Banks behaving badly: how it’s all Keating’s fault

Numerous examples of a self-absorbed, imperious management style at financial regulators have been exposed.

Greed and malpractice in the financial services industry have been known for years but the Turnbull government resisted repeated calls for a royal commission. Finally, as the revelations became more frequent and lurid and public support for an inquiry grew louder, the government capitulated last December and ordered the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, led by High Court judge, Kenneth Hayne.

Evidence before the commission confirms what was known or suspected. Dishonest practice and corporate governance failures have been widespread in financial services institutions. The hearings have made almost daily headlines. Less well covered has been the behaviour of regulators. Numerous examples of a self-absorbed, imperious management style have been exposed: a picture of feeble, inept investigators and a culture more attuned to the rule of the sheriff than the rule of law.

A most important conclusion from the commission’s interim report is that lack of competition in the Australian banking sector, together with demanding super fund shareholders, ever in search of higher short-term returns, help explain not only what happened, but why it continued.

The Four Pillars (no major bank mergers) policy and, compulsory superannuation, both introduced in the early 1990s by Labor treasurer Paul Keating, have much to answer for. Keating believed financial stability and retirement security would be better achieved through political direction than through market discipline and voluntary savings. This is now open to question.

For almost 30 years, these policies helped encourage a legislated cartel and more importantly the concentration of risk. It’s not surprising. As senior executives moved freely between members, the regulators and the media, an incestuous, chummy network was established. A culture of greed, collusion and complacency flourished. Systems and practices developed a sameness. The Productivity Commission’s Inquiry into Competition in the Australian Financial System found “a blizzard of barely differentiated products” and “an illusion of choice”.

Likewise with compulsory superannuation. With trillions of dollars invested and members somewhat detached from the management of their savings, funds have become sticky, with competition confined mainly to the margins. There are many opportunities for malpractice to occur and even industry funds, which have performed to a higher standard, have been found, on occasions, to have misused members’ money.

A clear message from the hearings and Hayne’s interim report is that adding regulations simply leads to diminishing returns. What is required is for the existing law to be amended or properly administered. As Hayne says: “The conduct regulator, ASIC, rarely went to court to seek public denunciation of, and punishment for, misconduct.

“The prudential regulator, APRA, never went to court.” Which means case law is scant or, non-existent.

And, while the instances of impropriety heard by the Hayne inquiry are the most egregious and obviously unacceptable, they are a tiny fraction of the millions of financial services transactions professionally delivered each year. But they are enough for class action lawyers to sue banks and wealth managers for billions. These legal cases will distract boards and senior management for years to the detriment of profits and business development. They will benefit disrupters and smaller competitors who are making inroads into traditional markets. Their innovative business models will be a further test for regulators, who themselves are preoccupied with royal commission disclosures.

The first reaction of bankers to the royal commission has been to contract lending. Already, according to ratings agency Moody’s, the value of Sydney home loans was down 8.4 per cent in June, compared to the same time last year, driven by a 18.1 per cent fall in the number of investor loans year-on-year. Funding and prices are correlated and property prices are falling at the fastest pace in six years. Conversion of $480 billion of interest-only loans to principle-and-interest over the next three years will add to the downward pressure on prices and to the strain on personal balance sheets.

It’s no wonder the Reserve Bank sees property loans as the “main risk to financial stability over the next two years”. When total household liabilities are among the world’s highest, at 200 per cent of disposable income, and house price-to-income ratios are the third highest, it is right to worry. The Economist says that by international standards, Australian house prices are 40 per cent overvalued. For the first time in 15 years, housing supply and demand is nearing “equilibrium”. Monthly repayments, relative to mortgage size, are the lowest in history, which means the market is especially sensitive to interest rate rises and unemployment. Worse, it appears unsuspecting and unprepared.

Much rests on the banks’ risk-management models. More than 60 per cent of their loan books are in residential property, the most concentrated lending of its type in the world. Norway is second with 40 per cent. Today, more than half Australia’s mortgages are originated through brokers. Hayne says “this has been an important contributor to misconduct”, due to perverse incentives based on value and volume, leading to fraudulent statements of income and living expenses. The reliability of bank stress-testing scenarios should not be assumed nor the potential downside in house prices underestimated.

For small investors and borrowers, the post-Hayne landscape will change. It is an unintended consequence, but access to advice and loans will be harder and will come at a higher price as the associated costs and risks of servicing them are judged to have risen.

The commission has also highlighted the concentration of risk and structural weaknesses at the heart of financial services. It won’t fix them. But it has likely accelerated a long overdue correction. Having experienced 27 years of uninterrupted growth, we will see how under-50s managers deal with the unravelling of decades of easygoing practice, which they and colleagues have overseen.

Oh, what a tangled web.