As Australians continue to endure unprecedented economic and social conditions, the role of the banking sector continues to evolve. But when the immediate crisis is over, what will be the long term implications for the sector?
In 2019, the implementation of the Financial Services Royal Commission's (FSRC) recommendations was the single most critical focus for the banking sector.
In 2020, everything changed.
Faced with a global pandemic and its severe health, social and economic implications, the banking sector was forced to pivot in order to provide government directed and other support to the community. But when the immediate crisis is over, what will the long term implications be for the sector and the community? What will the next 12 months bring?
Since March 2020, the banks have played an important role in assisting Australia to navigate the economic crisis by supporting the federal government's stimulus packages and providing credit and liquidity support to the community more broadly in a number of ways. These include offering concessions, repayment deferrals, fee waivers and unsecured loans. Not surprisingly, the customer and community centric stance taken by the sector, with support from the regulators, has seen approval ratings of banks improve at a rate that might not have otherwise been achievable in the wake of the FSRC.
The challenged COVID-19 environment has manifested itself in a number of ways, each directly impacting the traditional value drivers of the banking sector. These include reduced economic activity, declining GDP, the pressures on small and medium sized businesses to simply survive, rising unemployment, a credit environment that is under some stress for the first time in years, a decline in asset values, inflation rates and interest rates that are at historic lows.
The earnings of the banking sector are likely to remain challenged for the foreseeable future. ROE figures - once among the world's leading - have slumped from high teens to single digits, with current returns on equity the lowest they have been since the 1990s. Significant falls in cash earnings reported in 2020 and a prudential regulator requiring restraint in dividend payout ratios means that the trend towards growth in half on half year earnings and fully franked dividends has been reversed. The regulatory imperative that Australian banks be ‘unquestionably strong’ has provided the capital for banks to act as the economy’s ‘shock absorbers’, but it too contributes to reduced ROE for banks.
Credit impairment, asset write offs, compliance, regulatory and remediation costs and growth in operating expenses have all contributed to the decline in earnings. In addition, the dampening effect of the very low interest rate environment on profits has been exacerbated by continued margin compression created as banks compete fiercely for market share. Although this is good news for borrowers, it will serve to maintain pressure on the profitability of banks and rate of return on their assets.
It is difficult to be definitive about the banking sector's outlook in these uncertain times. Bank performance is inextricably tied to the economy and much will depend on the shape of the recovery. If the downturn is prolonged, the challenges of maintaining market share and acceptable returns, together with the high cost of meeting regulatory requirements and doing what is necessary to pivot could lead to some consolidation at the smaller end of the sector.
Changing demographics, heightened consumer expectations, evolving technology, increased regulation and the demise of the bancassurance model are shaping the way forward for the industry in both the short and long term.
Challenges to top line growth are forcing banks to accelerate their efficiency agenda. A cost control approach will no longer be enough and a permanent reduction in the cost base is needed. This will require a continued drive to simplify systems, products and processes, which follows the trend by banks to shed their wealth management and insurance businesses. Greater digitisation and more sophisticated use of data and analytics are central to this. In the short term this will result in a further but temporary drag on earnings because of the required write off of some assets, for example, outdated systems and software.
The Open Banking regime and the growth in the mortgage broking industry will add further dimensions to the banks' challenges. Continued customer centricity and targeted offerings to market segments and individuals will remain key to maintaining and growing market share.
Post the FSRC, ensuring the financial health, customer focus and reputation of organisations is a continuing top priority for regulators and those charged with governance and management. Accordingly, the prudential regulator has strengthened and intensified its focus on and oversight of governance, culture, remuneration and accountability.
The FSRC lifted standards of governance not just in the banking sector, but across corporate Australia. Under law, directors have a primary duty to the shareholders of the company. In today's world, there is a growing recognition that a strong focus on customers and other stakeholders builds long term, sustainable shareholder value. Improved governance standards are being evidenced in a variety of other ways, such as more effective accountability, appropriate remuneration structures, focus on non-financial risks, greater probing and following through to ensure that issues are not just being identified but also resolved. Bank directors are also receiving more mature data and insights on non-financial risk which assists with considering the interests of other stakeholders as a means of promoting the welfare of shareholders.
The structure and quantum of executive remuneration has changed significantly – and will continue to evolve. Levels of bank executive remuneration are the lowest they have been in recent years. There has been a material shift away from predominantly financial performance based short term incentives to incentives that take into account matters such as conduct, risk hurdles and customer care. Claw back and malus clauses, although routinely built into employment contracts previously, were rarely enforced. That too is changing.
“Organisations have put in programs for cultural change and are speaking about the purpose of banks in a different way to how they were a couple of years ago. A lot has changed already, but what remains to be seen is how enduring it is – especially in the area of remuneration.”
Dimity Kingsford Smith
Non-financial risk has been an ongoing, major focus for the banking sector over the last two years. APRA increased its focus on non-financial risk after the self-assessments conducted by organisations in 2018 revealed shortcomings across the industry. Meanwhile, ASIC began to closely examine how companies treated these risks more broadly. The rollout of BEAR has also led boards and management to place much greater emphasis on the culture of the organisation and the conduct of its management and staff, together with operational performance and accountability.
