Commerce Commission report – a recipe for disruption?

Phil Doak - Partner

Defining the problem

The recently released Commerce Commission (“CC”) report on NZ’s personal banking sector has, not surprisingly, garnered a range of responses. ?

Having spent a good part of my career in a major bank, I confess to feeling somewhat bemused by the whole process and the specifics of the “problem” it is/was trying to solve. My focus these days (and that of Mosaic) is to support clients with what is, hopefully, pragmatic advice and solutions to contemporary operational challenges. Being clear on the problem statement is a key starting point.

With that context in mind, the problem statement in this instance felt seemed somewhat muddled.

Is it:

.That NZ Banks’ (more specifically Australian-owned banks’) level of “profitability” is too high, relative to what it could/should be (however that might be defined)?; or

.That NZ consumers are paying fees that are too high and/or interest rates that are too high (if borrowing) and too low (if making deposits); or

.That NZ consumers are receiving services that are sub-par compared to other international jurisdictions, this being a function of either inadequate investment in technology by banks in general, and/or lack of market innovation more broadly?; or

.That the banking sector is largely Australian (as opposed to NZ) owned and is underinvesting in “NZ Inc” and repatriating dividends to parents to satisfy rapacious shareholder return expectations?; or

.That banks are too risk averse and should be lending to higher risk sectors?; or

.All of the above and more?

A narrow scope

The review’s scope excluded a sizeable chunk of the broader banking sector (it’s not all about personal lending and retail deposits), many parts of which contribute very meaningfully to New Zealand’s economy and, in doing so, contribute to the sector’s (particularly the Australian-owned banks’) reported profits.

Business and rural banking/lending services will now get their day in the sun courtesy of the Finance and Expenditure Committee's Inquiry (in consultation with the Primary Production Committee) into banking competition, so it will be interesting to see what emerges from this exercise. A focus on understanding any banking-related impediments to the productive sector’s ability to access capital seems more likely to have a meaningful impact on “NZ Inc” longer term than debating the levels and margins on personal home loans and deposits, acknowledging of course the very real effect both have on NZ consumers.

Notwithstanding the limitations of its scope, the CC’s personal banking sector review provided a helpful analysis of the “state of play” and put forward a range of recommendations, a few of which may, at the margin, have a modest, positive impact for NZ consumers.

So, what about disruption?

There is much talk of “disruption” – that it needs to happen, how it could happen, and who/what could drive it.

Disruption is an interesting term. I expect the RBNZ, from a systemic perspective, would prefer to see disruption emerge from the development of new services that consumers will value and are prepared to modify their behaviours to adopt. Open banking and the associated?enablement of Fintech-provided propositions may potentially assist with this.

I’d expect that the RBNZ is less likely to prefer disruption in the form of banks or other financial entities inappropriately recalibrating credit and/or operational risk appetite settings to enthusiastically charge into new fields of lending or other endeavours. That has happened in the past with credit settings (including with Government owned entities) and it wasn’t pretty. ?

As the saying goes, banking is boring, except to bankers and except when it goes wrong. ?If/when it does go wrong, I’d suggest we are better served by a NZ banking sector which is well capitalised and has strong profitability, than the alternative.

Pre-requisites for a disruptor

What characteristics might a “disruptor” need to possess to make any significant impact, in the sense envisaged by the CC’s report?

- I think either one or more of the following will need to be in the mix:

- It has a materially lower cost of capital; and/or

- It has a materially lower cost of funds; and/or

- It has a materially lower cost operating model; and/or

- It has developed a truly innovative offer or service proposition that consumers want; or

- All of the above.

The cost of capital in absolute terms for an entity will be a function of the level of capital it requires, and the return expectations of those providing that capital.

As regards the level, for a “Bank” the RBNZ has set the rules on that and, understandably, appears reticent to tinker too much as it wants, rightly, a prudentially sound financial system.

Of course, a firm could disrupt without having to lend money or raise deposits, but if you register as a Bank or NBDT you need to do both and if you call yourself a Bank, the RBNZ has some requirements, including the need to stump up with a significant amount of capital - $30m. Finance Minister Willis has indicated an appetite to engage with the RBNZ on this topic so we will see how that plays out.

