Banking royal commission story is just beginning

If the banks put profit before people, their super fund investors were cheering them every step of the way. Now we’ll all pay.

Commonwealth Bank chairman Catherine Livingstone leaving the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry in Sydney. Picture: Hollie Adams

The big long-term big losers from the unprecedented banking revolution set to take place in the wake of the Hayne royal commission are bank shareholders, led by superannuation funds. To them, you can add those who bought residential property in many areas during 2016, 2017 and early part of 2018.

But the collateral damage will spread to the entire economy and change the nation. Australia’s prosperity is linked to its banking system. That system is to be dismantled and made risk averse. That will slow the whole economy.

Those who doubt the importance of the final Hayne report to shareholders, property owners and the economy have not understood what it means.

It’s not that the changes proposed by the royal commission are wrong. Indeed they are very sensible. Rather, what matters is that they are so radically different to the way the way banking has been conducted in recent years. Accordingly, the revolution means there will be plenty of collateral damage.

Before I show just how dramatic the changes will be, let me start with February 4, the day the report was released, and the way many bankers saw it. For weeks the directors and top executives of the top four banks had been bracing themselves for the release of the royal commission report. But they were not prepared for the sight of a 40-storey Melbourne apartment block clad with flammable ACM with flames soaring up the side, Grenfell Tower style.

While the bankers’ first thought was for the occupants, their second was the damage two major disasters in less than eight weeks will do to apartment values in Sydney and Melbourne.

Already around 400,000 people have negative equity in their residential property (that is, they owe the banks more than the property is worth). That figure is now set to rise sharply. That weakens the fabric of bank balance sheets and raises the risk of a firestorm of writs based on allegations of irresponsible lending. Nervous bankers have a loose pact not to pull the rug on developers with massive land holdings and unsold units. Will it hold in the current environment?

An unfortunate aspect to the royal commission report is that Kenneth Hayne never came to grips with why bankers acted badly.

He simply attributed it to the “greed” of bankers. That’s not right. The “greed” came from the institutional shareholders, representing those who entrusted their superannuation and share portfolios to professionals who demanded banks earn more money and pay big dividends.

As I pointed out on Monday, bank boards responded to this shareholder pressure by appointing and rewarding executives on the basis of their ability to deliver profits. Nowhere was this task more professionally executed than at Commonwealth Bank, where 75 per cent of the big bonus rewards involved comparing CBA’s total four year shareholder return with the total shareholder return of the 20 largest ASX-listed companies (excluding resources companies).

The executives the board appointed were like highly trained racehorses and they made the CBA bank the most profitable company in Australia. Other banks followed and banks dominated the list of top 10 ASX companies.

If anyone was “greedy” it was the shareholders who threatened to bully boards who did not appoint executives and staff who would deliver. But the royal commission now demands that director, executive and staff reward systems all must change, and it proposes a wide variety of APRA and ASIC driven mechanisms to make sure that happens.

The agenda of banks will switch to serving customers rather than making profits for institutional shareholders. Big director and executive pay reductions are ahead. That’s a good thing, but when the professionals, representing the superannuation funds under the whip to deliver performance, begin demanding better bank results, they will be faced with a set of directors and executives who have a different agenda to those of the past. That means lower share prices. And then add the ALP’s retirement and pensioners tax, which will prompt people to switch from bank shares to other investments.

For those in big superannuation funds, particularly industry funds, there has been huge revenue from the massive amounts held in duplicated default funds held by lower paid workers, whose default fund income is eliminated by fees. That will be stopped. We don’t know how far that boosted returns and unfortunately Kenneth Hayne did not try to find out. It was a big gap in the commission’s report.

Now let’s go back to when shareholder “greed” transformed the banks. The banks slashed their branch costs by outsourcing home lending growth to brokers who were very casual in reporting to banks the financial position of borrowers. They were concentrating on getting the loans made — that’s how they were rewarded. This dramatic hosing of money at the housing market sent dwelling prices through the roof and the rise was further boosted in some areas by Chinese buyers. That Chinese buying has fallen to a small amount and APRA and ASIC are forcing banks to go to incredible lengths to check the financial status of borrowers.

The royal commission says that mortgage brokers represent the borrowers and should be paid by borrowers, not lenders. This breaks the branch cost reduction broker model. Bill Shorten will mince Josh Frydenberg and the government if they renege on this demand but in any event the broker model which has dominated bank loan generation is in trouble because of the need to check the financial status of borrowers. Swinging new loans back to bank branches will lift costs and much of that higher cost will come out if the pockets of shareholders.

The royal commission did not further intensify the current credit squeeze. But it locked it in. That means that there is going to continue to be far less money for people to buy dwellings. Accordingly, dwelling prices must continue to fall and the rate of negative equity will rise. New home building is crumbling, and this big employment area will be hit hard in 2020. All this means a further fall in discretionary consumer spending.

Add in the ALP’s negative gearing plans, and it’s clear the royal commission has locked in a likely disaster in the dwelling market and the economy. In 2020, the next government will have to find a way around the credit squeeze.

The reserve bank has been very slow to understand what is happening in the real world and is now talking about lowering interest rates. That will not help. It’s the credit squeeze.

But there is an even bigger problem: fear among bank staff. All banks will watch former and current executives and directors of at least two banks fighting the courts to avoid huge fines and possible jail. Perhaps irrationally, most bank staff members will think: “that could happen to me”. The fear factor in bank staff will further clog the whole system. Add that to the billions facing the banks in payouts to customers, courts cases and other settlements. And then suddenly farm loans are to be uneconomic. This story is just beginning.