Tuesday night’s Federal Budget had some of the widest implications for banks in Australia (and particularly the major banks) of any budget in recent history. The measures themselves and the nature of how they were announced serve as a stark reminder of the acute pressure that the major banks are facing across multiple fronts. Emboldened and concerned regulators, hostile politics and public scrutiny have combined to drive a progressive build-up of action on bank conduct, competition and, now, a new tax. This all amounts to a step-change in intervention that has the potential to dramatically impact how the banks' operate and their returns at a time of economic uncertainty. The implications need to be carefully considered in the context of all the banks’ stakeholders.
There really is no ‘them and us’ when it comes to the major banks. They are at the epicentre of the Australian economy in almost every way. Collectively, they employ over 160,000 people (most of whom are in Australia), pay over $10bn of tax a year, are directly or indirectly owned by almost every Australian through superannuation, are Australia’s main conduit to offshore funding, and finance over 70% of Australia’s lending. Strong and stable banks have served Australia well, but that does not absolve them from scrutiny. Australians have always had a delicate relationship with the major banks (making them good political fodder as a result) and a procession of public scandals set against upper quartile returns has understandably led to the intense scrutiny and action that has built over recent years.
As the commentary following the budget has highlighted, the consequences of action will flow to all Australians in some way, given the significance of the major banks to Australia. The implications of measures taken need to be considered carefully as a result to ensure the desired consequences, be they fiscal or otherwise, are balanced with what we really want, and need, our banks to be.
Perhaps the most concerning element for the banks will be the ‘surprise’ element of the levy and what that might say about government’s attitude towards them. For many, its positioning amongst a number of other measures directly aimed at bank conduct could be interpreted as more of a fine for being ‘big and bad’ rather than a notion of paying your ‘fair share’ to help the deficit. For the banks to respond effectively for all stakeholders, and with an already challenging growth outlook, the stability of knowing where they stand with government, and that they have principled support, will be critical.
While we are not advocating any loosening of focus on the banks from regulators or government, we do feel it is critical to appreciate the plausible impacts of all this action on the banks’ capacity to keep Australia growing.
This overview collates the wide and varying measures likely to affect banks both directly and indirectly from the budget - in terms of shareholder returns, conduct and competition in the sector. It presents some early thoughts on the key questions raised and possible implications for stakeholders, boards and management. While spending on infrastructure and a desire to stimulate both saving for and affordability of housing may create opportunities across the value chain, the headwinds already faced by the banking sector have significantly increased.
In the context of growing capital requirements to meet unquestionably strong benchmarks, falling net interest margins, and a potentially slow growth credit environment, return on equity for the major banks was already under pressure relative to past highs, having declined to what had appeared a ‘new normal’ band of 13-14%. The budget measures to introduce a bank levy and changes to the tax regime on hybrids tax arrangements will require further trade-off decisions to be made to ensure shareholder expectations of returns. In light of the potential ACCC competition reviews (see section below) and the sensitivity of consumers to bank pricing decisions on retail products, the ability to recoup these new costs directly from customers is intended to be restricted.
As a result, return expectations will likely need to be further tempered, with greater detail required before the true cost is really known. A number of tax amendments that would simplify matters for the sector could have been addressed through the budget but remain unfinished business.
From 1 July 2017, the Federal Government will introduce a bank levy (the levy) for Authorised Deposit-taking Institutions (ADIs) with licensed entity liabilities of at least $100 billion, effectively limiting the levy to the four major banks and Macquarie. The budget estimated this will generate $6.2bn over four years.
The levy will be payable quarterly for an annual 0.06% charge per annum. Its impacts are likely to be felt by all participants in the economy – bank customers, bank employees and, ultimately, shareholders.
In the absence of a change in bank costs or income, the charge is estimated to reduce major bank cash earnings after tax by an average of 4.5% (4–6%). Over four years, without changes to dividends, this would erode 20% of the capital raised since the Financial System Inquiry in 2014.
Current expectations, although detail is sparse, are that the levy will apply to all level one liabilities other than those the Financial Claims Scheme applies and additional tier one capital. As noted below, there are many questions that need to be resolved to work out what this actually means.
The concept of a bank levy is not new. A number of countries in Europe implemented bank levies following the GFC, notably the UK, France and Germany. These broadly followed the recommendations of the IMF in a report to the G20 in June 2010 as to how the financial sector could make a fair and substantial contribution toward the cost of government interventions to repair the banking system but also to incentivise banks to alter their operations and increase safety in the system, for example by reducing the levy payable on longer term liabilities.
