APRA’s prudential inquiry into Commonwealth Bank may have dire consequences for Australia's biggest lender as well as for the rest of the industry.
This is the view of UBS analyst, Jon Mott who said investors who think Commonwealth Bank is looking cheap may be ignoring the potential fallout from the inquiry.
In a client note, the analyst pointed out that CBA has underperformed the other banks by about 10 per cent since money laundering allegations were made in early August.
But buying CBA because it's cheap is predicated on the view that there will be no lasting impact from these allegations on its earnings and Mott thinks this may be optimistic.
The analyst acknowledges that any fines relating to the money laundering charges will be a one-off and agrees it could easily be argued that CBA will still be the superior bank.
But in his view, the outcome of APRA's prudential inquiry into CBA poses a real risk to the bank following the allegations.
“Firstly, we believe the panel members recently appointed by APRA are highly experienced and are likely to undertake a thorough review of CBA," he told clients.
“We also believe that the inquiry into CBA's financial objectives is likely to raise a number of important questions - not just for CBA but also the banking industry.”
Risk culture versus profits
Mott is interpreting the investigation into CBA's financial objectives as looking at the Group's return-on-equity targets and whether they conflict with a sound risk culture.
“If the APRA panel finds these financial targets are not consistent with sound risk management and compliance outcomes will the Board need to adjust its targets down?
“And, if CBA is required to reduce its financial targets, potentially hold higher operating risk weights or prudential capital then the impact on its valuation could potentially be much more significant.”
Although CBA's ROE targets have never been announced to the market, Mott is convinced it is targeting an ROE of between 16 and 17 per cent, which is consistent with recent performance.
If it was targeting an ROE lower than this level, Mott went on to say, it is unlikely it would have re-priced its mortgage book as aggressively as it has over the last few years.
From where he sits, the panel will need to consider whether these ROE targets are appropriate in an era of 2 per cent interest rates and where the market implied cost of capital is 9 per cent.
Whole sector hit by inquiry
In his view, the CBA's financial objectives will likely be found to conflict with a solid risk culture especially given the number of scandals over the last few years – financial planning, life insurance, money laundering charges.
“Although we would not expect the panel to provide any definitive guidance on new targets, we would not be surprised if the Board reduced its ROE targets to comply with the panel's recommendations.
By cutting its ROE target by 1 per cent to around to between 15 and 16 per cent, CBA’s net profit target would be cut by around 6 per cent.
“This in itself would eliminate the valuation appeal in CBA and return it back to a healthy premium to the sector. In effect, this is already in the price.
“However, if CBA's Board reduces its ROE target by between 1 and 2 per cent - in response to the APRA Inquiry - it is likely that the rest of the industry would be impacted.”
In his view, if CBA's group financial objectives were reduced it is likely to pass some of this onto customers in the form of lower fees and product margins.
Given CBA is a price leader, the other banks would need to follow and industry profitability could be impacted, he said in the client note.
Mott also worries that the earnings outlook for CBA will be influenced by hiring new chief executive.
“Although internal candidates cannot be ruled out, we believe an external appointment is more likely. Previous experiences have shown that the appointment of a new chief executive can lead to elevated senior executive turnover and associated disruption.”