As regards the “cost of capital”, that’s an interesting one – (re) capitalising Kiwibank seems to be a theme – sounds nice but will those providing the new capital be any less sanguine as regards their risk/return appetite compared to a current shareholder in major Australian banks (which will likely include your friendly KiwiSaver scheme manager investing in banks’ securities on local members’ behalf)? That’s questionable in my view.

Further, KiwiSaver managers will, like most investment managers, have a best interest duty in the first instance to their KiwiSaver members, not “NZ Inc” or NZ consumers in the broader sense.

Cost of funds is usually influenced by where and how one chooses to raise money (e.g., locally or offshore, retail or wholesale), the term of that funding, and considerations such as credit ratings.

Again, the RBNZ has some rules in this space, particularly regarding management of liquidity. The Australian banks have AA- ratings and active offshore borrowing programmes so a new entrant, unless they have a AAA rating, might struggle to make an impact in this area.

Of interest in the CC report was the reference to reviewing who has access to ESAS accounts and potentially broadening this out to promote competition in the deposit space – this is an interesting development which could well spawn some (disruptive) future action.

Cost of the operating model. The CC report commented at length on RBNZ prudential policies relating to capital etc, yet I noted only one passing reference to the RBNZ’s outsourcing policy (BS11).

BS11 sets regulations relating to “large banks’” (net liabilities $10b+) outsourcing arrangements.

On the positive side it provides a level of “protection” to NZ depositors should a large bank fail and require the RBNZ to intervene operationally.

It also constrains ambitions that large banks may have had to run significant parts of operational processing from centres in Sydney or Melbourne, or Bangalore. Depending on your point of view that could be a good thing, or a not so good thing.

In any event, local banks spent hundreds of millions of dollars to get compliant with BS11 – arguably those millions could have been otherwise directed to investments in core technology that the CC observed hadn’t happened to the extent it wanted, but that’s speculation of course.

Of greater interest is that BS11 adds a challenge to navigate for the global bank out there running contemporary technology with real scale (and lower cost) with the ability to “clip on” NZ as a market and scale up locally to a meaningful (in a balance sheet context) level.

I note neo bank Revolut has recently been granted a banking licence (with restrictions) in the UK after a drawn-out process and almost 10 years of establishing itself – it has a small footprint in NZ offering FX payment services so that may be a space worth watching, but I think we may be watching for a while.

Then there’s NZ consumers

The last “C” is not a cost component, it’s the (NZ) consumer. ?Should a new offer be made available, consumers need to care enough to change their behaviour. And there needs to be enough of them to make a difference.

To provide that new offer, a disrupter needs to have the human capital capable of real innovation (not just incremental change) and, even more importantly than coming up with a great idea, it needs to be capable of practically implementing it successfully and scaling it to a level of commercial viability without blowing themselves (and those who provided them the capital) up in the process.

Final thoughts

The CC report provided an excellent summary of the personal banking market, and is well meaning in its intent, albeit with a degree of wishful thinking.

Wishful thinking in that it seems to assume that major banks would simply sit around and allow themselves to be disrupted and/or accept some sort of material hit to their profitability without a response. Well, I expect there would be a response and presumably that’s a positive outcome if it results in an uplift in the consumer experience. The Aussie banks have been in NZ in some form since 1840, I expect they will continue to be around for a while yet, baring no major risk management missteps.?

NZ has a population base the size of Sydney – while that is clearly not a constraint to us coming up with innovative responses to enable an environment that is competitively robust, it is a reality check from a scale perspective.

The size of the prize for a “disruptor” needs to be appropriate given the time, effort, capital and risk required for the journey required. In that context, perhaps our potential disruptors should consider NZ as “ground zero” and seek inspiration from pursuit of a global opportunity set?

No doubt the debate regarding the level of Australian bank profits and potential “solutions” will continue for some time yet – it’s been raging in some form for most of my 35+ years in the sector.

From a NZ Inc perspective – I’ll look forward to discussion on NZ business’s access to capital (debt and equity) and the costs of that capital. The Finance and Expenditure Enquiry will likely provide some insight on this and no doubt there will be further debate to come.

Further insights and opinions: https://mosaicfsi.com/insights