Is the Royal Commission solving yesterday’s problems?

The Royal Commission (RC) into Misconduct in the financial industry in Australia, is doing an invaluable service to the Australian public by stripping away the facade that the largest financial institutions in Australia were operating honestly and that they were being well-policed by  world-class regulators.

However, in making recommendations to change the Australian financial regulatory system, the Royal Commission must endeavour to fight the next war, not the last one.

The commission’s  Interim Report highlights the ‘greed’ that permeates the Australian banking system, in particular the largest banks, the Four Pillars,  and drives reprehensible, even illegal, conduct in banking, investment and insurance.

But, unfortunately, the commission is, driven by its terms of reference, looking backwards, at an industry that has already moved on.

This commission is the commission that Australia had to have, as it was generally, but erroneously, believed that the misbehaviour unearthed in other jurisdictions, just could not happen in Australia.  Misconduct did occur and was just as pernicious as elsewhere.

The Commission must, of course, finish its valuable work, making recommendations as to how laws should be enhanced and/or simplified and identifying and punishing firms and individuals responsible for the egregious and systemic misconduct unearthed.

But is the Commission in danger of solving the problems of the past?

The End of Universal Banking

The commission’s interim report notes that the commission is dealing with “moving targets”, especially as the largest banks are busily rearranging the deck chairs

“More than once, the Commission’s announcement of its intention to hold public hearings into particular kinds of conduct was followed soon after by an entity announcing some change in its products, processes or procedures”

However, changes were already taking place in the Australian banking industry that will fundamentally alter how banks operate in future.  The interim report gives a short history of how the four major banks became “Universal Banks”, or “one stop shops” for financial products, by acquiring insurance and funds management business in the late 1990s.  As the commission notes, the banks have, save for Westpac, already divested themselves of these firms.

However, these divestments were not directly related the Royal Commission’s investigations, but fundamentally a result of the banks being not very good at running these businesses. The strategic logic of the original acquisitions was flawed, as the economies of scale just could not be achieved in such a small market, especially when facing intense and, ultimately lethal, competition from the industry superannuation sector.

With higher costs, the banks’ so-called wealth management arms just could not make reasonable returns without indulging in questionable selling practices, such as charging ‘fees for no service’.

The divestments of wealth management divisions would have happened without the RC, but the commission provided an impetus to get rid of the dead wood (albeit in what will be seen in future as a knee-jerk fire-sale).

But it was not only wealth management from which the banks have retreated.  Over the past few years, both ANZ bank and NAB have retreated from their ambitions to create a significant  international presence.

In effect, this retreat from overseas markets, means that by the time the RC finishes its work in 2019, the Australian financial system will be dominated by four very large retail banks that, by necessity, will have to compete head to head in the home mortgage and small business markets (as large businesses are serviced by international firms with large overseas networks).

But the four largest banks have already been castigated in the interim report for misconduct in home lending!

“In recent years, banks have acknowledged that aspects of their conduct in connection with home loans have been unacceptable and have caused detriment to consumers”

In future, with the four major banks operating in a small, volatile market (new home loans in the major Australian cities), the pressure to continue unacceptable practices will be immense, especially if pressure is increased by the Reserve Bank (RBA) requiring that banks lend more prudently.

Competition in the retail banking sector, for each and every new mortgage, will be cut-throat, if current profitability is to be maintained.  Cold winds are already starting to blow through the mortgage market, even without factoring in impact of the Royal Commission.

The Four Pillars Policy

The commission notes that “competition within the banking industry is weak”,

“But there being little threat of failure of the enterprise, and there being little competitive pressure, pursuit of profit has trumped consideration of how the profit is made. The banks have gone to the edge of what is permitted, and too often beyond that limit, in pursuit of profit.”

This means that without real competition to the large banks, and notwithstanding any changes to business practices recommended by the Royal Commission, there will be immense pressures to return to old, bad habits.

