Banking sector risks and opportunities

Financial companies make up the largest portion of the Australian share market at 47.7% of the ASX200 index1. In the wake of the mining downturn, bank share prices have benefited from their robust reputation for high profits and dividends. In light of this, our Environmental Social and Governance (ESG) research team set out to discover the opportunities and risks presented by  this sector. This article presents some of their findings, including what their analysis involved and which factors AMP Capital considers most relevant to the overall performance of companies in the banking and financial services sector.

Given the size and importance of financial companies in the Australian share market, our ESG research team at AMP Capital recently conducted a review of the Australian-listed banking and diversified financial sector.

The analysis considered how companies perform as environmental stewards, how they manage social relationships and the quality of their governance. It also evaluated lending and investment policies, focussing on the traditional checkpoints of human rights, environmental harm and financial crimes.

The approach this analysis took was to look at:

Driving value: industry-wide

Before analysing individual companies, it makes sense to take a step back and consider the factors likely to shape earnings growth at an industry level. While these can change from time to time, the value drivers for the banking and diversified financials sector can broadly be broken down into the following themes:

Driving value: company-wide

While a broad range of ESG factors could drive the value of individual companies in the financial services industry, AMP Capital’s ESG team believes the most material factors are those relating to risk management. Given the size and complexity of most financial institutions, it is difficult for anyone outside the company to determine precisely how well risks are managed across the entire organisation. Public disclosure of risk management frameworks and policies provides a good starting point, but ESG analysts seeking a better understanding of how effective those processes and policies are need to dig deeper, considering factors such as customer satisfaction, company culture, corporate governance and innovation.

Customer satisfaction

While banks often speak about the importance of customer satisfaction, historically, it would have taken significant effort for a customer to switch banks. However, technology shifts mean this situation is changing, so an analysis of customer satisfaction metrics can provide investors with valuable insights.

Culture

Culture is a major indication of company value, regardless of the industry the company operates in. Early insights in relation to red flags in company culture can help investors avoid negative surprises. Company culture is difficult to assess from outside an organisation and for this reason, our ESG analysis uses a range of proxies to shed light on company culture. These include:

Corporate governance

The financial sector is highly regulated and overall, compliance with the basic ASX Corporate Governance Guidelines is good, particularly among large banks. As smaller banking and diversified financial companies often draw on the expertise of affiliated directors, their strict adherence to the ASX Corporate Governance Principles can lag somewhat. While non-adherence with the ASX Corporate Governance Guidelines might result in risk flags for investors, we believe in the importance of factors such as board skills, potential accounting issues and the way remuneration structures could drive particular management behaviour are more valuable.

Innovation

Innovation is necessary to keep up with a changing financial environment and world, but this brings with it both opportunity and risk.

Understanding ESG can lead to better investment outcomes

Risk management remains the key factor for financial institutions in generating sustainable long-term growth for shareholders. Analysts can uncover valuable insights and early warning signs by looking beyond the obvious risk flags that are already being captured by the market. Our analysis shows the major banks which scored highest on our ESG ratings tended to outperform those with lower scores. Over the period of one year, the major banks with the highest ESG ratings outperformed those with the lowest ratings by 3.9%. When analysed over a longer time frame (five to ten years), the outperformance by most preferred banks was even stronger by 15.5% cumulative over five years and 71% cumulative over 10 years. These results demonstrate the strong positive correlation between the investment performance of banking and diversified financials companies and the way they manage their ESG risks and opportunities.

 

1.  S&P/ASX 200 Financials Index contains companies involved in activities such as banking, mortgage finance, consumer finance, specialised finance, investment banking and brokerage, asset management and custody, corporate lending, insurance, and financial investment, and real estate, including REITs. Measured 1/7/2015 compared to 1/7/2010.

Source: AMP Capital

Karin Halliday

Karin Halliday was appointed to her current position with AMP Capital in May 2000. She is responsible for determining how AMP Capital votes on behalf of the firm and its clients at all meetings held by the Australian companies in which AMP Capital invest. In doing so, Karin also monitors various aspects of corporate governance in many Australian companies.

 

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.