February 20, 2019

Vertical integration: The tough climb ahead for banks

The practice of 'vertical integration' has faced the full wrath of the Australian Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Royal Commission). At times the headlines seemed to be merciless: 'Banking royal commission targets vertical integration', 'Unprecedented: Banking royal commission to spur widespread change', 'Banks’ vertical integration wealth management - going, going, gone'. But is one of the bedrocks of Australia’s banking sector, and a strategy that is common practice in financial services firms throughout the world, really about to disappear from the Australian financial services sector altogether? At least for now, it is unclear what the future holds for vertical integration in the banking system, but the Royal Commission Final Report was far from the slam dunk on the practice that some had predicted.

What is it?

‘Vertical integration’ is the term used to describe the practice where banks both make and sell financial products. It is not an unfamiliar concept, with the majority of customers using at least one of their bank’s secondary services in addition to the core banking services provided –  whether this is superannuation products, insurance, or mortgage broking and wealth management services. Beyond banking, perhaps the best adopter of this strategy has been Apple Inc – a company that has truly perfected the art of vertical integration with complete control over its products from manufacture to distribution and sale to the end customer.

All the big names from the Royal Commission, and indeed the ‘four pillars’ of Australia’s banking system (the four major banks) offer at least some form of financial services products: CBA offers wealth management and mortgage broking via its subsidiary Colonial First State (itself the subject of a class action by superannuation customers); ANZ Wealth offers financial services to customers (the sale of which to financial services firm IOOF is currently on hold as a result of the Royal Commission); NAB has a wealth management division, MLC, which it has been trying to sell over the past year; and Westpac offers similar services through its provider BT Financial Group, which it told the Royal Commission it had no plans to sell or separate from.

One of main criticisms levied at vertical integration in the financial sector is that when the same companies that have advisers selling financial products also manufacture them, this leads to real or potential conflicts of interest. This was a recurring theme throughout the public hearings of the Royal Commission.

"There is inherently a conflict between manufacturing a product and supplying a product but then having advice network or advisers who are supposed to be providing advice in the best interests of the clients, putting the clients – or prioritising the interests of the clients – so doing both within the same firm is allowed under the regime, but it does produce a conflict that needs to be appropriately managed"

- Peter Kell, former ASIC deputy chairman during the Royal Commission public hearings

While the Royal Commission has certainly shaken the banks into somewhat of a frenzy about the financial services each offers beyond their key core banking services, the Final Report stopped short of actually recommending that banking be separated from funds management altogether. So what have we learned from the Royal Commission on the decades-old practice of banks being a one-stop-shop for customers?

Three key lessons

Firstly, vertical integration remains. This is despite the Final Report findings highlighting the extent of the various ongoing ‘fees-for-no-service’ scandals within the banks, perpetuated almost exclusively by the wealth management (i.e. non-banking) branches of each major bank. Commissioner Hayne pointed out that at least AU850m will be paid out in compensation by the banks and other financial institutions as a result of the ongoing issue. However, three of the Commissioner’s 76 recommendations will certainly tighten the provision of any ‘extra-banking’ services offered:

  • all ongoing fee arrangements must be renewed annual by the client;
  • financial advisers must disclose their lack of independence to clients; and
  • any financial adviser who provides personal financial advice to retail clients should be subject to a single, central disciplinary body.

Commissioner Hayne also recommended banning the remaining 'grandfathered' trailing commissions on financial products – the kickback that an adviser gets for as long as the customer is invested in the product – and also called for a ban on commissions for financial planners selling insurance policies. While these go some way to addressing the inherent difficulties of vertical integration within the banking system, they are not the wholesale rewrite of the Australian financial services system that some had been predicting. Arguably it wasn’t within Commissioner Hayne’s terms of reference to do so, however the Commissioner did not hesitate to recommend other practices be banned outright.

Secondly, the Final Report has paved the way for the ‘return of the regulators’. According to the Commissioner, Australia’s twin peaks system of banking regulation, the Australian Securities and Investments Commission (ASIC) and the Australian Prudential Regulation Authority (APRA), have been missing in action. The Final Report could be seen as a call for more activist regulators, and also a chance to review the regulators themselves – Commissioner Hayne recommended the establishment of a new oversight body for ASIC and APRA, and the Australian Government has commissioned a further investigation into APRA in response to the Final Report recommendations. Beyond the Final Report, there are murmurs that executives from overseas regulators, such as the UK’s Financial Conduct Authority and its Prudential Regulation Authority, may be drafted in to help with the transformation.   

From this it is clear that Australia’s regulators are only going to become more active in their supervision of the vertical integration model within the banks, particularly in circumstances where the Royal Commission has not recommended that the practice be abolished altogether. This is only bolstered by the Commissioner’s recommendation that the regulators themselves be supervised.

Thirdly: Politics. There is no avoiding a brief review of the political environment in which the Final Report has been released. The Australian federal election is but a lucky 12 weeks away (although a specific date is yet to be announced) and there has been a real sense of urgency in both the government’s and the wider parliament’s consideration of Commissioner Hayne’s 76 recommendations. On the day the Final Report was made public the government immediately agreed to ‘take action’ on 75 of the 76 recommendations. Although there are no specific calls by either major party, or a growing number of independents, for the abolition of vertical integration in the banking sector, electoral pressure to respond to the Commissioner’s findings is strong.  

Increase of professional and regulatory claim risk

In summary, although vertical integration is down it certainly is not out – for now. Our predictions for the Australian market are twofold:

  • an increase in regulatory supervision and closer surveillance of the extra-banking services being offered by banks; and
  • a potential ‘professionalisation’ of the financial advisory sector, with a particular focus on those advisers within banks, with additional duties and a new disciplinary body on the horizon.

Both of these carry an increased claim risk, both for the banks as a whole but also their advisers, should the Commissioner’s recommendations be adopted in full. Ultimately the Royal Commission has changed vertical integration, if only that some of the banks have begun to shed their non-banking service offerings. But vertical integration hasn’t been disintegrated altogether – if anything the Royal Commission has moved the banks towards an environment of better governance of financial advice services; a journey most of them were already on.