In an unusual speech delivered to the Customer Owned Banking Association (COBA) 2020 Convention on Wednesday (2 December), the deputy chair of the Australian Prudential Regulation Authority (APRA), John Lonsdale, suggested that it would be “prudent” for smaller banks to “consider the preparatory steps required for a merger or transfer of business” should they face a severe financial stress.
In his speech, Mr Lonsdale outlined that 2020 had been “a very challenging year for everyone, confronting the Australian community with firstly a health crisis and then testing the financial system with a resulting economic crisis”.
“[T]his crisis has also highlighted the vital role that financial institutions, particularly authorised deposit-taking institutions, play in supporting households, businesses and communities, as well as driving economic growth,” he said, emphasising the importance of a strong financial system.
He noted that the theme of this year’s COBA conference was “Forging our path ahead”, which he said was “appropriate for the current times”.
“In this period of considerable uncertainty, it is more important than ever that COBA members continue to work together to strengthen the foundations for a prosperous and competitive mutual bank sector.”
He forewarned that the industry would need to work together to “overcome current challenges and to plan for those challenges that are yet to materialise”.
After outlining that the mutual banks, and smaller ADIs more generally, had a “sound operating state” currently, he warned that a large number of the small banks – and not only mutuals – have “business models that are challenged”.
“High cost-to-income ratios, with a high cost operating model, are likely to continue to constrain the ability of smaller ADIs to generate earnings for further balance sheet growth. Because of this, it is important the industry strives to tackle costs,” he said.
“In addition, the current low interest rate environment has contributed to declining net income margins, with the mutual sector particularly vulnerable given its funding model, which has a high dependency on low rate transactional accounts.
“The low interest rate environment is set to stay for a while and margins across the industry are likely to continue to be squeezed,” he said.
“While capital ratios in the sector are generally in excess of minimum prudential requirements, with low profitability and limited capital raising options, small ADIs may be challenged to generate enough income to offset potential asset write-downs and provisions in a downside scenario,” Mr Lonsdale continued.
Digital offerings could pose future challenges for smaller banks
He later told delegates that changes in consumer behaviours and expectations also “pose challenges”.
For example, he suggested that bank customers are increasingly expecting a “quality digital offering”, and therefore added it was “important that small ADIs refocus on digital offerings and invest in technology in order to stay relevant to members and compete with innovation in the financial sector industry”. Moreover, he outlined that resilience to cyber attacks was also key.
However, Mr Lonsdale foreshadowed that mutuals may face a “particular set of risks due to size and scale”.
He explained: “The shift to digital services of the financial services organisations and increasing customer expectations means that mutuals are having to adopt cloud-based solutions to remain competitive and relevant. However, the transition to cloud also presents challenges, particularly concerning whether they have the skills to manage an outsourced environment. Accordingly, a cautious and measured approach is warranted.
“The challenge for mutuals in considering third-party arrangements has been evident in the number of relief requests we have received,” he said, revealing that over 25 per cent of all extension requests received and approved for regulatory relief until January 2021 were from COBA members.
“These were provided in respect of the third-party arrangements transition provision in CPS 234 Information Security.
“By working together, we can hopefully use increased connectivity to strengthen the system’s resilience to attacks,” the deputy chair said.
“Clearly, with all of these challenges, the importance of contingency planning has increased and there is much more to do.”
The APRA deputy chair then looked to the state of recovery plans (a bank’s contingency plan to avoid failure in the event of a severe financial stress).
APRA had reportedly completed a thematic review of small to mid-sized ADI recovery plans, including COBA members, as part of its ongoing work to improve recovery planning capability across the ADI industry and “to ensure that institutions are prepared as much as they can be to recover from severe stress”.
According to Mr Lonsdale, APRA observed that the general quality of recovery plans among smaller ADIs was “weaker than [it] would like it to be”, and that there was a lack of understanding of APRA’s expectations.
Mr Lonsdale therefore suggested that while there may be a range of recovery options available to ADIs, “APRA recognises that for smaller ADIs with simple businesses, the range of recovery options may be more limited, and that a merger or transfer of business may be the most effective recovery option”.
“Therefore, it is prudent that such ADIs consider the preparatory steps required for a merger or transfer of business, including criteria to identify potential partners at an early stage rather than wait for a deterioration in financial position,” he told the COBA conference.
“Hopefully, recovery plans never need to be enacted, but it is important for all APRA-regulated entities, even smaller ones, to ensure they have an effective plan in place if needed – and it is APRA’s role to supervise that.”
He concluded: “The composition of the mutual sector has changed over the last couple of decades, with increased consolidation in the industry, which is expected to continue to play a part as mutuals seek to gain scale and remain competitive.
“It’s clear that as a cohort of mutuals/small ADIs, there is much COBA can do to continue to thrive and deliver an important service to your communities.
“The need to be working together to continue to build strength and resilience has never been more important,” Mr Lonsdale said.
Recent mergers could reflect growing trend
The customer-owned sector has already seen several mergers and acquisitions in the past year, as smaller operators look to join forces with like-minded organisations.
In August, Victoria-based credit union Firefighters Credit Co-operative Ltd (FCCL) signed a memorandum of understanding to merge with Teachers Mutual Bank Ltd (TMBL) – which already comprises Teachers Mutual Bank, UniBank, Health Professionals Bank and Firefighters Mutual Bank.
Earlier in the year, Illawarra-based lender IMB Bank completed its merger with Newcastle-based lender Hunter United Employees’ Credit Union after receiving regulatory approval from APRA.
In late 2019, WA-based bank P&N Bank and Queensland-based lender Bananacoast Community Credit Union (bcu) also officially merged, after the deal received both shareholder sign-off and regulatory approval.
Indeed, data analysis agency GlobalData stated earlier this year that one in four ADIs could exit the market within the next five years, as unemployment levels rise, and credit appetite dissipates.
Andrew Haslip, head of financial services content for Asia Pacific at GlobalData, suggested that the recent upswing in the number of authorised deposit-taking institutions (ADIs), driven by the introduction of neobanks to the market, could be set to reverse in light of COVID-19.
According to GlobalData, “up to a quarter” of ADIs could exit the market within the next five years, either via sales or mergers, as a result of mass unemployment and a decreased appetite for credit following the COVID-19 crisis.
“Loan growth will also suffer, despite efforts to keep lending to businesses and households at extremely attractive rates,” Mr Haslip said at the time.
“The Reserve Bank of Australia and government funding to lenders will help, but it is highly uncertain whether there will be sufficient appetite for credit to see anything more than marginal increases in 2020.
“New residential mortgage lending will collapse during the weeks, possibly months, of lockdown and enforced social distancing as even viewing a property safely becomes a challenge.”
Annie Kane is the editor of The Adviser and Mortgage Business.
As well as writing about the Australian broking industry, the mortgage market, financial regulation, fintechs and the wider lending landscape – Annie is also the host of the Elite Broker and In Focus podcasts and The Adviser Live webcasts.