Thursday 04 October 2018 by Andrew Mayes Opinion

Interim Report of the Financial Services Royal Commission

The Interim Report of the Financial Services Royal Commission is sober reading, highlighting a financial system where misconduct engineered poor outcomes for many customers and, when revealed, the remediation and punishment appeared to fall substantially short of expectations. But the industry response to the Interim (and final) Report could also increase the visibility and attractiveness of some non bank finance companies as an alternative provider of credit, including some FIIG originated deals. 


On 28 September 2018, the Interim Report of the Financial Services Royal Commission was tabled in parliament. The Interim Report covers policy related issues arising from the first four (of seven) rounds of hearings--consumer lending practices, financial advice, lending to small and medium enterprises, and the provision of financial services in remote and regional communities. 

The Interim Report asked a lot of questions - 693 questions by someone’s count, but made no recommendations, which will form part of the final report due in February 2019. Many of the findings by Commissioner Kenneth Hayne centred on a financial system riddled with conflicts of interest that ultimately engineered a culture of greed and ineffective application and perhaps more worryingly, enforcement of existing regulations.

When the terms of reference were released in December 2017, commercial banks clearly saw the writing on the wall, and as Commissioner Hayne himself recognised, some in the industry have already commenced the process of dealing with these conflicts of interest even if coincidentally. NAB, CBA and ANZ have been in the process of withdrawing from some areas of wealth management, with CBA also looking to dispose of its mortgage broking business. In hindsight, the integration and cross sell into wealth management has never proven truly successful for the commercial banks, so the respective exits should not come as a significant revelation. Other banks have already commenced remediation programs, with WBC announcing last week that its cash earnings in FY18 will be reduced by an estimated AUD235m to provide for customer payments and related costs.

Much of the recent media attention has centred on the Interim Report findings in relation to consumer and small business lending and the implications for credit (and house price) growth. This is understandable as credit is vital for economic growth in Australia, but also house prices and indeed household wealth, with home equity accounting for more than half of Australian household net wealth.[1]

Context is always important. Residential property prices in Australian capital cities have fallen by around 3% over the last twelve months[2], although coming off a period of remarkable growth (see Figure 1). However, they have also been accompanied by a significant increase in leverage; Australian household debt is amongst the highest in the world at 190% of disposable income.[3]

Figure 1: House price growth (indexed) (seasonally adjusted)

Source: Australian Bureau of Statistics 

The recent decline in residential property prices and slowdown in credit growth have been welcomed by regulators and alike, keen to engineer a soft landing - see Figure 2. The concern emerging out of the Interim Report is that further regulation intensifies the slowdown in credit extension and decline in property prices, eroding household wealth and private consumption, noting the latter accounts for 57% of nominal GDP[4]. Australia’s household savings ratio is already at a 10 year low at 1.0%[5]. Any further pressure on households--real or perceived--could prove to be a significant drag on household consumption and as such, economic growth.

Credit and earnings growth to slow as regulatory scrutiny intensifies, but more regulation unlikely

Although the Interim Report made no recommendations, the findings (and questions surrounding those findings) provide sufficient insight into the thinking of the Financial Services Royal Commission and the probable implications when the final report is published.  With respect to consumer and small business lending, we believe two key developments to emerge will include tighter credit conditions and increased regulatory scrutiny.

  1. Tighter credit, flowing through to slower earnings growth. One of the primary issues highlighted by the Interim Report concerning consumer lending was the banks’ reliance on the Household Expenditure Measure (HEM) to measure a borrower’s household expenditure. The HEM is produced by The Melbourne Institute and represents ‘a measure that reflects a modest level of weekly household expenditure for various types of families’. While banks generally adopt the higher of declared expenses or the HEM, the Interim Report found that in a targeted review conducted by the banking prudential regulator in 2016/2017, in

    ‘as many as three out of every four home loans…the banks assumed that the borrower’s household expenditures were equal to the relevant HEM. … Using HEM as the default measure of household expenditure assumes, often wrongly, that the household does not spend more on discretionary basics than allowed in HEM and does not spend anything on ‘non-basics. … It follows that using HEM as the default measure of household expenditure does not constitute any verification of a borrower’s expenditure.’

