) and APRA to investigate, as well as other potential legal action, these should not be unexpected and will be factored into share prices by investors.
Significant effort and focus by the key players in the wealth and banking industries is required and the pace of change in culture is going to be most important. On this score, a path has been set for IOOF to re-establish trust and regulatory support, build a leading-edge compliance framework, leverage scale and still find a viable business model to extract economic profits across the value chain in a backdrop of substantial demand and need for advice.
We will continue to actively engage with companies involved to ensure ongoing progress is achieved.
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were or will prove to be profitable
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The information contained in this presentation has been compiled with considerable care to ensure its accuracy. But no representation or warranty, express or implied, is made to its accuracy or completeness. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not
be assumed that any of the security transactions discussed here were or will prove to be profitable.
Martin Currie has procured any research or analysis contained in this presentation for its own use. It is provided to you only incidentally, and any opinions expressed are subject to change without notice. The opinions contained in this document are those of the named manager(s). They may not necessarily represent the views of other Martin Currie managers, strategies or funds. Please note the information within this report has been produced internally using unaudited data and has not been independently verified. Whilst every effort has been made to ensure its accuracy, no guarantee can be given.