Triple threat

Perspectives

Triple threat

Banking and digital disruption 

The banks' easy run is being hit by issues of trust, regulation and digital disruption. And the potential loss of the triple A isn't helping either, writes James Eyers, Financial Services Editor, Australian Financial Review. Republished from 2 May 2015 with kind permission of the Australian Financial Review.

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The profit-generating engines of Australia's banking oligopoly have been powering them forward like a fleet of destroyers. Competitors have been left in their wake as the big banks' guns have fired fully franked dividends to millions of shareholders.

The waves of the global financial crisis merely lapped their bows. Benign economic conditions have kept local seas calm, low unemployment has sent bad debts to record lows, buoying bank profit, and market concentration and high levels of household debt have led to world-class returns on equity, propelling bank equities higher. 

But the oceans are becoming increasingly choppy for the banking fleet "There are a lot of things in the world that are at extremes," Wayne Byres, the chairman of the Australian Prudential Regulation Authority, told The Australian Financial Review's Banking and Wealth Summit in Sydney this week. 

"Interest rates are at historic lows, commodity prices are moving from record levels to falling sharply, household debt is very high, house prices are very high and underlying economic conditions are subdued at the very least".

Financial System Inquiry chairman David Murray, Goldman Sachs and Deutsche Bank warned this week that Australia's prized AAA credit rating looked vulnerable as the federal budget deficit blows out. And if it comes to pass and the Commonwealth rating is downgraded, the cost of personal and business loans would rise across the economy.

"Significant deterioration in the fiscal position as a result of a financial crisis would be expected to threaten this [sovereign] rating," Murray said in his final report to the government "A reduction in government's credit rating is likely to lead to the banks' credit ratings being downgraded, increasing funding costs."

These threatening, dark economic clouds are gathering at the same time as several icebergs are forming in front of the banking ships. Three are looking particularly dangerous: the spectre of regulatory intervention to push banks to hold more capital; the loss of customer trust over financial planning scandals; and the threat of digital disruption from technology giants such as Google and Apple, and fintech start-ups.

And in surprise admissions at the Financial Review banking and Wealth summit the captains of the banks said they were no longer confident they would be able to crash through the obstacles ahead. Commonwealth Bank chief executive Ian Narev summed up the feeling when speaking about digital disruption: "How's it all going to play out? I can answer that question pretty quickly, which is, I don't know."

On the bridge, senior bank executives are nervously watching their radar screens and urgently determining a new course to navigate these threats that have bobbed to the surface. Investors are also fretting that the icebergs might inflict damage and cause the big banks to take on water. 

There has been an almost 20 per cent run-up in bank shares between January and March. But surging share prices also reflect the extraordinary conditions in global financial markets, where the unprecedented printing of money by central banks to buy bonds has depressed interest rates to stimulate their economies.

"Yields are incredibly low - not just the lowest in living memory but in all likelihood the lowest ever in human history, as far as we can tell," Reserve Bank of Australia governor Glenn Stevens told the summit on Tuesday. But by depressing fixed-income returns central banks have forced investors to search for higher-yielding investments to provide returns - and the shares of Australian banks, which pay about 70 per cent of their profits in dividends, have been lapped up as a result.

With Westpac Banking Corp, ANZ Banking Group, National Australia Bank and Macquarie Group reporting their half-year profits next week, investors are asking how long can the banking purple patch continue?

This week there was an indication it would not Bank stocks sank by about 5 per cent wiping about $20 billion off the value of the big four. The reason was the first big iceberg: the likelihood that APRA will force the big banks and Macquarie to carry more equity capital against their mortgage loans. The move would hit returns on mortgages.

Byres told the summit the regulator would act "sooner rather than later" on this and his remarks were partly to blame for the huge bank sell-off. Macquarie analyst Mike Wiblin, who was at the summit said tighter requirements would mean the big four banks would have to raise an additional $10.6 billion to $17.8 billion of capital.

If the banks are not able to pass the costs of this capital on to borrowers or depositors, which will be difficult given the competitive environment, the banks' return on equity would be cut by 2 to 3 percentage points, he said.

Wiblin also said the regulator would give a "wrist slap" to NAB, Westpac and ANZ, after credit statistics on Thursday showed each bank was increasing its lending to investors by more than the 10 per cent that APRA says is prudent to limit risks, given the frothy housing markets in Sydney and Melbourne. Any additional APRA macroprudential action could come in the form of a capital penalty, Byres told the House of Representatives economic committee last month. 

The second iceberg looming in front of the big banks is the deficit of trust created by failures in their wealth management divifax Media's Adele Ferguson and subsequent parliamentary reports. These showed bank advisers putting their financial interests ahead of their customers'.

