Watching the news yesterday left me a little gobsmacked. After standing strong for so long, the PM has finally given in and done a complete backflip. The Turnbull Government will establish a Royal Banking Commission. Well Turnbull really had no other choice after the CEO’s and chairmen of the big four banks wrote a letter to the Government asking for an inquiry in a bid to end the uncertainty once and for all. Despite his belief that it will do more harm, he admitted defeat and called the commission ‘regrettable but necessary’. The Royal Banking Commission will run for 12 months with a final report due by February 1, 2019. For months Labor, National MPs, the Greens along with some of the Government’s own party members have been pushing for an inquiry for some time. It’s now in the national interest to have an inquiry and may be the only way to restore confidence and faith in a sector that has been plagued with so many misconduct and fraud cases. Turnbull described it as a thorough inquiry that won’t just cover the banks but will cover wealth managers, superannuation providers and insurance companies.

In this article we’ll go through what we think are the positives and negatives not only for the banking sector but to its customers and the economy as a whole. We’ll also discuss whether we think the banking sector is still attractive.

Positives

  • The calling of the inquiry will once and for all end damage being caused by speculation affecting the banking sector.
  • It will end the days of banks behaving badly by addressing issues such as misconduct, rigging the BBSW rate, fraud, and sub-par customer service. It may also change the culture that has evolved in the banking industry.
  • An inquiry will help restore trust and faith in our banking system including in offshore markets. Because of the various misconduct cases that have occurred over the past few years, it has given the four banks a bad reputation. There is no faith.
  • Every stone will be turned and all the skeletons in the closet will come out. A complete rethink and clean out will help produce a better banking culture going forward.
  • Without an inquiry, we risk undermining the critical perception that our banks are unquestionably strong.
  • It is in the national economic interest for an inquiry to be held.
  • The public are dissatisfied with bank fees and costs. The inquiry could address these issues and reduce fees.

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Negatives

  • A Royal Commission will expose everything. All the bad with the good. There could be some deep secrets that lay buried away that if unturned could damage our banks beyond repair both domestically and globally. The inquiry could do a lot more harm than what it attempts to solve. If there are any new issues that are of a serious nature that can undermine that bank’s reputation and profitability, especially if it’s a systemic or an operational failing.
  • The system where by employees are paid via incentives such as the bonus structure faces a complete overhaul.
  • Whilst just about every arm of the bank has faced some sort of scrutiny, one division has flown under the radar. That is the real estate lending arm. With Australia having the highest household debt in the world, there’s no question that bad behavior could have extended to this part of the business as well.
  • The commission won’t just look at the banks but also insurers, wealth managers and superannuation companies. Companies that have been operating smoothly may suddenly find themselves in hot water.
  • The biggest losers here will be shareholders. Banks shares are expected to remain under pressure until the inquiry is over. Shareholders could also foot the bill for any changes banks are forced to make.
  • The banks are already heavily regulated. This inquiry will put them through further scrutiny. That will tarnish the capitalistic way banks operate. It won’t be a free market. Banks will start to operate a lot less freely and will be more reserved.
  • Moody’s credit ratings agency says that if new issues emerge they will be forced to revise their assessment of the major banks. That can affect bank funding and the possible increase in costs.
  • One can argue that the inquiry is of no benefit to both banks and customers. It will not award compensation for any wrongdoing and it will cost around $75 million.
  • Culture can’t be regulated or governed.
  • The inquiry could bring about more compliance costs that will be passed onto customers.
  • More regulation and stricter lending policies will be implanted making it harder for small business and customers to borrow. Banks will become more risk averse.
  • It will capture not just the banks but insurers, wealth advisers and Superannuation Funds. There is the risk that the wealth models which exist in the Banks, AMP and IFL will be upset. Potential conflicts of interest could be targeted such as advisers selling and using in-house products. Bell Potter says “AMP faces additional scrutiny surrounding the provision of Life Insurance, with level of rejections and procedures to come under review.” The broker says it doesn’t any good to come of the review for AMP and IFL.

Unconventional View: What do we think? Well there’s no point in discussing whether the inquiry is a good thing or bad thing, it’s been decided and it’s happening. As you can see above there are both good and bad points. I think the more important question is to work out the short and long term impact and whether investors should be exposed to the banking sector.

The Royal Commission is expected to be finalised by February 2019. Until that time, its throws the entire banking sector into uncharted waters. No one can predict what will come of this. It could either be a positive thing for both the banks and customers or it could go really bad. In the short term, it will most definitely be a negative for bank shares, staff and customers. Mum and dad superannuation shareholders will cop the brunt of it. Investor confidence will sink as we all know the market hates uncertainty, so you can expect investors to reduce exposure to this sector. If the inquiry  helps improve the way they conduct business, then great. If however the inquiry digs up some nasty secrets… it may harm the bank’s reputation and profitability. It risks undermining the critical perception that our banks are unquestionably strong. Global clients may stop doing business with us and credit agencies may increase their funding costs. It’s a snowball effect.

On the flip side, we think the longer term impacts are positive. It is in the national economic interest for an inquiry to be held for the benefit of not just the economy but for every Australian. At the moment, we simply have no faith or trust in our banks. The bad behaviour and culture that has plagued this industry after the GFC needs changing. This has to be done before the public can regain its faith and confidence in sector. If problems are unearthed and actions put in place to fix them, the banks will become even stronger. The inquiry will translate into a better banking system in the long run that will benefit customers, the economy and shareholders.

For that reason, we advise investors looking to gain exposure into the banks to hold off for the short term, just until there is further clarity surrounding the inquiry. The banking inquiry will be all plastered over the media for the next month, you’ll see it everywhere. So expect this to hangover the share price in the short term. We think the banks will pull back. In the medium term, provided no real nasties are uncovered, the market will revert back to earnings and profit expectations. We think banks will continue to beat earnings expectations. They are highly profitable, high ROE, have little competition and are globally competitive. So expect bumper profits. It’s a buy in the medium term. If we had to choose our of the big four, we’d lean towards NAB. They’ve got the least exposure to the residential mortgage market and have undertaken a massive innovation tech drive that will drive earnings going forward.