The Royal Commission Report: a new path for the Australian finance industry?

On Monday 4 February, the final report from the Royal Commission inquiry into misconduct in the Australian financial sector was published. It contained a scathing review of years of misconduct and of the failures by regulators to appropriately supervise and hold companies accountable. The report also provided 76 recommendations to fix these issues.

In this article, we briefly summarize the key points of the report, show how our ratings on the largest Australian financial entities have evolved over the past year, and look at the way forward.

The Hayne Report

Some of the key recommendations in the report by Justice Kenneth Hayne include the following:

• Changes in remuneration and reward practices, including revisions, caps and/or bans of certain types of commissions and fees – particularly for brokers and financial advisers;
• Higher consumer protection standards for insurance claims; better loan protections for farmers, particularly if affected by droughts or natural disasters; and safeguards for people living in remote or rural areas to access banking;
• Amendments to the Banking Executive Accountability Regime (BEAR) and the banking code of conduct, and the creation of a new disciplinary regime for financial advisers – with a view to increase integrity culture and individual accountability;
• Extra resources for regulators, who should focus on enforcement through court action rather than on infringement notices and enforceable undertakings; and the creation of a new independent authority to oversee and assess the two key financial regulators, ASIC and APRA.

Many expected, and some had hoped, that the final report would demand a more radical overhaul of the country’s banking, superannuation and financial advice industries, and a structural revision of the regulators’ powers and functions. But the commissioner stopped short of this.

Some of the criticism relates to:

• The reliance on regulators, who previously failed to adequately supervise and sanction misconduct, to fix the issues;
• Not imposing a break up of vertical integration, particularly for banks – although pressure to reduce conflicts of interest remains;
• Not improving responsible lending requirements to assess borrowers’ suitability, and not expanding these requirements to other sectors of the economy, particularly for small businesses;
• Concerns that changes to a borrower-pays system for mortgage brokers may consolidate the market position and pricing power of the Big Four banks, thus stifling competition.

Nonetheless, others have welcomed the softer approach on banks amid fears that forced restructuring might have been too costly and disruptive, and that tightening of standards might have led to a credit crunch. Given the limited duration and scope of the inquiry, it is no surprise that the recommendations are limited and that more work is needed. Either way, it’s clear it would have been difficult for the commissioner to address all expectations given stakeholders varied interests.

Sustainalytics’ ratings

Sustainalytics has closely followed the developments of the inquiry and our rating for Australian banks evolved over the past year as the inquiry unfolded. As noted in our May 2018 article, Sustainalytics’ Controversy Research had already observed patterns of involvement in incidents prior to the inquiry. We flagged significant levels of impact and risks with downgrades up to Category 3 (with Category 5 being the most egregious) and negative outlooks.

As shown in the graph below, in 2018 we tracked a record number of incidents in the Australian financial sector. While the increase in incidents is partly due to the widespread media coverage of the Royal Commission inquiry, it also reflects the significant public interest and the many instances of misconduct that were revealed.

Source: Sustainalytics Controversy Research

Note: incidents include business ethics, bribery and corruption, accounting and taxation, corporate governance, product/service quality and safety, anti-competitive practices, marketing practices.

Following up from our previous article, we also look at how our assessment of business ethics management has changed (see chart below). Scores deteriorated for all financial companies apart from ANZ and Macquarie, with significant gaps between current management standards and what Sustainalytics’ methodology considers best practice. The slight improvement for ANZ was attributable to the strengthening of anti-money laundering and anti-corruption requirements (unrelated to the commission proceedings), while Macquarie remained largely untouched by the inquiry. Meanwhile, we also noted fresh charges in August 2018 against ANZ for alleged cartel conduct in a 2015 share placement, and continuous scrutiny of Macquarie for its past participation in controversial cum-ex trades in Germany. Commonwealth Bank of Australia (CBA) and AMP had the biggest decrease in score, as we further downgraded their controversies to Category 4.

Source: Sustainalytics ESG Research & Ratings

Note: The Business Ethics Management Score aggregates underlying indicators such as: Bribery & Corruption Policy, Whistleblower Programmes, Money Laundering Policy and Political Involvement Policy, deducting companies’ involvement in controversies.

Leveraging our newly launched ESG Risk Rating framework, we also noted changes in our assessment of Australian financial institutions’ ESG risk exposure to material Business Ethics risks. In fact, our quantification of exposure to material Business Ethics risks for the sample above increased on average by 20% over the course of 2018.

The risks and concerns surrounding these companies are further confirmed by their ranking. Of the roughly 3,500 companies in our coverage for which business ethics issues are identified as material, the Big Four and AMP are among the 20% of issuers that face the highest unmanaged risks from Business Ethics.

What’s next?

The Royal Commission inquiry, together with falling house prices and broader market volatility, has resulted in billion-dollar losses in the market cap of ASX-listed financial companies. Shares regained some value the day after the report was released, to the relief of investors.

This relief, however, may only be temporary. Justice Hayne referred 24 companies to regulators for possible civil or criminal actions over their treatment of customers, specifically for the fee-for-no-service scandal (which we flagged to investors since the beginning of the inquiry). These include some of the biggest financial institutions such as CBA, AMP, NAB, ANZ and Suncorp.

In 2019 and beyond, we anticipate ongoing operational impacts as banks and wealth managers implement changes to products, processes and business practices and strengthen their compliance programmes and integrity culture. Regulators will heighten their scrutiny, oversight and enforcement actions – and have started doing so already. Some investors may want to engage closely with management to monitor developments and responses.

Combined legal, compensation and compliance costs for the sector are estimated by Macquarie to reach AUD 6 billion (USD 4.6 billion) over the next four years, more than double the current provisions of around AUD 2.6 billion (USD 1.9 billion). These costs will likely hurt bottom lines, but with over AUD 57 billion (USD 41 billion) in annual profits, it is not too much for the Australian finance industry to shoulder. Rebuilding and regaining trust will be a much harder process, but a necessary one for the industry to continue to serve its purpose and avoid repeating similar mistakes.