The Four Pillars policy, which is “aimed at ensuring that whatever other consolidations occur in retail banking, the four major banks will remain separate” has been a subject of debate since it was first introduced in the 1990s.

A recent report, by the Australian Productivity Commission (PC), into competition in the financial services system echoed the commission’s conclusion that competition was weak,

“While protecting competition may have been the stated objective of the Four Pillars policy, in practice it has protected a specific market structure above all else — one dominated by four domestic banks. It has thus had the scope to weaken the four major banks’ ability to pose a credible competitive threat to each other. The subsequent lack of takeover threat (posed by the major banks) to discipline board performance would normally be expected to depress competitive pressure”.

In its submission to the PC inquiry, the Australian Competition and Consumer Commission (ACCC) agreed

“Arguably the effect of the “four pillars” policy in addition to the implicit guarantee and prudential measures entrenches the large banks’ strong position in relevant markets and reinforces their “too big to fail” status”.

The Productivity Commission concluded bluntly that

The Four Pillars policy is a redundant convention [and …] There is no evidence that the Four Pillars policy has enhanced competition; and far more reasons to conclude that it may have dissuaded it by embedding a fixed market structure [emphasis added].”

The RC’s interim report does not explicitly mention the Four Pillars policy, so it is not known whether the removal of the policy has yet been discussed by the commission. Nonetheless, given the commissioner’s stated belief that competition is weak, it is likely that the final report will make recommendations that are designed to increase competition and hence make it more difficult to maintain the profit levels of today’s banks.


But whether or not the Four Pillars policy is removed, there is one set of pressures that will inevitably impact the profitability and viability of the major banks – Technology.

The major banks in Australia have not yet encountered the disruption caused by technological innovation that are beginning to impact overseas banks.  It has been reported that, in the UK, almost 1,000 bank branches are being closed each year and the rate of closures is rising inexorably. This is because of technology!

Today, with mobile banking, many of the basic transactions that used to require attending a branch bank, such as bill payments, transfers and deposits can be done online, at an ATM or even at a local supermarket. The New Payments Platform (NPP) which went live early in 2018, means that payments, such as to tradespeople,  can be made anytime, in real-time, at zero or minimal cost.

Australian banks operate over 5,000 full bank branches (mostly by the Four Pillars) and over 30,000 ATMs, which means that there is roughly one branch for every 1,700 families and one ATM for every 300 families.  And that does not count the many tens of thousands of EFTPOS terminals from which people can withdraw money from their bank accounts, at supermarkets and Post Offices.

Australia is clearly over-banked and a shakeout of bank branches, however painful that may be in small towns, is long overdue.  It will be painful for staff and some customers but will allow banks to reshape their expensive real estate to target high-value transactions. Such so-called ‘flagship’ branches will be based on the model developed by Apple and others, which highlights the range of products available in a high-tech setting.

Reducing the number of bank branches and making the remainder more user-friendly should, in theory, reduce the opportunities for misconduct by staff, allowing experts to be placed in the most efficient locations to provide high value, error-prone transactions, such as home mortgages.

So, in 2029, a decade after the Royal Commission hands down its final report, Australian banking will look very different to today and a set of recommendations made to tackle the misconduct that began a decade ago, just after the GFC, may be outmoded.

In practical terms, what does this mean?

It is obvious from the scathing critiques of the banking regulators in the commission’s interim report that the commissioner will make strong recommendations as to changes in the regulatory environment. It is hoped that the recommendations will be made with at least one eye on the future and the likelihood that economic and technology pressures will radically change the banking system in the next few years.

To handle the immense changes inevitable in banking, regulators that are empowered to take a big-picture, forward looking and flexible view of the banking system are needed.  And this new breed of regulators must be encouraged to be proactive, since an ounce of prevention is better than millions of dollars of fines and remediation costs.

The Royal Commission should be careful to try to set out to win the next not the last war!


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