Thursday, February 8th, 2018
CBA had a dip in price last week after a weak lead from Wall Street, but the subsequent 1% rally correctly priced in the reduction in uncertainty from the appointment of Matt Comyn, Group Executive Retail Banking Services, as new CEO – and took the stock closer to our unchanged $84 valuation.
We never thought CBA needed an external CEO. The scandals in financial planning advice, life insurance claims processing and money laundering indicate egregious breakdowns in governance, accountability, culture and operational risk management but the same successful group strategy since 2005 continues to deliver satisfactory growth in earnings and dividends for shareholders. There is no total, organisation-wide breakdown in corporate strategy to require an external CEO to introduce a new strategy. Rather what we would like to see is an end to the scandals so the underlying value creation momentum in the franchise is more visible.
Appointing a local insider also reduces the remuneration bill for shareholders. An external CEO, especially a foreigner, would have required a particularly large package to compensate for the hard yards of steering the group through this year’s multiple enquiries and legal proceedings, especially when there is little organic revenue growth available in the subdued Australian banking industry. There is also not the need or opportunity to turn the bank around, further reducing the remuneration upside. The chair was able to use the internal appointment to reduce the CEO’s package in line with public expectations, which will help restore CBA’s reputation.
An internal appointment can also sustain momentum on operational, legal, compliance and regulatory matters when an external CEO could take a year to 18 months to learn the business, then design and deliver a new strategy. On balance, the chair has probably made the right choice, though the appointment amounts to a huge ‘trust us’ message to the market so the new CEO and the whole board now have much to prove.
Matt Comyn has a respectable record as head of CBA’s all-important retail banking division, where earnings have risen 60% under his five-year leadership. The division contributed 50.2% of group earnings in FY17 and also has the most profitable business lines, so it funds much of the dividend. It is therefore reasonable for the CBA CEO to have come from the retail division. We see the new CEO as pragmatic, aware of the challenges and opportunities facing the division (regulatory lending caps, slower mortgage lending growth, price competition for prime mortgage customers, digital leadership) and capable of responding to them. Now he needs to prove he can oversee a team of executives managing the SME, large corporate and wealth divisions.
We would also like to see a more developed strategy on costs from CBA, which is starting to lag its peers on cost efficiency and cost reductions. This will be a test for the new CEO in his first year. CBA’s current approach to operating costs could be described as business as usual, which is starting to lose a little credibility when other banks are pushing harder on costs.
Matt Comyn was head of the division that owned the ATMs which facilitated the money laundering. Chair Catherine Livingstone is known as a detailed and diligent operator with a reputation to protect. She would have privately sought APRA’s approval of the new CEO, which means the regulator does not think the scandals are the new CEO’s personal fault. Were this the case, the new CEO could not have passed the regulator’s fit and proper test.
The chair is right, however, to admit this appointment increases pressure on CBA, as she now has to prove the money laundering was due to organisation-wide breakdowns of operational risk management, as she says, and not the failures of the retail banking division’s senior management.
CBA also has to demonstrate it has created a culture where staff feel safe telling senior management bad news, and where management addresses bad news or staff concerns about operational risk management. CBA has acknowledged some branch managers received no replies when they asked head office what they should do about the excessive amounts of cash being deposited into the ATMs. Ensuring senior management hears what’s going on is always difficult in very large organisations but it is essential in organisations managing serious risks like financial crime.
We see the new legal proceedings by ASIC against CBA for alleged rigging of the bank bill swap rate as another embarrassment but immaterial to earnings long-term. After ASIC alleged 50 breaches by NAB and 44 by ANZ, the two banks admitted to a smaller number of breaches and settled for fines of $50m each. ASIC is alleging only three breaches by CBA. The main cost will be higher regulatory and legal expenses, an item already set to surge in next week’s interim result.
We do not see material losses of market share as customers desert the bank in response to the scandals. In our view, customers are more likely to choose financial products for their digital convenience, ease of operation, suitability to their goals and lives, and value. CBA is a leader here and continues to report strong customer satisfaction ratings, which should support its market shares. We have seen some preliminary reports of moderate share losses in the December quarter but market shares fluctuate constantly in banking and CBA says it trades off volume for price by deliberately ceding unprofitable or excessively risky share. So in the 7 February interim result, we need to see steady or wider lending margins.
CBA is on track to meet APRA’s deadline for unquestionably strong capital by early 2020. It is also selling its Australian and New Zealand life insurance businesses for $3.8bn in 2018 and there is a strategic review of Colonial First State Global Asset Management with a view to an IPO. Both divestments will release surplus regulatory capital and come when CBA is already generating surplus capital due to slow lending growth (less regulatory capital is required to back new loans). CBA also had $1.1bn of surplus franking credits after paying last year’s final dividend. We predict that within a year CBA will announce a small fully franked special dividend or a small buyback.
“The existing momentum in the business” was a theme of the chair’s press conference to announce the new CEO when she also described the outlook for 2018 as “encouraging”. This augurs well for next week’s interim result.
Clime Asset Management owns shares in CBA on behalf of mandates for which it acts as investment manager.