The price of banks becoming crime-fighters

Today I present a dispassionate analysis of the current Westpac drama and the RBA's exceptionally detailed road-map as to how QE will unfold in Australia. I explain how the genesis behind the big banks' AML sagas derive from the introduction of the transformational AML legislation, which came into full effect in 2010, that forced them to morph from passive reporters of transactions over $10,000 into fully-fledged law-enforcement and counter-terrorism agencies. (Click on that link to read the full column or AFR subs can click here.)

The problem of course is that their legacy mainframe computer systems and IT networks were never designed with active intelligence gathering and analysis of money-laundering, serious crime, and counter-terrorism in mind. 

Almost all the AML breaches that caused CBA and Westpac strife were attributable to singular technology errors that prevented the automatic AUSTRAC reporting systems from working. 

This is not an idiosyncratic bank issue: it is a systemic challenge that most banks will struggle to come to grips with. I go on to explain that in Westpac's case, it was also actively sending AUSTRAC Suspicious Matter Reports (SMRs) on all 12 individuals that were subsequently identified as engaging in child exploitation using "typologies" that AUSTRAC had given it. 

Westpac's mistake was to not upgrade these typologies for 18 months with a new batch of information that AUSTRAC had offered in December 2016, which would have resulted in it sending more SMRs on the same individuals over and above the ones that it was already transmitting. 

Westpac has stated repeatedly on the record that at no point was it informed that these individuals were engaging in child exploitation until 15 November 2019, just five days before AUSTRAC filed its statement of claim. 

Overlooked in all of this debate is the major banks' extraordinary---and globally lauded---financial crime-fighting joint venture with AUSTRAC, called the Fintel Alliance, where the banks second their staff into AUSTRAC to sit along-side government intelligence experts to identify and prosecute criminals and terrorists. AUSTRAC reports that the banks have helped them detain or arrest 73 paedophiles and saved 35 children.

The AUSTRAC penalties look wonderful for the regulator, but they will create huge problems for small banks and non-banks that suffer from similar problems and risk wiping them out completely. Westpac already has 750 people working to stop financial crime, which will jump to 950 next year. That's more than the entire staff of most smaller banks and non-banks. Lender Afterpay recently reported that it had no AML compliance at all on all of its loans between 2015 and 2019 because it had defined itself as a lender to businesses, not consumers. This is a business that is loss-making---what would a huge AUSTRAC penalty do to them? AUSTRAC's $700m CBA fine was the biggest in the world outside of the US regulators, who conspicuously tend not to fine their local banks, focusing on foreigners. We have to be careful we do not throw the baby out with the bathwater.

Finally, I discuss the RBA's new speech on QE, which confirms our contrarian May forecast that the RBA would likely start QE when they hit their effective lower bound. In early November we warned that this lower bound was likely regarded by the RBA to be 0.25%, not 0.50%, which governor Phil Lowe confirmed. He also confirmed that the RBA's strong preference was to do QE by purchasing government bonds, which was well known. He did, however, hint to some interesting complementary opportunities that could enhance the efficacy of its QE measures, which we had previously canvassed. One problem for the RBA is that the AUSTRAC penalties are going to further diminish any pass-through the banks have left to offer as it continues to cut the cash rate, which will only accelerate the movement towards 0.25%.

Excerpts enclosed:

AUSTRAC says the Fintel Alliance is a “world-first private-public partnership” including “major banks...as well as law enforcement and security agencies from Australia and overseas” that has contributed to the “arrest of 108 persons of interest”.

Nathan Lynch, Thomson Reuters’s head of regulatory intelligence, says the “Fintel Alliance is admired around the world as best practice when it comes to pioneering real-time intelligence gathering between banks and law enforcement agencies”.

“Banks voluntarily second staff, paid for by the bank, who are sworn in as public servants,” Lynch says. “They sit in the same room, working alongside government criminal intelligence experts.”

The Fintel Alliance's 2018-19 annual report says it helped save or protect 35 children and detain or arrest 73 persons engaged in child exploitation. It has also identified 27 suspects involved in outlaw motorcycle gangs.

“It is the most impressive public-private partnership globally and has resulted in the prosecution of many financial crimes, including numerous child sexual exploitation cases,” Lynch confirms. “All the big four banks are strong supporters of this project, including Westpac.”

This is where the tension arises between perception and reality regarding the banks’ contributions to preventing serious crime. In practice, they are essential partners of both AUSTRAC and ASIO in the cyber security domain where they are considered “islands of excellence”...

Despite having the best public-private financial crime fighting partnership in the world, Australian banks are paying a broader price for AUSTRAC’s record-setting fines in the form of a higher cost of capital. Wholesale bank funding costs jumped following the latest AUSTRAC news with Westpac's costs rising as much as 15 basis points. This will directly reduce their ability to pass on future rate cuts, especially in an environment in which the big banks’ returns on equity have slumped to almost half what they were reporting a few years ago...

The concern is that the RBA is going to look increasingly redundant as it exhausts its monetary policy ammunition, giving it no choice but to embrace QE to get the jobless rate down below 4.5 per cent. The banks will certainly be reluctant to sacrifice their shrinking net interest margins given the intensifying regulatory headwinds and the fact they have privately advised the RBA they cannot provide pass-through beyond 0.5 per cent.

Lowe predictably pressured Scott Morrison’s government to loosen fiscal policy to help him hit his objectives, but Standard & Poor’s promptly responded that if Treasurer Josh Frydenberg did so he would sacrifice Australia’s AAA rating. The government does not tell the RBA how to run monetary policy, and Martin Place would be advised to stick to its own knitting when it comes to fiscal policy.

This column had proposed several other QE measures to complement vanilla government bond purchases, which most bankers and economists think will have only a limited impact on the currency and virtually no influence on domestic borrowing rates. The reputational risk for the RBA is that it spends over $100 billion buying government bonds with no discernible community benefits.

One alternative is extending the RBA’s existing lending operations to banks via cheap longer-term repurchase arrangements, which Lowe countered should be reserved for a liquidity shock. Another is buying assets that are already eligible for repurchase by the RBA, including senior bank paper and AAA rated RMBS, which Lowe ruled out unless there was a crisis.

A final interesting option is evolving APRA and the RBA’s existing bank liquidity rules to accommodate the RBA’s QE initiative and, by doing so, indirectly support it. Lowe hinted at this when he said that the RBA would have to “consider the effects on market functioning”. “We are conscious that government securities play a crucial role as collateral in some of our financial markets,” Lowe said.

“Given the limited supply of government debt on issue, the Reserve Bank and APRA have already had to put in place special liquidity arrangements for the banking system…These considerations are not impediments to undertaking QE, but we would need to take them into account.”

This refers to the fact that banks hold government bonds as part of their liquid assets to protect against crises. A secondary buffer is the RBA’s special Committed Liquidity Facility that banks have access to, which is secured by their home loans, other senior bank bonds, and third-party RMBS. If APRA and the RBA boosted the size of the CLF to accommodate the RBA’s QE program (and therefore avoid crowding the banks out of the government bond market), it would have the effect of significantly reducing bank funding costs, enhancing the RBA's monetary policy transmission mechanism.

Read the full column here.