By Megan Bowman, University of New South Wales

Sydney: 18 April 2013

The report by the UK Parliamentary Commission on Banking Standards on HBOS released last week gives new meaning and context to the findings late last year of an Australian Senate report on Bankwest titled The Post-GFC Banking Sector. Taken together, the two reports have important regulatory implications for the Australian banking industry.

As CLMR Director, Justin O’Brien, recently noted on these pages, the UK Parliamentary Commission on Banking Standards condemned HBOS risk management strategies as incompetent and the HBOS Board as willfully ignorant, and concluded that these deficiencies alone were sufficient to tip the bank into insolvency. The Commission specifically noted that a cardinal area of weakness in HBOS was its group risk functions. The Commission concluded that they were weak by design not accident. As such, the HBOS failure was “a case of a bank pursuing traditional banking activities and pursuing them badly” (p. 53). The Commission’s conclusion is evidenced by the high level of loan impairments for HBOS in Australia, a jurisdiction that has been notably resilient in the wake of the GFC. The result of this flawed risk approach was that HBOS “had significantly worse asset quality than other banks” (p. 69) in this jurisdiction, and sustained heavy losses (approximately 20% of the total) quite out of proportion to the performance of its Australian competitors.

It is here that we see the direct link between HBOS’s failure in the UK and the issues for Bankwest in Australia. HBOS was the former owner of Bankwest, a West Australian bank that engaged in aggressive lending practices for its East coast expansion during 2003 - 2007. When HBOS became vulnerable in 2008, CBA bought Bankwest at a heavy discount. It was only after the purchase, however, that CBA audited Bankwest’s loan book and found a large number of the loans to be impaired, which prompted CBA to review over 1000 accounts. That the ‘incompetent’ lending attitude of HBOS had tainted the Bankwest portfolio was undeniable. As stated by the Senate Committee: “loans were sought for ventures that were a considerable risk even during the more stable economic environment that existed prior to the global financial crisis; this is evidenced by the cases where banks other than Bankwest had refused to finance the initial loans” (par. 9.2). Many of these loans were held by small businesses (SBs) over commercial property such as pubs and hotels in regional Australia. CBA’s portfolio review prompted downward loan revaluations, which led to many borrowers being unable to make loan repayments thus triggering default processes and eventual foreclosures.

In 2012 an Australian Senate inquiry was conducted by the Economics References Committee. It published its findings on 28 November 2012 after receiving nearly 160 submissions and conducting five public hearings over three months. The broad mandate of the Committee was to examine recent developments in the Australian banking sector arising from the impact of the GFC, including any changes in lender attitudes and lending practices. Despite the fact that the Committee had a mandate to review the banking sector generally, overwhelmingly, the evidence it received related to allegations of mistreatment by aggrieved Bankwest borrowers subsequent to the CBA acquisition.

The CBA acquisition and subsequent behaviour of Bankwest has precipitated class litigation by aggrieved Bankwest customers and deep media scrutiny. In short, allegations coalesce around two main issues: first, the integrity of revaluations of Bankwest loans subsequent to CBA acquisition; and second, Bankwest’s treatment of borrowers once revaluations were conducted and default proceedings initiated.

However, an essential aspect of the Bankwest issue is its possible impact on regulation of the Australian banking industry. Ultimately, the Committee recommended the timely establishment of an independent “root and branch inquiry” into the state of Australia’s post-GFC banking sector and broader financial system (Recommendation 10.1). The potential systemic implications of such an inquiry will be canvassed by this author in coming weeks. Of interest here are the Committee’s recommendations arising from the Bankwest allegations.

Given that the majority of evidence related to alleged mistreatment of small business customers by Bankwest/CBA, the Committee was at pains to clarify its role and approach to the hearings. It stated clearly that it was not a court; instead, it had  “reviewed the evidence from a broader, systemic perspective” (par. 9.1). To this end, the Committee clarified that a collection of disputes, even if they share certain characteristics, would and should not automatically trigger macro regulatory change that impacts a broad constituent of borrowers. Accordingly, its recommendations for regulatory response to the concerns about Bankwest/CBA’s behaviour were directed specifically toward “support[ing] more equitable dealings generally between small businesses and banks that can apply to a broad range of future situations” (par. 9.4).

To this end, the Committee made recommendations regarding dispute resolution options for SBs vis-à-vis alleged bank misconduct (Recommendations 9.3-9.4) and the appointment and conduct of receivers to defaulting SBs (Recommendations 9.5-9.9). However, its key recommendation focused on lending practices to SBs (Recommendation 9.1).

Interestingly, although the Committee noted that SBs and consumers both face significant power imbalances when negotiating with large financial institutions, it eschewed government intervention for SBs that would mirror extant legislative protections for consumers. Instead, the Committee recommended a self-regulative or ‘soft law’ solution by the industry itself. Specifically, it called for the ABA to develop a voluntary code of conduct for small business lending in consultation with SB representatives.

The logic behind this soft law recommendation appears to come from the Committee’s acceptance of arguments by the major banks regarding the cost and burden of added regulation in general (par. 9.6). Certainly, the GFC has been a catalyst and inspiration for legislative change in key market economies, notably: the US Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010; amendments to the Australian Banking Act and National Consumer Credit Protection Act in 2011; and reforms proposed by the UK Independent Commission on Banking chaired by Sir John Vickers in 2012. Moreover, it seems clear that it is too soon for banks to complain of regulatory fatigue: legislative reform of the financial sector has some distance to run yet. Indeed, it would be unsurprising if SBs approached the ABA consultation with complete equanimity given the level of distrust about voluntary bank conduct, as evidenced by this inquiry. And that poses a clear regulatory conundrum: is more self-regulation an appropriate solution to self-regulatory failure absent trust?