Manager, Corporate Governance, ESG research team
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:
- Industry drivers – ESG risk and opportunities that affect the industry
- Company drivers – how each company manages the industry drivers
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:
- Maturing domestic markets
The sustainability of earnings growth for banks has been questioned in light of Australian banks’ high gearing to the property market combined with the high level of debt within Australian households. It is argued that Australian banks operate in a mature market and need new areas to propel growth, which could lead to new operational, legal and reputational risks.
- Technological change
New technology has lowered barriers to entry, driven customer empowerment and increased data privacy and cyber security concerns. With the success and execution of major IT projects likely to impact their profitability, companies are understandably cautious with regard to their overall IT and IT security spend.
- Regulatory change
At its core, banking regulation aims to improve the transparency, stability and efficiency of the financial system. While increased regulation of the industry is inevitable, not all companies are in a position to adapt quickly.
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.
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.
- Links to management incentives
Among the large banks, the remuneration of executive management is increasingly being linked to customer satisfaction measures.
- Numbers are improving
The four major Australian banks have reported rising customer satisfaction results over time, particularly with regard to internet banking.
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:
It says a lot about a company if it chooses to be open and honest with its stakeholders. The disclosure provided by banks is good but it does tend to focus on historical performance and reporting as a total group, rather than at a divisional level.
- Employee engagement
With employee engagement closely linked to productivity, profit growth and operating efficiency, staff churn can be costly in the financial services sector. Poor employee engagement can also impact customer satisfaction.
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 is necessary to keep up with a changing financial environment and world, but this brings with it both opportunity and risk.
While technology needs to remain competitive, over the long-term the greatest impact on company value will come from how data is collected, managed, stored, leveraged, understood and protected. Risks associated with disruptions in technology include disrupted service and reputational damage caused by anything from human error, malicious attacks or natural disasters.
- IT spend
There is a wide belief that Australian banks have under-invested in IT, possibly as a result of our oligopolistic market. To keep up with the high pace of technological change, there is now a risk that banks will need to spend more and faster.
- Data security
The rate of technological change, particularly when combined with the afore-mentioned under-investment, presents significant risks and opportunities. As technology develops, there is a risk of increased security breaches via hacking – see article Why cyber security matters to your investments.
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.
1S&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.
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.