The UK Government’s bank levy has been a very effective revenue raiser. That levy rate has been increased nine times since its introduction in 2011, and a staggered reduction – from the current 0.17% to 0.1% by 2021 – was recently introduced (although applied to a base that is different to that of the Australian model). In the UK, the calculation of the balances to which the bank levy attaches has been complicated to say the least, requiring in-depth reconciliations not previously necessary to apply the tax law. The levy had wide-ranging implications on the banking industry in London, with some major banks seriously considering moving their headquarters out of the UK, although recent amendments have now resolved this.
The rationale for introducing the bank levy in Australia is certainly different to overseas experience. It appears to be about the major banks making a fair and substantial contribution toward repairing the budget, as well as a less clearly articulated need to ‘pay’ for the implicit guarantee from government that does, in part, support bank ratings and credit spreads. Given the continued increase in bank capital, with some $37bn added since 2014 alone, the value of this guarantee, while real, is arguably lower today than at any point in the past ten years.
Given experience overseas, and to some extent here in Australia with the Mining Tax, it is critical that appropriate time is devoted to consideration of the potential indirect or unintended consequences of introducing a bank levy. The consultation periods are extremely short and we have articulated some of the key questions and potential consequences below.
What is the actual benefit to the budget? At the time of writing, a range of possible calculations do not appear to derive the assumed budget figure but government have made it clear that they will take whatever steps necessary to ensure the target amount is achieved.
A range of scope issues including:
The ACCC mortgage review explicitly focuses on banks explaining changes to mortgage pricing, making it challenging to pass the cost of the levy through a significant portfolio.
If banks exclude mortgage repricing as a cost recovery option then trade-offs need to be made that have implications for shareholders, business customers and cost structures within the bank.
Shareholders are likely to bear some of the burden through lower returns and, in all likelihood, dividends.
There is likely to be more intense competition among the major banks for ‘levy free’ deposits which could create a more significant price differential between guaranteed and non-guaranteed deposits. Perversely, this would actually mean that customers who benefit from the explicit government guarantee on deposits get a better return than those that don’t.
The regional, foreign or mutual banks may have a competitive advantage to target large deposits not covered by the Financial Claims Scheme (FCS), as major banks seek to expand their share of deposits within the FCS through higher returns traded off for lower returns to large depositors.
A range of practical issues also arise, especially around the ultimate impact on the budget from the bank levy and the global competitiveness of the major banks. This will largely depend on how banks respond but the indirect consequences could be significant from reductions in everyday superannuation balances, lower deposit rates and savings or reduced Australian workforce participation.
The government will act to counter hybrid tax mismatches that arise for new cross-border tier one capital transactions. This refers to ‘frankable/deductible’ instruments issued through a foreign branch of an Australian bank or financial institution.
The mismatch will be eliminated by preventing franking credits from being attached to distributions on the securities in circumstances where the payment is deductible in the foreign jurisdiction. If the funds are utilised in Australia, a penal franking debit will arise.
The measure will usually apply to payments occurring after 1 January 2018 or six months after Royal Assent, whichever is later. However, for instruments issued before 8 May 2017, the rules will not apply until after the next call date for the instrument. Depending on the instrument, this may provide several years of relief.
Interestingly, this announcement has been made without the Board of Tax releasing a further report of its findings on this issue. It is unclear what the local response would be if New Zealand (or any other relevant foreign jurisdiction) adjusts its treatment of such instruments, especially if it departs from the recommended OECD framework.
There may a funding supply issue arise depending on the sequencing of call timing. Banks will need to revisit their hybrid funding strategy and the impact to their overall funding approach.
Hybrids have been attractive to investors and assisted banks to manage funding costs and therefore end consumer interest rates, however, alternative funding sources may not be as efficient for the banks, which will lead to either higher consumer costs or lower shareholder returns. Further pressure on NIM may be an outcome of this change.
Furthermore, investors have received benefits through franking credits making these instruments attractive in the past, investor returns after tax may now be lower as a result.
At one level the budget has only served as the most recent in 12-18 months of developments in the way that the industry is being scrutinised. Few of the conduct measures announced had not been discussed or suggested through the parliamentary hearings or the numerous reviews that the sector has endured over the past year.
However the release of these measures in a single package, with the degree of legislated intrusion from regulators which has been proposed, represents a step change in the way that conduct risk and regulatory sanction should be perceived by banks. Suggesting that this heralds a conduct environment equivalent to the one we have seen in the UK for the past five years might be a step too far, but this is a clear and unequivocal statement from government and regulators alike that the standard to which banks and executives are going to be held has changed.