    The final report is likely to recommend that the use of HEM alone will not be sufficient for making a reasonable inquiry into a borrower’s household expenditure. The prudential regulator, APRA, has already issued guidance earlier this year to reinforce the obligation for banks to make reasonable inquiries into borrower’s actual living expenses.

    It is also eminently plausible that the industry had anticipated some of these findings, which may lessen the impact when the final report is released.  Anecdotally, the application of tighter lending standards in recent months - principally greater scrutiny of income and expenditure - has already contributed to the current slowdown in credit growth for both consumers and small businesses. CBA reported a 4% decline in statutory earnings earlier in the year, and analyst expectations are for a decline in earnings for the remaining major banks who report within the next month or so.

  2. Increased regulatory scrutiny. One of the more worrying developments to emerge from the Interim Report was the apparent willingness of regulators—namely the Australian Securities and Investments Commission (ASIC) to find an amicable solution to instances of misconduct within the financial services industry. Commissioner Hayne found that ‘when deciding what to do in response to misconduct, ASIC’s starting point appears to have been: How can this be resolved by agreement? This cannot be the starting point for a conduct regulator.’ Financial services providers did not escape the Interim Report unscathed, with a litany of examples in which providers exhibited an inability or unwillingness to identity, report and ultimately remediate breaches of the law. The findings are unlikely to result in further regulation, in our opinion. One of the key questions from the Interim Report concerns the value of further regulation, and it appears Commissioner Hayne is not overly enthusiastic on that front. 'Passing some new law to say, again, ‘Do not do that’, would add an extra layer of legal complexity to an already complex regulatory regime. What would that gain?’ However, the correct application and more rigorous enforcement of existing regulations, which is where the final report is likely to land, in our view, is almost certain to influence the ultimate availability of credit, if it hasn’t already.

Why does credit growth matter?

A fairly strong correlation exists between credit and property price growth - see Figure 2. You could overlay the figure below with auction clearance rates or sales volumes and you would come up with a similar construct. Key to housing activity is the availability of credit and the banking sector is currently rationing it. Recall that housing is also a critical component of household wealth in Australia. Greater adherence to and improved enforcement of existing regulations is likely to prolong the current slowdown in credit growth and decline in house prices.

Figure 2: House price and credit growth (seasonally adjusted)

Source: Australian Bureau of Statistics [ABS] 

Silver lining for FIIG-originated deals? 

Readers of the Interim Report would be hard pressed to make any positive conclusions. The final report, which will include the recent public hearings into insurance, is likely to make for a further round of sober reading. On the other hand, we believe industry and regulatory responses to the findings are likely to increase the visibility and attractiveness of non bank finance companies as an alternative source of credit, particularly for small businesses.

A number of FIIG originated deals involve non bank finance companies stepping into a void left by the banks, particularly lending to small businesses on both secured and unsecured terms. These include CML Group, Moneytech Finance, and StockCo. Although the Interim Report provided a strong indication that tighter regulation for small business customers was unlikely, in an environment in which commercial banks are clearly operating in a ‘risk off’ mode, we do not expect credit conditions for small business customers to improve in the near term. 

Around 33% of small businesses approached a finance company, that is a non bank lender, in 2016-17 for debt finance), up from around a quarter in 2015-16 - see Figure 3. The findings coming out of the Royal Commission into Financial Services are likely to see this momentum carry forward, in our view, providing a further impetus to already strong growth prospects as authorities try and engineer increased competition within Australia’s financial services sector.   

Figure 3: Approaches for small business debt finance (%)

Source: Australian Bureau of Statistics 

[1] Australian Bureau of Statistics [ABS]

[2] ABS

[3] Roy Morgan

[4] CoreLogic

[5] Reserve Bank of Australia