Banking in Australia, 2020 and beyond
The Australian financial system is facing a number of headwinds which will continue to influence and change our systems of banking as we currently know it.
Financial services are central to our economy; in Australia there are currently over 140 authorised deposit-taking institutes (ADIs) regulated by APRA under the Banking Act. The big four banks, CBA, Westpac, NAB and ANZ, account for just under 60% of market share based on revenue.
The size and types of ADIs vary significantly and includes mutuals, credit unions and foreign and domestic banks plus the big four. Through these companies we’re provided with methods to exchange value, manage wealth, and get credit.
The Australian banking sector is evolving in the face of increasing regulatory supervision, market pressures and fintech challengers. This post examines three of the biggest pressures at play. The combination of these factors are leading to a gradual reconfiguration of market shares and banking business models. This will ultimately unlock greater value for consumers through a more competitive marketplace.
Increasing regulations and banking supervision
The regulatory environment for banking and onus on boards for an effective corporate culture and governance has been elevated since the failures that led to the GFC in 2007-08. Trust in financial institutions was severely undermined by a number of banking failures across the US and Europe. To strengthen banks and prevent future failures, tighter regulation on capital, liquidity and funding were introduced through the Basel III accords agreed by the Basel Committee on Banking Supervision (BCBS) in 2010.
In Australia, APRA regulates the banking sector. Our banking regulations play a key role in reducing risk in the banking system and providing system stability. This is beneficial for the economy and consumers, but it comes at a cost for the banks.
Regulatory capital increases
One outcome has been the requirement to increase regulatory capital that banks must maintain on their balance sheets. Increasing capital adequacy ratios protects against risk should a financial or credit crisis occur ensuring stability in the financial sector. Bank’s are able to absorb more credit loss in such a situation.
Higher capital requirements have been gradually phased in over the past few years. By 1 January 2020, the major banks will be expected to have a minimum 9.5% Common Equity Tier 1 (CET1) capital ratio, with an additional 1.0% above the minimum to take it to an ‘unquestionably strong’ level as defined by APRA.
The implementation of these accords imposes a significant cost on banks. Not only the physical cost of increasing their minimal capital requirements, but in the operational costs of implementing these standards to ensure compliance. CBA reported that risk and compliance costs were up 50% in 2018 alone.
Across the Tasman, the RBNZ is considering increasing capital requirements to 16% for banks operating in NZ (14.% of CET1). Australian banks are no doubt considering their operations in New Zealand and ‘reduce, demerge or sell’ will become the options for Australian banks with NZ subsidiaries.
The latest data from the Bank for International Settlements (BIS), shows that globally banks are making progress in meeting their Basel III requirements. CET1 level have been increasing in all regions since 2011 when Basel III changes started to be phased in. This shows there is ability for the banks to implement these important buffers. However, given the risks building in the global economy this is certainly not a time to weaken any regulatory capital or liquidity requirements.
Capital adequacy ratios have been increasing globally as Basel III changes have been introduced. Source: BIS
The increase in regulatory requirements from APRA, has seen a material increase in the volume of reports and data being sent to APRA. The process of generating these reports and data sets is complex and highly dependent on strong data quality in banking systems and data warehouses.
The disclosure of capital adequacy figures is only as good as the data used to calculate it. Without proof that bank’s data is accurate, complete and of general good quality, capital ratios cannot be trusted anyway. Investment in regulatory technology - ‘regtech’ - solutions to automate these processes will need to continue, along with developing strong data governance frameworks, data management capabilities and control frameworks to build confidence in risk data.
Ensuring data quality and investment in technology automation of regulatory returns are examples of new costs the banks are incurring to ensure compliance and manage their regulatory obligations.
Royal Commission outcomes
This year 76 recommendations were delivered as an outcome from the Hayne Royal Commission. 17 were specifically on banking, and 7 on culture and governance. APRA and ASIC both were called out during the Royal Commission for not taking harder action against the banks when poor practices and behaviours were uncovered.
Since, both ASIC and APRA have been given broader power, funding and general resources. The sectors regulatory bodies now have a mandate to oversee change to improve sales cultures at banks, governance and accountability. Banking models will change as a result. Perhaps most significantly are the removal of businesses focused on financial advice and superannuation. The increased oversight has seen the banks judge these no longer aligned to their purpose and have been divesting their groups of these entities to streamline operations and focus on core banking operations in Australia.
