RC findings could dent bank profits: Moody’s

A report penned by Francesco Mirenzi and Patrick Winsbury from Moody’s Investors Service predicts a number of potential outcomes of the financial services royal commission, including reduced bank profitability.

“Combined with higher wholesale funding costs and the need for technology investment, this is likely to pressure banking sector profitability over the next 18 months,” the report stated.

The authors of the Moody’s report, titled Commission findings likely to pose profit risk, but credit profiles will remain stable, also expect “more interventionist and more litigious” regulatory and compliance oversight, which could lead to higher penalties for misconduct.

The federal government is already in the process consulting the public on new, harsher penalties for corporate and financial sector misconduct, including introducing new criminal offences, increasing fines and raising jail times under the Treasury Laws Amendment (ASIC Enforcement) 2018 Bill. The legislative changes aim to align penalties with “the seriousness of the misconduct”.

“The interim report cites that both the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commission (ASIC) rarely took banks to court over infringements and, in most cases, the financial penalties imposed were immaterial,” the Moody’s report stated.

“We expect that policymakers will provide regulators with more resources to effectively investigate and pursue cases of misconduct or infringement of rules.”

Improvements in compliance frameworks will likely be required, which will add to the banks’ operating costs, according to Mr Mirenzi and Mr Winsbury.

“We still expect financial penalties to be manageable given the strong profitability of the banking sector. However, increased penalties will create additional pressure on bank profits,” they wrote.

The authors also predict that residential mortgage lending practices will become more stringent, especially around income and expense checks.

Following the suggestion during the royal commission that ANZ Bank was “non-compliant with the National Credit Act, responsible lending obligations and with regulatory guides issued by ASIC” by not verifying “inconsistent” living expenses, many lenders have been tightening up their credit policies around expenses and benchmarking, including Commonwealth Bank and Westpac.

“This could lead to further tightening in the availability of credit. Annual housing credit growth ended August 2018 was 5.4 per cent, and is now at its lowest point since January 2014,” the Moody’s report stated.

While there have been numerous claims that banks are overly reliant on the Household Expenditure Measure (HEM) benchmark when it comes to assessing a borrower’s ability to repay a loan, Moody’s does not believe HEM will be outlawed.

“We believe that there is potential for policy recommendations to restrict the use of HEM, but it is unlikely that it will be completely prohibited,” the report stated.

The authors of the report said that the open banking regime — set to come into effect on 1 July 2019 — could help reduce reliance on the HEM benchmark.

“We expect that technological advancement, as well as the introduction of open banking in July 2019, will provide banks with greater capability to fully assess borrowers’ living expenses and credit commitments, which, over time, could lead to lower reliance on HEM as a benchmark measure,” they said.

On the upside, the ratings agency believes that credit profile will remain stable due to the “strong operating environment and concentrated industry structure”.

“The strong economic outlook for Australia, combined with a healthy labour market, will support asset quality, which remains robust, despite our view that residential mortgage delinquencies will rise moderately,” the Moody’s report stated.

“Additionally, the sector will continue to benefit from the concentrated industry structure that has afforded it good pricing power.”

The report noted that many banks, including three of the big four, have hiked their mortgage rates, citing higher wholesale funding costs.

“At the same time, banks have recouped some profitability by lowering deposit interest rates. These actions are evidence that the sector still retains pricing power,” the report stated.

The Productivity Commission in its final report on competition in the Australian financial system warned that data on profitability, pricing and product development shows that there is non-competitive pricing in the banking market, especially the prices set by major banks.

“Major banks are the dominant force in the market. As a result, they are able to charge higher premiums above their marginal costs, compared with other institutions. Approximately half of the loan price that major banks charge is a premium over the marginal cost — double the margin that other Australian‑owned banks have,” the PC report stated.

The banks’ refusal to acknowledge their power over market prices is further contradicted by a “recurring argument” the industry has used against increasing costs, which is that such cost rises will have to be passed on to consumers, the Productivity Commission argued.

Standard & Poor’s similarly said that the royal commission report did not require a reevaluation of Australian bank ratings, but that this could change following the release of the final report in February next year, with the report expected to contain recommendations.

[Related: Major banks used market power to ‘exploit’ customers: PC]