There are many valid concerns from the banking community about what is proposed, and a lot of detail is yet to emerge, but the reality is that in the current climate, these initiatives will absolutely be seen to further address community concerns about the conduct of banks and are in addition to the myriad of steps being taken by banks already. This will inevitably mean the diversion of bank resources to regulatory compliance activities, potentially taking them away from growth, innovation and meeting shareholder expectations. It will also likely lead to more risk aversion in the sector, which is a concern when the country has such a broad-based need to grow.
Foreshadowed in recent banking sector senate inquiries attended by the “big 4” Banks, the budget included a Banking Executive Accountability Regime. At least on the surface similar to the UK’s Senior Manager Regime, the proposed regime will be administered by APRA, and will establish expectations for senior executives and directors, with potentially significant consequences for both ADIs and the executives if these expectations are not met.
APRA has received $4.2m to implement the scheme over four years and with powers to raise financial penalties, this may mean APRA takes a more active enforcement role in the future. There is substantial risk to senior executives from the ability of APRA to disqualify executives from future employment in the sector. In addition, executives will no longer be shielded by group decision making with the UK experience making it clear that an individual's contribution to collective decisions can be questioned.
The UK experience highlights that the devil is in the detail with employment contracts and role descriptions needing granular review and specific operational detail to be meaningful for use in the accountability matrix, the need to cascade the matrix to lower levels of management for assurance, alignment or role purpose statements and accountability matrix, policy review and alignment, understanding the accountability of risk chairmanship and board governance obligations.
What are the proposed measures within the regime?
This regime bolsters APRAs existing powers to prosecute executive misconduct with powers to set clearer expectations of executives, understand accountabilities, to effectively monitor performance against these expectations and take action where appropriate.
For ADIs, the new measures are likely to lead to significant projects in the short-term and an increased compliance burden in the long-term. While ADIs would already have accountabilities mapped through job descriptions, compliance plans, and responsible person requirements, the new accountability mappings will be subject to increased scrutiny by executives given the individual penalties executives may face due to breaching accountabilities. This may be particularly onerous for smaller ADIs. APRA also has a view that boards own risk, ultimately this regime may create greater board risk in executing their governance accountabilities under prudential standards.
While further industry consultation is expected, organisations will need to start considering how they design and operationalise a pragmatic approach that gives regulators and stakeholders the comfort they need that senior managers and directors are discharging their accountabilities to meet increasing expectations. ADIs now need to:
Executives of all ADIs will have a minimum of 40% of their variable remuneration deferred for a minimum period of four years. For certain executives, such as the CEOs, it will be a minimum of a 60% deferral. The intent of the proposal is to ensure ADIs can adjust bonuses down when the consequences of decisions materialise, even if this is a number of years after the decision was made and the associated bonus awarded.
While a simple concept, there is a significant amount of detail to be finalised before the measure can be implemented. The definition of ‘executive’ for the purposes of the mandate will need to be determined. While it is likely to be aligned with the definition of ‘senior executive’ under the accountability regime, there will be a need to consider how this operates within a group of companies where the parent is not an ADI.
However, the potentially more complex issue is how to account for, and value, different incentive instruments when determining ‘variable remuneration’. Specifically, the treatment of long term incentives is likely to be contentious and to potentially add significant complexity.
In addition to the deferral requirements, the government is giving APRA the ability to review and adjust ADI remuneration policies. These proposed additional powers and remuneration requirements come as APRA begins its review of the implementation of CPS 510 and the effectiveness of the current remuneration related requirements. Many may hope that the Banking Executive Accountability Regime bill provides flexibility such that APRA can take a pragmatic approach to the implementation of these reforms. Given their increased power, many may hope that APRA provides more prescriptive guidelines on remuneration following their review of CPS 510, which is due to be completed next year.
Interestingly, it appears these requirements will also apply to the executives of smaller ADIs. Deferred, and even variable remuneration, is less commonplace in these entities so the impact may be onerous.
APRA’s new powers will have the potential to add more confusion to the already blurred sharing of responsibility for executive remuneration between policy makers, shareholders and boards. Pressure will also continue to build on aligning remuneration, performance and the shareholder experience. Identification of the most appropriate performance measures and the setting of targets will remain a key focus area, as will how these changes are implemented in light of the Sedgwick Retail Banking Remuneration Review and its focus on conduct and culture.
To achieve a robust implementation the industry and regulators need to consult on implementation questions to avoid inadvertent breaches of compliance. Issues requiring clarification include:
the definition of executive under remuneration and senior executive under accountability regime; are they the same or slightly nuanced?
how will variable remuneration be defined?
how will APRA oversee and review accountability and remuneration policies prior to implementation?