Financial stability through strengthening the bank’s capital requirements, has not been the only the focus for APRA. There are plenty of other non-credit risks the banks still need to focus on. APRA’s corporate plan was released in August which gives insight into their priority focus areas for the coming years. This includes transforming governance, culture and improving cyber resilience. Late last year, APRA released the final version of Prudential Standard CPS 234 Information security, which provides a clear set of requirements and expectations covering information security, including cyber risk.
APRA’s focus on governance, culture, remuneration and accountability (GCRA) follows on from the findings of the CBA Prudential Inquiry, Royal Commission. CBA was given a $1bn capital addon as part of the initial inquiry. Westpac, NAB and ANZ had $500m after their own self assessments into risk management practices to reflect the higher operational risks at the banks. Policy, practice and culture change are required to improve accountability at the banks. The implementation of Banking Executive Accountability Regime (BEAR) to heighten standards of accountability will continue to support this.
According to APRA, the Australian banking system is well capitalised. Ensuring stronger risk management and governance practices are in place across the full spectrum of risks that banks face, would help make the banking sector even stronger.
Too much regulation, unexpected consequences
With greater supervision and regulation, compliance costs will rise for ADIs. APRA’s comprehensive policy agenda both on bank capital and non-financial risk will not be limited to simple policy and procedure, extensive spend will be required on IT, automation, training and reporting capability. Smaller ADIs could actually be overburdened given their size compared to the big four banks. For the majors, the fixed costs of compliance is more easily absorbed by their business.
Whilst regulation applies to all ADIs many mutuals, building societies and credit unions are customer owned and not purely profit driven as the major publically listed banks are. It seems they will incur regulatory burdens as outcomes of the Commission even though it was the larger listed banks where so much evidence of poor practice and behaviour and conduct was found.
It’s important for the government and supervisory bodies to think about proportionality when applying new regulation. That is considering the size and complexity of the ADIs. The cost of compliance could significantly burden smaller ADIs which hampers market competition.
Compliance for banks covers not only regulatory capital, but a multitude of areas including governance, liquidity, responsible lending, information security and AML/CTF. The opportunity cost of compliance is the money that could have been spent on product innovation, technology or customer experience.
The challenge for banks will be ensuring they can efficiently meet their reporting and compliance obligations whilst still investing enough in productive capability to remain competitive in the long term as they face other technological and economic pressures.
Fintech, the challenge and opportunity
Deutsche Bank recently shed 18,000 jobs, by shutting down their equities division, and committed to investing $US20bn into fintech in a massive restructure designed to address their severe underperformance the last few years. In the US, JP Morgan has been ahead of the curve, investing $10bn, or 16% of its budget on tech in 2017. Locally in Australia, NAB is in the midst of making 6000 staff redundant as they pursue their digital transformation agenda. Will this be real innovation though, or just ‘innovation theatre’?
Fintech around the world is blossoming. Fuelled by the push toward a world of open banking and investors from both incumbent institutions and challengers seeking disruptive opportunities. Consumers are increasingly demanding faster, easier ways of paying bills and getting credit. 2018 saw over 1,800 VC investments in Fintech firms, worth $40.5 billion.
The Fintech ecosystem is disrupting all areas of financial services. Source: CB Insights
Fintech growth is global
Innovative technology and well funded fintechs are bringing complex financial products to everyone. From roboadvisors for wealth management, neobanks for saving and lending, to platforms for leveraged trading, and peer-to-peer lending marketplace for alternative finance.
In the UK and Europe, Revolut, Monzo, Starling and N26 lead the way. N26 in Germany offers app-based checking accounts and debit cards, and now has over 3.5 million customers across 24 countries in the EU.
Arguably ANT Financial in China is the leading fintech company in the world, and is now 50% bigger than Goldman Sachs. Tencent’s WeBank is another top Chinese fintech that delivers products across lending, investing, banking, and wealth management.
The leading fintechs are also starting to build out other financial services beyond their initial go-to markets. Betterment, a robowealth advisor is now also moving into banking.