Stevens, Byres and Assistant Treasurer Josh Frydenberg all said at the summit the cultures inside Australia's banks had been called out by these high-profile scandals. "There has been a crisis of confidence by the general public in the financial planning sector, and that has a flow-on effect from the advice and product failures we have seen recently," Frydenberg said.

Stevens said: "The root causes seem to include the distorted incentives, coupled with an erosion of the culture that placed great store on acting in a trustworthy way."

The banks say they have learnt their lesson and are working hard to rebuild consumer Trust.

"As major providers of financial advice services, banks have a responsibility to lead by example and ensure improvements happen," Australian Bankers' Association chief executive Steven Munchenberg said. "We know that to rebuild trust and confidence we have to meet consumers' expectations when they sit down opposite a financial adviser to discuss their immediate financial needs and plan their future."

It remains to be seen if the banks' efforts will work. Many disgruntled consumers are still waiting for compensation from the big banks for the poor advice they received. 

The third iceberg is perhaps the hardest for the banks because it is moving so fast digital disruption.

Computer power continued to grow at exponential rates, and just like the media industry before it, financial services were facing a technological tsunami now that was threatening to disintermediate their most profitable lines of business, Deloitte's Larry Keeley and Katherine Milesi said at the summit.

CBA's Narev outlined the dangers: "One of the challenges about managing through this environment is there are an inordinate number of people who want to tell you how the world is going to play out They exude a great deal of confidence. Some of them are going to be right. The problem is we don't know which ones are going to be right.

"We can't predict. We have to manage." Westpac-owned St George Bank's chief executive George Frazis told the summit it was near impossible to predict how the digital revolution would play out but it was human nature to underestimate the scale of the change and how quickly it arrived.

"What has made banking successful is trust," he said. "Now that is being challenged. Another is assessment of risk. That is also being challenged by big data.

 "It’s the Googles and the Apples that we have to watch closely."

Google Wallet and Apple Pay allow users to pay for things in stores and online through applications without using cards, using existing bank data. But analysts say these innovations could represent the start of both companies using their massive balance sheets to move into banking.

Narev has identified the global tech giants as serious competitive threats. He said on Tuesday that the new digital economy would challenge banks and their regulators because competitive responses needed to be faster, and some would inevitably fail.

"This is not an environment you can spend years building things and make them perfect" he said.

"Rather, you have to experiment and either scale up or cull. This is a big challenge for financial institutions and regulators because you have to ask, what is the level of failure we are willing to tolerate?"

Customers were increasingly demanding from their banks the same sort of online experience they had come to expect from tech brands, Bank of Queensland chief executive Jon Sutton told the summit. “If it is Google, it is 24/7, no matter where you are in the world, so long as you can connect to the internet" he said.

"As banks think about their future, they absolutely have to be open to an open architecture to deal with customers. Any banks that choose not to be multi-channel, and not to keep up with the various avenues of distribution, will do so at their own peril. In a smaller bank like ours, it is about being nimble and partnering up with tech firms that can do different things, so you get that customer intimacy."

Banks potentially face competition in the future from the big retailers - a dynamic that has emerged in Britain - given their strong brands and large numbers of customers.

The Australian Securities and Investments Commission also confirmed this week that it would help fintech start-ups to potentially disrupt the banks and enhance the customer experience.

Digital disruption offers new forms of access to greater competition and greater efficiency and it provides business with new ways of creating and sharing value with customers," ASIC chairman Greg Medcraft said.

Of course, the realisation of the need to adapt could mean that none of the above icebergs will be big enough to sink the banking ships.

On capital, analysts suggest APRA will provide long timeframes to meet any additional impost which could allow them to be met by organic capital generation or through the use of dividend reinvestment plans, obviating the need to conduct equity raisings.

On advice, the banks are working with Frydenberg and regulators to-lift standards through better adviser education that might restore trust. 

On technology, the banks might acquire start-up disrupters and form partnerships with the tech giants to enhance customer experience and stave off the threat.

But there's no doubt the banks are no longer charging full steam ahead, oblivious to the fact that their world has changed.

Narev said CBA management was focused on how the bank could become adaptable. Customer-centred design "is one capability we need to build as if we are a 21st century technology company, not a 20th century financial institution".

The CBA chief also highlighted perhaps the biggest advantage the big banks have over potential rivals: on the high seas of finance, they are the massive passenger liners, while start-ups are tiny runabouts.

"One of the classic dilemmas of a start-up is how do we attract the customers? But we have 15 million of them. So we start with a big advantage."

One of the classic dilemmas of a start-up is how do we attract the customers?
Lan Narev, CBA

How's it all going to play out? I can answer that pretty quickly: I don't know.
Ian Narev, CBA chief executive

There has been a crisis of confidence by the public in the financial planning sector.
Josh Frydenberg, Assistant Treasurer

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