Insights

Banks – the Growing Trust Deficit

By December 17, 2019 December 19th, 2019 No Comments
By William Wu

Bill Gates once famously said in 1994, “We need banking. We don’t need banks.” Banking’s role in providing lending is a critical enabler to economic growth. Yet why do we leave our savings with banks despite the exponential technological advances over the last two decades? Because we trust them. The simple truth is you wouldn’t leave your life savings with a stranger nor would you lend money to unknown individuals. The word credit is also derived from the Latin word “credo” – I trust. So why has our trust in banks eroded so much in recent years?

By William Wu

Bill Gates once famously said in 1994, “We need banking. We don’t need banks.” Banking’s role in providing lending is a critical enabler to economic growth. Yet why do we leave our savings with banks despite the exponential technological advances over the last two decades? Because we trust them. The simple truth is you wouldn’t leave your life savings with a stranger nor would you lend money to unknown individuals. The word credit is also derived from the Latin word “credo” – I trust. So why has our trust in banks eroded so much in recent years?

Culture – the power of language

Corporate culture is an extremely important, and often the most critical aspect, when assessing a company. So important, that the overarching theme of Commissioner Haynes’ Royal Commission report was corporate culture. He described it as “what people do when no-one is watching. Culture can drive or discourage misconduct….. although culture cannot be prescribed or legislated, it can be assessed.”1

One of the ways to assess culture is through Melior’s proprietary language processing tool which provides an indication of corporate culture by clustering key language from large amounts of report data. We have focused on risk, customer, income and remuneration language used in financial reports over the last five years to reflect the core issues facing the big banks from the Royal Commission. A number of interesting findings can be observed from the data:

  • Customer” was broadly the lowest priority for the big four during the period. Whilst there has been an increase post the Royal Commission for all banks, there is still significant scope for improvement. This provides a particularly interesting insight given the recently alleged regulatory and legal breaches and the brand damage that has resulted.
  • Risk” differed greatly for all four banks. For example, NAB had the largest risk focus decline in the lead up to the Royal Commission announcement (2017) and was the slowest to increase its focus; suggesting a correlation with the Royal Commission NAB fall out. CBA had a steadily increasing focus on risk however that accelerated greatly post the AUSTRAC Statement of Claim and the Royal Commission. Overall, “Risk” for all four banks increased post the Royal Commission.

Source: Melior

Incentives - money talks

Another key aspect influencing company values are remuneration and incentives. As Commissioner Haynes described, “culture, governance and remuneration are closely connected.2

The analysis below takes a closer look at the incentives of key management personnel in the financial year ended 2017, prior to the Royal Commission to determine if there were any leading indicators into corporate culture for the big four banks:

Source: Annual Reports

The lower weightings of non-financial factors in STI such as customers, risk, people and reputation compared to the financial factors is consistent with the findings from the culture assessment. In FY19, it was pleasing to see positive changes for three of the big four banks as non-financial measures held a greater weight for STIs compared to 2017. ANZ financial measures declined from 50% to 35%, CBA financial measures declined from 55% to 30% and Westpac financial measures declined from 80% to 55%. NAB financial measures however increased from 50% to 75%.

With respect to Long Term Incentives (“LTI”), Total Shareholder Return (“TSR”) is a major component of most Australian listed companies. TSR is a measure of share price and capital (dividend) returns, typically compared to a certain benchmark or peer group of like-for-like companies. Macquarie Research estimates that 70% of ASX listed companies include TSR as a performance metric.3 Unsurprisingly, all four major banks included TSR in 2017 and for ANZ, the only measure of long-term performance was the share price. This also correlates with the Royal Commission ANZ fallout. Unfortunately, LTIs were largely unchanged since the Royal Commission.

Source: Annual Reports

At Melior, we do not believe that the performance of a Company’s share price, which may be influenced by externalities outside of management control, is the right incentive for management as it fails to take into consideration other stakeholders such as customers and the community. We believe that the TSR weighting for LTIs should be reduced to align management to a broader set of stakeholders.

In our view the alignment skew of remuneration towards financial outcomes has been a significant contributing factor to their recent misconduct. Melior monitors any changes to remuneration policies through our proprietary ESG framework.