In Europe, neobanks like Revolut, have been growing and acquiring customers from traditional banks for some years. But in Australia, the neobanks are just emerging. Volt, 86400, Judo and Xinja have received their banking licenses from APRA in the last year. These banks will compete on customer experience whilst maintaining lean operating models. Alternate non-bank lenders have been around a little longer. Fintech lenders like Ratesetter, and SocietyOne operate peer-to-peer lending models, connecting borrowers and investors on their marketplace for loans.
Collectively the growth of fintechs and development of their offerings, is leading to the ‘unbundling’ of banking services. In the coming years, the market will likely become more fragmented and competitive as consumers get their banking services from a multitude of providers.
Lean over legacy
Traditional banks are encumbered by legacy systems and complex IT architectures. The large Australian banks house some of the biggest data centres and technology platforms in the southern hemisphere. There are significant costs for banks to implement change, let alone maintain current systems.
Research by Accenture calculated that banks spend around 70% of their IT budgets on traditional IT services (such as maintaining core legacy systems) and only about 30% on non-traditional solutions related to digital transformation, such as cloud or data analytics. Respondents in the recent Digital Banking Report identified legacy technology (72%) and system integration (76%) as the two most difficult challenges of digital transformation.
Fintechs don’t have this problem. Born digital, integrated services allow these startups to deliver tailored personalised experiences for their customers. Fintechs are customer-centric, asset light and scaleable due to their legacy-free systems and use of cloud technologies.
Competition is increasing
Incumbent banks with access to lower wholesale funding costs will be able to defend their customer base by offering better rates, but may find it difficult to compete with fintech specialists focusing on just one product. Market share will increasingly become concentrated in the hands of best-in-class product providers as channel-barriers fall and information becomes more abundant.
The top digital transformation challenges for banks. Source: Digital Banking Report.
Most neobanks are not yet profitable, but they are growing their customer bases and attracting more investment as they continue to expand into new markets and improve contribution margins per customer. Whilst banks offer commoditised services, fintechs can take single financial services, produce them better through deep customisation and superior user experiences, and acquire customers.
Banks not only have to consider new neobanks, and alternate lenders, but large technology companies entering into core banking services. Facebook’s planned launch of the Libra cryptocurrency in 2020 looms large - assuming it will get over the regulatory hurdles it is facing. It could change global payment systems and draw deposits away from the banks to it own network.
Open banking is coming
The Consumer Data Right in Australia is being implemented to give Australian’s greater control of their personal data. It will be rolled out first in banking where it’s referred to as Open Banking. After banking other sectors will like energy and telecommunications will go through a similar transition.
Open Banking is powered through the use of common APIs (Application Programming Interfaces). These APIs will force institutions to open up customer data for sharing with other institutions. Digital transformations always start with data, and open data architectures keep the user at the centre of product development. The result is greater value for consumers and a more innovative and competitive banking market.
Open banking standards are now being regulated in many western banking systems, and Australia will closely follow the model developed and implemented in the UK. The first phase of Open Banking in Australia, beginning February 2020, will see the big four banks sharing customer data on deposit, transaction and lending products. Data can be shared with authorised third parties at the direction of the consumer who needs to give consent to the data recipient.
How consumer data flows from data holders to accrediated data recipients under the CDR. Source: Treasury.gov.au
Banks use consumer data, complex pricing and other tools to maximise margins on their individual customer accounts. By price discriminating between consumers, upselling, and lock-in contracts, these practices have reduced trust between banks and consumers. Open Banking seeks to redress this through the use of technology.
By empowering consumers with greater control over their financial data, they will be able to switch and compare providers more easily. Through enhanced user experiences that take advantage of open APIs, customers will have increased ability to find companies that offer better deals.
Open Banking also makes it easier for a startup to develop banking products. Through this regulation, major banks are having to invest to open up their data to their competitors, thereby eroding their competitive moats. In the UK since the launch of Open Banking in 2018, nearly 100 new companies have registered to use the new APIs. Product innovation will bring ever more value for consumers changing the product and service mix of banks as we know it.
Open, trust-minimised finance
On the technology frontier blockchain driven solutions in finance continue to gain attention on their promise to disrupt existing financial systems and service providers. From payments, lending, settlements, bonds, there are both open and private blockchain solutions in all areas of banking and finance gathering traction.
Global payments shakeup
The first digital currency to emerge was bitcoin in 2009. Due to the open source nature of the codebase, many more cryptocurrencies have been released since, all developed outside the current financial system.