The government continues to respond to community concerns in relation to conduct. Banks now need to continue to manage their community interactions to demonstrate the appropriate use of their social licence to operate and validate the need for a strong banking sector.
Significant compliance and regulatory risk is posed by the regulatory regime. This risk is intensified through additional compliance and reporting requirements through internal dispute resolution self reporting, managing changes and the communication of changes to the accountability framework and register of executives.
Executives and senior managers will face decision-making constraints in the light of increased regulatory oversight. This affects speed-to-market of product innovations and organisation changes to improve efficiency; with customer experiences and management decision making dampened by the constraints imposed by the regulatory environment.
The decision making roles are being blurred between executives, board and regulators with greater scrutiny of decisions and unintended outcomes of decisions made in good faith.
Increasingly boards will be seeking assurance from management that compliance with regulatory requirements is addressed in day-to-day business operations and that board members are discharging their governance responsibilities. How will boards seek to understand the overall regulatory and risk environment and satisfy themselves that management is in compliance with the boards policy directives?
Competition in the Australian banking system has become ever more fierce over the past five to six years. An increasing focus on the domestic market from the major banks, the emergence of a new generation of non-bank competitors and ongoing scrutiny of pricing decisions from the community have combined to drive Net Interest Margin down by 26 basis points since 2011, and there has been no nominal increase in fee income for at least a decade (while capital has more than doubled). The budget has served to substantially increase these pressures, with some measures comparable to the oversight of a regulated utility. The one balancing force for the major players is the funding of APRA to enhance its supervision of the non-bank sector - at a system level this is perhaps one of the most critical of the budget measures in the role it can play in enhancing system stability.
However, in aggregate, these measures will accelerate the need for banks to focus on their point of difference with customers, and simplify and streamline the operational model behind the key capabilities required to deliver. Systems and processes are going to need to facilitate ever more transparency to stakeholders and real-time interrogation. Open data may provide the opportunity for a fundamental shift in customer orientation and certainly has the potential to dramatically increase the number of competitors in a number of domains.
The government’s budget has allocated additional funding of $13.2 million over four years for a new unit within the ACCC dedicated to ‘undertake regular inquiries into specific financial system competition issues’. Initially the ACCC has been requested to conduct a residential mortgage pricing inquiry to coincide with the introduction of the bank levy. It is expected, over time, that this new dedicated unit will be deployed to inquire into other dimensions of the financial system where competition issues arise.
The residential mortgage pricing inquiry will operate until 30 June 2018. This will enable the ACCC to require relevant ADIs to explain any changes or proposed changes to residential mortgage pricing, including changes to fees, charges or interest rates by those ADIs.
This inquiry is likely to be similar to earlier ACCC pricing inquiries, such as those undertaken following the abolition of wholesale sale tax and the imposition of the GST in July 2000 and, more recently, when the now repealed carbon tax was introduced in July 2012. These inquiries were designed to place regulatory pressure upon businesses to justify any price increases by reference to increased operating costs attributable to the imposition of the new tax.
It would seem that the ACCC inquiry is designed to consider mortgage pricing at an overall level rather than solely the implication of the bank levy. While political pressure is being applied to ensure that the major banks do not increase residential loan interest rates to recover the costs of the new bank levy, we would not expect this to be the nature of the review itself. Rather, there will be a need to demonstrate the basis of any change in rates, not just those driven by the levy, and to ensure they don't mislead customers by inappropriately citing the levy as a driver.
ADIs will need to exercise rigorous cost-based pricing calculations during the course of the ACCC’s inquiry to be able to demonstrate a reasonable basis for any changes to residential mortgage rates and other charges. The industry may want to explore a standardised costing methodology to calculate the cost and allocation of the bank levy, including to mortgages, but the ACCC will challenge any initiative deemed to undermine vigorous competition between ADIs.
Banks have a strategic opportunity to provide transparency to the ACCC and to the public to have a full debate about the connection of the Reserve Bank cash rate and mortgage pricing. Public and political discomfort with recent out of cycle mortgage rises are largely due to banks ability to easily explain the drivers of mortgage pricing. In addition the ACCC may take this approach to other portfolios to review pricing and competitiveness. The implications for the banks is that once the approach is set as a precedent the ability to influence future investigations on more complex products may be limited leaving pricing decisions open to debate by the ACCC. Influencing and educating the ACCC today may provide a better base for future reviews.