Too big to manage?

Since 2018, three of the big four banks have published their Culture, Governance and Accountability reports, with ANZ being the only bank not to self-publish. Here are some key findings from those reports:

  • CBA – “…unclear accountabilities…immature and under-resourced compliance function…”4
  • NAB – “…approach to managing compliance and conduct risk was not sufficiently robust or effective…remuneration and performance management didn’t consistently and visibly sanction poor behavior…”5
  • Westpac – “…organisational tendency to cultivate complexity…non-financial risks across all lines of defence remains generally less mature than its management of financial risk…”6

A good proxy for a bank’s investment in compliance tools is to look at technology expenditure as percentage of sales. Analysing the results for ANZ, CBA, NAB and WBC over the last five years indicates that technology spend has increased but not at a step change pace for most banks.  NAB is the exception with a significant increase in spend in 2019 following a period of underinvestment versus peers. Interestingly, whilst Westpac had the highest technology spend over this period, they have not been shielded from system related compliance breaches with the recent AUSTRAC Statement of Claim pointing to underinvestment in Westpac’s key IT systems “…failure to properly resource the AML/CTF function, to invest in appropriate IT systems and automated solutions…”.7 This suggests that current technology expenditure has not been sufficient to manage the complexity of financial institutions and increasing compliance and regulatory demands. We expect further IT expenditure to be required going forward.

Source: Melior

Melior's response

From an impact perspective, Melior recognises the benefits of banks in providing economic growth particularly in areas such as small business lending. Melior however do not currently have exposure to Australian Banks due to:

  • No banks currently* passing our ESG framework assessment given their poor performance, particularly in the areas of governance and social licence to operate
  • Increasing customer transitions away from the big four banks as a result of declining trust post Royal Commission, AUSTRAC and ASIC findings
  • Headwinds in maintaining their dividends and strong capital positions due to higher system and resourcing costs of compliance and further risk of regulatory fines

Melior however is advocating for positive change in the banking industry through direct company dialogue and participation in the Australian Sustainable Finance Initiative (“ASFI”). Specifically, Melior is advocating for:

  • Enhanced disclosure and transparency to allow investors to evaluate not only financial risk but also environmental and social issues and risks;
  • Greater alignment of remuneration to incorporate environmental and social outcomes;
  • Embedding greater environmental and social considerations into corporate strategy; and
  • Banks to take wider consideration of all stakeholders including their customers and the community.

*As at 18 December

Sources

1 Kenneth M Hayne (2019) Final Report – Royal Commission into Misconduct in the Banking Superannuation and Financial Services Industry
2 Kenneth M Hayne (2019) Final Report – Royal Commission into Misconduct in the Banking Superannuation and Financial Services Industry
3 Macquarie Research and CGI Glass Lewis (2015) Executive incentives: motivate me
4 Macquarie Research and CGI Glass Lewis (2015) Executive incentives: motivate me
5 John Laker AO, Jillian Broadbent AO, Graeme Samuel AC (2018) Prudential Inquiry into the Commonwealth Bank of Australia
6 National Australia Bank (2018) NAB Self-Assessment on Governance, Accountability and Culture
7 Westpac Banking Corporation (2018) Governance, Accountability and Culture Self-Assessment
8 Statement of Claim (2019) Chief Executive Officer of the Australian Transaction Reports and Analysis Centre v Westpac Banking Corporation

https://www.sustainablefinance.org.au/
https://financialservices.royalcommission.gov.au/Pages/default.aspx/
https://www.apra.gov.au/news-and-publications/apra-releases-cba-prudential-inquiry-final-report-and-accepts-enforceable
https://www.westpac.com.au/about-westpac/media/culture-governance-accountability/
https://news.nab.com.au/news_room_posts/nab-releases-self-assessment-into-governance-accountability-and-culture/

This content is for general information only. In preparing and publishing this content, Melior Investment Management Pty Ltd (ACN 629 013 896, authorised representative no. 001274055) does not seek to recommend any particular investment decision or investment strategy and has not taken into account the individual objectives, financial situation or needs of any investor. Investors should consider these matters, and whether they need independent professional financial advice, before making any investment decision.