Bitcoin is still a young currency, and has yet to fulfill its use case as a global medium of exchange - although it has exhibited store of value qualities when compared to other financial assets. Due to the price volatility of cryptocurrencies, ‘stablecoins’ have begun to emerge that are pegged to commodities like gold or the USD, or other cryptocurrencies like Ethereum. Facebook is the first bigtech company making a play in digital payments with their own stablecoin called Libra.
Banks have traditionally focused their payments networks on national standards. Interbank settlements handle international payments, with many process layers in between. With blockchain, cryptographic proofs, and peer-to-peer networks, payments can be truly global. Facebook’s mission is to ‘connect the world’ and they see financial transactions as yet another communication form. They’re planning to build a digital currency that people can access everywhere.
Libra may not a true cryptocurrency when compared to Bitcoin, since it’s not a truly open, permissionless and borderless network like Bitcoin or Ethereum. So it won’t compete against these open, public blockchains, but it will compete against both retail banks and central banks.
Libra will be backed by a basket of bank deposits and treasuries from high-quality central banks. This is designed to limit its price volatility. This means as the currency becomes available, fiat currency will partially move away from the banks. This is of profound impact for the banks, and it was notable that not one of the founding 28 Libra partner organisations included a traditional bank. America’s biggest bank, JPMorgan Chase has 50 million digital clients, Libra could dwarf that figure with access to Facebook’s 2.4bn users.
In response to the emergence of cryptocurrencies like bitcoin and now private issued digital currencies like Libra, the European Central Bank has said that the global dominance of the USD could be challenged by digital stablecoins. He follows the Bank of England Governor Mark Carney’s calling for work to begin on an international central-bank digital currency (CBDC). The development of CBDC could mean the end of paper money.
Comparing decentralised vs centralised money types. Source: IMF, The Rise of Digital Money
There is still a long way to go before Libra is released into the public domain, and there are many regulatory hurdles to get through. Banks must assume Libra will get approvals it needs to launch and will find a way to ensure compliance with KYC/AMK and other regulations. They must then determine their role in this new network, or in others that compete with it.
Decentralised Finance - DeFi
Decentralised finance emerged as a true use case for the Ethereum blockchain in 2019. Decentralised finance, known as ‘DeFi’, is the development of decentralised, open, trust-minimised financial services driven by open source protocols built on the Ethereum without unnecessary intermediaries. DeFi services provide an alternative to traditional financial markets.
DeFi services are emerging for payments, lending, insurance and many more. These open finance platforms enable individuals globally to participate in new financial systems without the need for trusted third parties. These services are run by smart contracts on open blockchains where transparency and accessibility underpin their design. Counterparty risk is reduced for participants via cryptographic verification on blockchains, like Ethereum. The open nature of the system uniquely allows for public accountability, as any user can audit the system.
Protocols such as MakerDAO, Compound and DyDx are using crypto assets to collateralise loans, all through smart contracts. Whilst use cases are still emerging, these platforms could service new markets that include the under and un-banked consumers. There is still an opportunity for banks and financial institutions to develop products on these open finance networks that leverage the protocols benefits whilst providing the regulated structures that consumers require when using sophisticated financial services. A precursor to this will be institutions agreeing on shared data standards and common workflows.
Total Value Locked (USD) in DeFi. Source: defipulse.com
Unlike fintechs, DeFi services are being built outside the existing financial system - an emergent parallel financial network. This could be significant market disruption just like streaming services redefined distribution of music, or ride-sharing apps in transport. These services don’t appear a threat for banks short term, but there are long-term implications for the sector that need to be examined and explored.
Many banks are beginning to experiment with provision of financial products and services using blockchain technology. This is happening both on open blockchains like Ethereum, and through private enterprise consortia solutions like Corda by R3. Blockchain technology is enabling the tokenisation of real-world asset and securities. This is the creation of digital tokens on a blockchain that represent ownership of an underlying asset. There are many benefits to this such as fractionalisation of assets, creating liquidity for previously illiquid assets, improving settlement times, lowering transaction costs and the development of other programmable features.
Banco Santander is one bank experimenting with tokenising bonds. They just issued a $20m bond on the Ethereum blockchain as a potential step toward creating a secondary market of security tokens. The bond, the cash used to complete the investment and the quarterly coupons have all been tokenised; you can see the Ethereum transaction here. Automated through the use of smart contracts, “the one-year maturity bond has reduced the number of intermediaries required in the process, making the transaction faster, more efficient and simpler” said Banco Santander.
