Beware the Devil on Commonwealth Bank's Shoulder

Beneath the scandals, Commonwealth's bigger challenge is an erosion of lending standards.
Photographer: Brendon Thorne/Bloomberg

Banks occasionally get swept away in the storm of a financial crisis, but that's not how they usually decline. More common, and more deadly, is the slow erosion of income statements and balance sheets when a once-mighty institution loses its way.

That's been the situation for Deutsche Bank AG, whose return on equity rebounded sharply from the 2008 financial crisis but has slumped since and hasn't hit positive territory in two years. And it's the fate that Commonwealth Bank of Australia should now fear, as it tries to right the ship in the wake of an alleged money laundering scandal.

From one perspective, the resignation of Chief Executive Officer Ian Narev and pending refresh of CBA's board can be seen as a great buying opportunity. Even after an 11 percent share decline since Australia's money-laundering regulator Austrac brought a suit against the bank last month, CBA is still only just outside the top 10 lenders globally by market capitalization.

Among developed-country banks with at least $10 billion of annual revenue, only Hong Kong's Hang Seng Bank Ltd. and Canada's First Republic Bank sit on price-book multiples richer than CBA's 2.03.

Its problems, however, run deeper. The inquiry announced last week by the Australian Prudential Regulation Authority, the country's financial stability watchdog, goes to the heart of the matter. APRA will try to spot any "core organizational and cultural drivers" behind the series of scandals that have engulfed the bank in recent years, and suggest ways to change them.

To see why culture matters, consider a recent survey conducted by UBS AG. It quizzed Australians who'd applied for mortgages over the past 12 months and found that only two-thirds said their applications were "completely factual and accurate". Fully A$500 billion ($400 billion) of the country's A$1.69 trillion in mortgages outstanding are "liar loans" based on little or no documentation, the bank estimated. Despite a push by APRA and other regulators to improve underwriting in recent years, 46 percent said it had become easier to get loans, against 17 percent who said it was harder.

That's more than merely a culture issue. As U.S. and European banks discovered a decade ago, loose credit standards can be great for profits when the sun is shining, because they allow firms to hoover up a larger market share with the expectation that improved prices will bail them out of any underwriting failures. But with housing prices in all major cities expected to fall in the coming years as an unprecedented wave of supply hits the market alongside further tightening of credit standards, we're about to see whether Australia's mortgages are really as affordable as lenders have been saying.

To be sure, Commonwealth Bank wasn't the worst offender in UBS's survey, with less-than-accurate mortgage applications making up 33 percent of its total compared with 38 percent at National Australia Bank Ltd. and 45 percent at Australia & New Zealand Banking Group Ltd. Nonetheless, the findings showed a steady deterioration of standards over the past three years -- and CBA's A$417 billion mortgage book is the country's largest, accounting for about 26 percent of all home loans outstanding.

That's not even getting into the hit to profitability from a host of regulatory probes that Credit Suisse Group AG estimates will add A$200 million to operating costs in the coming fiscal year.

A well-functioning bank is like the old metaphor of a person with an angel and a devil on each shoulder. On one hand, sales teams should be salivating at the prospect of making money; on the other, the compliance department should be shivering at the possibility of one-time losses. 

Traditionally reviled, compliance officers are held in higher esteem in banks across much of the world after the near-death experience of the 2008 crisis and subsequent monster fines imposed by regulators -- but the mid-2000s go-go spirit lives on in Australia.

CBA has done well over the past decade out of being Australia's default lender, a former state-owned central bank that accounts for the bulk of consumer deposits and loans. But it's not all that long ago that it placed third on both fronts, with a price-book valuation that trailed competitors.

The status that comes with being a country's biggest lender can be invaluable, but it's not inherited -- it's earned.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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