Banks use quite varying mortgage pricing models using very different approaches and input variables such as hurdle rates and ROEs targets. This will challenge the ACCC to develop a single view of optimal mortgage pricing in the market.
A number of challenges are expected to emerge over the period of the review around capital and capital costs and funding rates may also vary. Whilst the ACCC conducts its review, the banks will have to work hard to actively recoup these costs during this time. This could lead to compounding effects on ROE and earnings ultimately impacting shareholders.
The opportunity to increase the transparency of pricing model drivers to explain how prices are determined to decouple the view that mortgage rates and Reserve Bank cash rates are linked.
Following the May 2017 report by the Productivity Commission, the government will introduce a new open data banking regime to drive competition in financial services. This will start with an independent review on how best to implement the regime, to report by the end of 2017.
This initiative, as seen in the UK through the Second Payments Services Directive (PSD2), opens up customer data across all banks and with approved third parties to access and aggregate data to provide innovative, more personalised products to customers. This represents a competitive threat to incumbent banks such as the major banks, who currently have a large data advantage due to the number of customers for whom they are main financial institution. An open data regime could facilitate existing banks and third parties to compete more effectively across traditional financial services offerings leading to significant risks to incumbent banks.
Banks have expressed concern regarding the data privacy and security implications of the release of customer information and this is a real risk that will need to be worked through as part of the initial review. The extent to which requirements are enshrined in law will also be a subject of question so as to balance the need to achieve compliance with the requisite flexibility given the pace of technological change.
Customers may be drawn to aggregator platforms that provide a single view of their banking and finance needs. Providing consumers with the power to cross reference and tailor offerings may lead to increased homogenisation of banking products, increased competition and customers demanding better customer experiences could lead to erosion of the banks natural trust/customer base and income stream.
New business models will emerge ranging from pure technology plays by non-banking third parties, existing banks developing parallel business models for a digital offering and a hybrid of third party and bank collaborations. Digital only players will have an advantage in offering exciting new approaches as they are not shackled by legacy system constraints. As a result these Fintechs may be able to innovate quickly and continuously to attract customers away from existing banks.
The opportunity exists for agile first mover banks to take advantage of access to existing customer data held in other institutions and working with Fintechs to build new business models that enhance customer experiences, cost and usability of platforms. Taking a wait-and-see approach could well lead to bank profits declining over time as customers seek better service and experience with third party providers.
The review will need to provide further information on the scope of open data, security measures to protect privacy and timing of the regime.
With the new open data banking regime, banks will need to proactively capture the opportunity or run the risk of watching highly profitable business leave the traditional banking sector; and with community concern about bank trust increasing, third party providers may have a significant advantage to capture share of banking wallet. With this considered, banks now need to:
Similar to the previous budget, a series of measures have been included to support the growth of Australian FinTechs.
From 1 July 2017, the government will remove GST from purchases of digital currency (e.g. Bitcoin) to align the GST treatment with that of money. This alignment will not extend to other parts of the tax law meaning that digital currency will still be treated as an asset for income tax and FBT purposes. Until these matters are addressed, continued limitations on integrating digital currency into Australia’s financial system are expected.
The government also intends to explore further measures in an effort to level the playing field between the big banks and smaller players. These measures include relaxing existing restrictions on closely held ownership structures, allowing use of the word ‘bank’ by smaller ADIs and introducing a phased approach to bank licensing.
Finally, the government has released draft legislation to extend the crowd-sourced equity framework to proprietary companies (from unlisted Australian public companies). The framework is designed to facilitate online fundraising, which allows individuals to make small financial contributions to a company in exchange for an equity stake.
Given increasing support for open systems and enabling Fintechs into the traditional banking domain, banks will need to find ways to innovate and collaborate with new entrants to maintain share of customer wallet while managing current profit centres.
Reducing barriers to the use of cryptocurrencies such as Bitcoin may also result in increased customer demand for banks to accommodate cryptocurrencies through digital wallets or related service offerings (e.g. cryptocurrency to AUD exchange facilities).
An unintended consequence of heightened oversight and review of pricing decisions and market forces, in conjunction with greater conduct oversight, may distract existing banks from market innovations benefiting end consumers.
When customers have full access to their data, the banks face greater risks in terms of data security and privacy resulting from identification controls.
Greater scrutiny of consistency of bank decision making may be questioned as customers gain greater access to their data across multiple banking relationships.
Tuesday night’s Federal Budget was also notable for being silent on a range of tax reforms that the financial sector has been eagerly awaiting – in some cases for many years. These reforms are either directed at simplifying Australia’s tax system, removing uncertainty or promoting Australia as a place to do financial services business.