The Santander blockchain-bond does not represent a first time a fixed income asset has been tokenised. Daimler AG, Russian Sberbank, the Government of Austria, BBVA and other have all been experimenting with this process.
Blockchain bonds and their value issued by banks around the world. Source: Binance Research
It’s innovative development like this that will push the adoption of finance applications on open blockchains - and private ones too. Most of the major banks around the world are looking at blockchain technology to see where it fits in their technology stack and product offering. Whether to support settlements, asset management, or payments and lending, there are plenty of opportunities for those who get in early and pursue blockchain as part of their digital transformation strategies.
A slowing economy and banking profitability
The global economy is now clearly slowing. GDP growth forecasts, and inflation expectations are trending lower. Questions continue to be asked around the level of debt in markets globally, whether that debt will be serviceable and what the impacts could be should defaults in certain markets start occurring. Excessive debts levels weigh on productivity and GDP growth and many investors are now on recession watch. Ongoing trade tensions, Brexit uncertainty and the low interest rate environment, will weigh on bank profits for the foreseeable future.
Europe is looking particularly fragile. German GDP is almost at 0% and Italy and France are not faring much better. The ECB is expected to cut rates further pushing more money into the system to try and push up inflation - which is trending towards 1%. Low interest rates have hampered banks’ revenues and further exacerbated their profitability issues.
Monetary policy effectiveness wanes
With few monetary levers to pull rates can only go negative. In Europe where the ECB has pushed rates below zero, Deutsche Bank, Credit Suisse, Societe Generale, BBVA and Barclays all trading near all-time lows. Reuters recently reported that UBS Group will be charging wealthy clients who deposit more than two million Swiss francs a negative interest rate of 0.75%. Banks in Switzerland and the Eurozone have been charging corporate clients negative rates.
Declining Central Bank interest rates. Source: BIS Quarterly Review Sept-2019
Further interest rate cuts are likely as monetary stimulus measures get more extreme given the already low starting point for short-term interest rates. The RBA has already cut rates by 75 basis points this year, New Zealand has cut 0.50% down to 1.00% (double what was expected), Thailand cut 0.25% down to 1.50% (first in more than four years), India cut 0.35% down to 5.40%, and the Philippines cut 0.25% down to 4.25% in the past month.
Lower interest rates drives down revenue from the loan portfolios of banks. The risk in Australia is zero or negative rates further dampening profitability across the banking sector. For the major banks lower rates have been offset by falling wholesale funding costs. For building societies and mutuals relying on deposits as their source of lending funding, the pressures are higher.
Tightening credit growth, shifting risk
APRA has also been focused on limiting riskier interest only and investor loans, both to ensure more responsible lending and keep bank balance sheets in check. Coupled with economic pressures which has dampened demand for credit, the regulatory focus has limited credit growth at the banks.
APRA’s has aimed to reduce the rate of credit lending through macro-prudential policies aim by imposing restrictions on lending institutions. The most common macro-prudential policies are caps on loan-to-value ratios (LVR) and debt-to-income ratios. APRA has been easing restrictions but the effects of the policies will remain, as banks apply tighter lending standards.
Credit growth in Australia continues to ease. Source: RBA, Sept 2019
Reducing credit risk at the banks means risk could shift elsewhere in the market. 90% of housing loans are currently provided by APRA regulated lenders but as lending standards have been tightened at the banks, non-ADI lenders, or the ‘shadow banking’ sectors has been increasing their share of the lending market. Risk reduction will continue to be a theme at the banks for the foreseeable future. This will put a dampening effect on profits as better governance, and consumers are front stage - as they should have always been.
Record debts and rising global risk
A record amount of debt is currently trading at negative interest rates, with $USD15 trillion of negative yielding debt in the economy. This could be a bond bubble, investment money, guaranteed to produce a loss. Falling yields have pushed investors to risk-off assets like gold in recent months, coupled with the falling AUD, gold is trading at all time highs. Even bitcoin has traded higher in 2019, up 200% as investors look to store of value assets as the opportunity cost of holding non-income producing assets declines.