Now, in the face of a crisis, the balancing act for boards in managing financial and non-financial risk, as well as the needs of differing stakeholders, has become more complex. There are many significant short term impacts arising from the longer-term objectives being pursued. However, the importance of managing non-financial risk – especially organisational culture and conduct – is magnified.
In the current environment, speed is of the essence. Critical, business changing information is being released daily, board and management committees are meeting more frequently and rapid decision making is becoming the new norm.
Longer-term, organisations are starting to consider the ongoing implications and lessons from the current situation they are facing. For example, they are looking at how the pandemic impacted offshoring partners and how well they were equipped to handle it. Scenario planning is now critical as organisations consider how they could manage the risks if similar events were to happen again. There is no evidence to suggest that there will be a large scale retreat from offshoring. However, the pressures of working from home during COVID-19 without adequate infrastructure in some offshore jurisdictions manifested itself in reduced levels of customer service. It appears likely that banks will closely examine which aspects of offshoring – from a risk reward viewpoint – are better served being onshored in the long run. Inevitably, banks are closely examining the robustness of their business continuity plans for offshored activities.
The BEAR or FAR model can also be leveraged to gain clarity about where accountability lies in the business. This is particularly valuable for helping the C-suite and boards to gain clarity around the distribution of authority.
Organisations should consider if they have a fully activated ‘voice of risk’ in the business. There are fewer face-to-face interactions between customers and employees, employees with each other and employees with management. It's clearer than ever that institutional change is the only way for banks to ensure they are building in appropriate listening, accountability and cultural settings and recruiting people with these skills.
The three lines of defence must work together more effectively than ever before, and line one in particular will require greater on-going clarity, particularly in relation to its responsibility for operational risk. More generally, unquestionably, the voice of risk and compliance functions has been amplified.
An increasingly digitised world brings with it a number of challenges. These include the loss of customer interface and the ability to differentiate from competition. Customers are increasingly conducting their financial affairs online and are adept at shopping around for the best offers and prices.
Data and technology hold the key to addressing many of the banking sector's shortcomings, including enhancing transparency, enabling a more customer-centric approach and facilitating data sharing. They will also enable financial services institutions to meet the growing competitive challenges posed by new payments systems, a growing fintech market and the introduction of Open Banking in 2021.
COVID-19 has made this even more apparent by accelerating digital transformation, with social distancing forcing banks to introduce digital options for customers much faster than anticipated. Likewise, customers are far more willing to embrace digital options than ever before.
Technologies such as artificial intelligence and machine learning can be used to reduce the regulatory burden, automate core business processes, improve the customer experience, and detect and prevent financial crime. These technologies are also crucial for analysing the vast amounts of data and documents required to model and predict risk, aid decision-making and ensure the right systems are in place.
Unfortunately, in recent years, many institutions were so tied up with responding to the perfect storm of challenges arising from the FSRC Report they didn’t have the bandwidth to pursue digital transformation. In many cases, they are still hampered by legacy systems that can lead to inconsistencies between risk management, regulatory compliance and customer information. The underlying and persistent difficulty has been under-investment in systems, with incomplete builds and many processes left to manual operation.
Once Open Banking is introduced in June 2021, attracting and retaining customers is likely to become more difficult. Investing in smart technology is one way that organisations can differentiate themselves in this new environment. Some organisations are already spending heavily on digital transformation projects. For example, CBA has spent well over $1 billion on its core IT systems in recent years. The bank also recently announced a $450 million investment in buy-now, pay-later provider Klarna, which can be accessed through the bank’s app.
However, with cost blowouts putting pressure on institutions to deliver services more cost-efficiently, many organisations will need to focus on updating core technology first.
Scarce resources, including specialist IT skills, are also creating challenges in a tight market. Despite the available technology, it is often impractical to buy out-of-the-box solutions as they will almost inevitably need to be customised at additional cost.
“Everyone, including the regulator, assumes the banks know everything about you. Which is sort of true, but that information is in 15 different places that don’t talk to each other. Linking that data to get a single view of the customer sounds simple but it is a huge challenge.”
Having a single source of truth for all customer data will be critical moving forward. This will help organisations to provide better service, create more meaningful customer experiences and offer products that customers want to use.
Don't underestimate how long it takes to get new technology up and running.
It may be simpler to implement a new solution than to try to fix legacy systems.
Customers will need help in different ways from the past.
Consider partnering with a nimbler fintech or regtech firm.
It is not a set-and-forget option. There are also several ethical and privacy considerations.
Don’t be disheartened if things don’t go to plan. Small iterative steps will deliver results.
The Australian banking industry enjoys a deserved reputation for being safe and stable. The industry is well regulated. Banks have sound fundamentals: they are well capitalised with healthy liquidity ratios and generally sound risk settings. Their business models and strategy are inherently low risk – other than exposure to the residential property market in Australia and high levels of household debt. Australian banks are also resilient and have a demonstrated track record of being adaptable and able to pivot when necessary.
However, the sector – already behind its overseas counterparts in the United Kingdom and the United States – cannot afford to take its foot off the pedal when continuing their journey towards long-term, meaningful cultural change. In this challenging, evolving environment, the banks must continue to balance competing pressures and priorities. Consistent throughout, however, is the customer centricity of their approach.
Banking Sector LeaderAn extensive career in the professional services industry has enabled me to build a reputation as a leading adviser to major banks and financial institutions in Australia and Canada.