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ESG in Australian Banking: A look at the Royal Commission Inquiry

Posted on May 10, 2018

Enrico Colombo
Enrico Colombo
Associate Analyst, Research Products Sustainalytics

The ongoing Government-appointed Royal Commission inquiry into misconduct in the banking and financial sector has put Australian financial institutions at the centre of a storm of public outrage, media attention and investor concern. Daily headlines are revealing a litany of wrongdoing and raising questions about what went wrong, and the reforms needed to fix it.

In this article, we analyse companies’ current and past misconduct, and highlight the companies that, in our view, are better prepared for the anticipated industry reforms. We also examine project financing, an area beyond the scope of the inquiry that might nonetheless be of interest to some investors.

The Issues Facing Banks and their Investors

Australia’s Big Four banks (Commonwealth Bank of Australia [CBA]; Westpac; National Australia Bank [NAB]; and Australia New Zealand Banking Group [ANZ]) together with AMP Limited have been the main targets of the inquiry. The hearings so far have focused on consumer lending and financial advice, and commissioners are gathering evidence of misconduct and shortcomings in compliance, such as charging fees without providing service, conflicts of interests, and misleading regulators.

Australian banks are accused of providing subpar financial products and services, negatively affecting customers, while simultaneously posting large profits. This environment, which benefitted investors and superannuation funds’ short-term returns, is now posing massive reputational damage and has wiped away billions of dollars in market value as share prices plummet.

According to investment research firm Morningstar, the fundamentals of Australia’s banks and the economy are solid, and it anticipates bank stocks will recover given the problem cases highlighted by the inquiry are limited in number compared to the size of the overall customer base. Similarly, our research shows Australian banks perform relatively well in terms of overall ESG policies and programmes compared to global peers. These companies have, at least on paper, internal processes to monitor operational, non-financial risks, ensure compliance and implement corrective actions. In practice, however, as widely reported by media and tracked by our Controversy Research, these controls appear to have not functioned effectively.

At Sustainalytics, we have seen increasing instances of misconduct by Australian financial institutions since 2015 – from charging customers for advice they did not receive, to rigging interest and foreign exchange rates to breaching anti-money laundering laws. Prior to the inquiry, Sustainalytics’ Controversy Research had already picked up patterns of involvement in incidents, flagging areas of significant levels of impacts and risks with downgrades up to Category 3 (with Category 5 being the most egregious).

The graph below shows the number of business ethics, corporate governance and customer related incidents in the Australian financial industry in the last five years.

Number of Incidents in Australian Financial Industry

Source: Sustainalytics Controversy Research

Note: incidents include business ethics, bribery and corruption, accounting and taxation, corporate governance, product/service quality and safety, anti-competitive practices, marketing practices

Australian financial institutions have paid around AUD 1 billion (USD 885 million) in combined fines, settlements and compensation since 2013, while executives and board members have resigned amid scandals and shareholder pressure, the latest being AMP’s CEO, Chairwoman and three board directors in April-May 2018. In the coming months, we expect companies to face continued negative reputational exposure, high legal risk and regulatory scrutiny, possibly translating in civil and criminal charges, corporate leadership changes, as well as fines, lawsuits and compensation claims. We maintain a negative outlook on the Business Ethics controversies, signalling the possibility of further downgrades of our controversy ratings, pending the developments of the inquiry and proceedings.

The Need for Reforms and Upcoming Changes

The Commission will share its findings and recommendations later this year. Meanwhile, industry observers and commentators have already highlighted some of the root causes of the issues that will need reforms: banks’ vertical integration, the oligopolistic configuration of the industry with sector concentration and lack of competition, and inadequate regulatory supervision and enforcement, resulting in a hubris culture among bankers.

In anticipation of sector reforms, the financial majors are selling or planning to sell their wealth management divisions, exiting the most problematic businesses in a controlled way instead of through a forced separation. In early May, NAB announced its decision to sell its wealth management arm, after similar moves in autumn 2017 by ANZ and CBA.

As an outcome of the inquiry, we expect increased regulation and supervision of the banking industry to counter the history of lax consequences which contributed to the current situation. Regulators such as the Australian Securities and Investments Commission will likely apply strengthened powers, more resources and stricter enforcement of the rules to hold companies and individuals more accountable. A recent report by the Australian Prudential Regulation Authority on CBA’s governance, culture and accountability has been defined a “must read” for executives at large firms, as it provided a “road map” for improvement which the bank’s new leadership has committed to implement. Consequently, we expect companies will be pressured to improve their own internal systems and governance structures.

In the chart below, we analyse our Business Ethics Management Score for some of Australia’s largest financial institutions prior to the commencement of the Inquiry. The Business Ethics Management Score aggregates underlying indicators such as: Bribery & Corruption Policy, Whistleblower Programmes, Money Laundering Policy and Political Involvement Policy, deducting companies’ involvement in controversies.

According to our research Westpac, NAB, ANZ and Macquarie exhibit higher scores, thus signalling relatively better preparedness, albeit still not reaching strong management levels as defined by Sustainalytics’ rating.

Source: Sustainalytics ESG Research & Ratings

Controversial Financing: NGOs Criticism and Investor Engagement

One area that the Commission will not examine is banks’ relationships with companies or industries whose products have adverse environmental and social impacts. However, some investors and other stakeholders are paying attention not only to how banks run their own operations, but also to the types of businesses they finance.

The Big Four have strong overall ESG due diligence requirements as part of their credit risk assessments, but gaps remain in the strength and level of detail of their standards and exclusion policies for high-risk industries. They have all been subject to criticism by NGOs and activists for their financing of certain projects and industries. NGO reports have called out the Big Four for being among top financers of fossil fuels, and none have made explicit commitments to completely end financing. Other criticism in recent years targeted Australian banks’ financing of palm oil and sugar plantations linked to human rights abuses, land grabbing and tropical deforestation, low quality fuels that damage human health, and manufacturers of nuclear weapons.

While the criticisms above do not have an immediate material effect on banks, controversial financing activities could still be of importance for investors, especially those focused on responsible investment. As the Task Force on Climate-related Financial Disclosures (TCFD) recommendations gains traction, investors will ask whether Australian financial institutions are adequately and diligently reporting on their exposure to fossil fuels and on climate change business scenario analysis.

In the light of shifting public expectation and the momentum of responsible finance, investors may wish to further engage with financial institutions on their responsible investment approaches and on potential misalignment between companies’ strategies and practices.

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