Is the Financial System Inquiry good or bad for bank shares?

Pessimists view the upcoming Financial System Inquiry as a reason to avoid bank shares. There is an opposing view that this inquiry will propel bank shares to new heights over the coming decade.

In our last Vector Insights we looked at how superbly bank shares have done in the last five years. This time we are looking at why we think this will be sustained well into the future.

The Australian banking system is said to stand on Four Pillars, meaning the big four banks. We have a different interpretation. We see Four Pillars that support the immense power of the whole banking sector: their size, their essential role in modern society, their diversification and their oligopoly power:

1. Banks are very big businesses by any standards. If they need to spend money on something, they can. If they need to cut prices on one product for a period of time to chase away upstart competitors, they can. If they need to buy out a small competitor to eliminate their product from the market, they can.
2. The services banks sell to us are crucial to our modern lives As customers we are captives who can’t do without them. We may switch from bank to bank but we need these services in our lives. We need ways to receive and make electronic payments and can’t do without at least one mortgage. Over the coming decades, carbon fibre will replace steel in most applications and the iron ore industry will become a relic. There is nothing that will replace banking. Even if the nature of money changes into something digital, the banks will adapt and continue making profits.
3. Banks are diversified across the whole financial services palette. They are relatively immune to shifts within the sector. If people shift from managed funds to term deposits, the bank is on both sides of the shift. When people shift back, they are there again to catch them.
4. The Australian banking sector is an oligopoly. Price competition between the four pillars is low. We see a stark example of this as interest rates move, but mortgage rates never quite adjust fully leaving more margin for the bank.

To have a profitable relationship with a bank means we need to be a shareholder rather than a customer.

When a beast gets this strong, it develops the power to shape its own environment. Elephants don’t climb acacia trees to get the juicy leaves. They just knock the tree down. If humans want a car park where a rainforest currently stands, unfortunately we just build it.

Banks are the homo sapiens of the Australian economy. If something doesn’t suit them, they change it.

The Inquiry will, amongst other things, look into how banking has changed since the last big enquiry in 1997. It is being chaired by David Murray who was Commonwealth Bank boss for 13 years, having spent his whole working life at the place. The upcoming Inquiry is not seeking to stop banks. It is an inquiry into how to help the whole financial system.

It’s formally called the Financial System Inquiry but it will come to be known as the Murray Inquiry. We like to anthropomorphise. It is informally being called Son of Wallis but we think it is more informative to call it Grandson of Campbell.

The Campbell Inquiry in 1981 was a turning point in Australian economic history. It was the first inquiry in the financial system and was the start of the rise of the banking sector. At the time they were sleepy businesses. One of the biggest ones was government owned.

Campbell led to the floating of the Australian dollar and much freer movement of money across our border. It also led to foreign banks being able to open their doors in Australia. This was needed at the time to lift the sophistication of the sector. Australian banks responded. They began their evolution into the mammoths they are today.

By 1997 the financial sector had completely changed and we had the Wallis Inquiry. This led to the cleaning up of the regulatory framework. On the one hand, the new regulators were more effective than their predecessors. On the other hand, the new regime is light touch. It guards against the biggest risks but lets banks do pretty much whatever they want within very broad parameters.

It doesn’t seem that the banks need much help at the moment. They are doing just fine. But they are clever. They will know what it is they need. And they are well-positioned to get it and to continue to make profits into the future.

Next time we will look at how the banks will shrug off the new capital requirement rules, despite what the pessimists say.