Increasing negative yielding debt, mainly denominated in Euro and Yen. Source: BIS Quarterly Review Sept-2019
Business confidence is declining, and tension with US-China relations are making investors anxious. The Chinese Yuan broke the 7 USD level for the first time in a decade as the US-China trade war continues. China’s depreciation of the yuan has mitigated many of the proposed effects of the tariffs and economic war, but China’s banking system remains at risk.
There have been recent banking bailouts in China for Heng Feng Bank, Baosheng Bank and Jinzhour Bank in 2019. Smaller regional banks in China at risk of failure may increase as number of non-performing loans continue to climb. One in ten of China’s roughly 4,000 banks received a fail rating. Four hundred and twenty firms, all rural financial institutions, were deemed extremely risky, and only two received a top rating.
Leading economic indicators
Manufacturing indexes are declining across major countries, likely attributable to uncertainty over global trade policy. Declining global PMIs help support the case for looser monetary policy. Across industry, car sales have been registering negative year-on-year growth in almost all major economies, a contraction which helps to explain the collapse in Germany’s economic growth.
In the US the 3m/10yr yield curve has been inverted for over three months. When the yield spread dips below zero with the short-term rate raising above the long-term rate, the curve becomes inverted. This means investors are pessmistic about the economic outlook and choose to place their capital in safer long term bonds driving the price up and the yield down. The inversion of the yield curve has commonly preceeded US recessions since the 1950s.
The inversion of the 3m10yr US Yield Curve has preceeded every recession since the 1950s. Source: Merk Investments
Household debt-to-income in Australia continues to remain elevated at some of the highest rates in the world, which dampens the impact of interest rate reductions amongst already higher leveraged households.
Increasingly, central banks are calling on governments to initiate a fiscal response to the slowdown as monetary policy has diminishing returns in stimulating the economy. In Australia this is likely to mean further infrastructure spending and entitlements.
As probability of a recession nears, investors, bank managers and regulators will be monitoring loan impairments closely. If banks are to sustainably work through the next downturn, they will need to find ways to diversify their revenues to maintain profitability, liquidity and their capital ratios to absorb any unexpected losses. The biggest pain will always be for customers when banks run into trouble, so APRA needs to remain vigilant to protect consumers.
Responding to the challenges
Despite the economic, technological and regulatory challenges, there is opportunity for banks to rethink, reprioritise and innovate through the digital transformation of their business. Increased competition is desired in markets and consumers can benefit in the long term by banks optimising their products and services portfolios for broader consumer value. Shareholders and investors will want to see investment in technology and people talent and the efficient use of capital whilst managing risk.
For big banks, 60% of their funding at the big four banks comes from deposits. With the low interest rate environment and pressure on net interest margins this makes revenue growth difficult. Should Australia fall into recession, credit losses could spike. The major banks have capacity to absorb the losses, but it may be different for the non-bank lending sector. Earnings growth will be challenged too by the need for banks to focus on cost reduction, their remediation backlogs and productivity boosting initiatives. We should expect lower returns on equity from the banking sector in the near term and potentially cuts in dividend payouts.
Technology must remain a key enabler, but it must be targeted. Digital transformation; including investments in machine learning, AI, robotic process automation, blockchain and other digital capabilities will be required to stay competitive operationally against lean digital first entrants. Ensuring customer centricity in the development and maturation of products helps both retain customers and save costs whilst removing system complexity.
As fintechs move fast and Open Banking rolls out, the market will continue to become more competitive as barriers for entry are lowered. There is a threat from the technology giants entering into finance that must be considered. They pursue growth aggressively and have large existing customer bases to market financial products to. Fundamentally, the shift to mobile and digital first customer behaviour will drive the development of new business models, so the banks will need to continue to shift their focus to the customer if they are to remain competitive. The banks have resilient moats however, large distribution networks through branches, pools of financial data and access to capital. It will have to use these benefits to compete head on.
So do the banks have a real big vision? The banks will get through their remediation efforts, reduce legacy technology, simplify their product offering, and they will optimise their operations. It will take them time, but what is the big compelling vision for banking in Australia? The banks will have to find and continue to define that. Ultimately it will have to revolve around rebuilding trust, providing great value that is profitable and putting their customers first.
The postings on this site are my own and don’t necessarily represent BDO’s positions, strategies or opinions.