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#5 17 November, 2014

Selected insights joining the dots between Socio-Economics, Strategy, Transformation and Delivery

THE RADAR

FINANCIAL SERVICES The reporting season closed on Westpac’s full-year 12% profit

jump to $7.56B. Cash earnings - the measure more closely watched by analysts which strips out volatile items - were up 8% at $7.63B slightly above expectations. The big 4 banks have made more than $28 billion in combined profits

> A lot has been written on Westpac, Gail Kelly, and Brian Hartzer: solid results, great CEO tenure, textbook succession. A big picture insight maybe on the nature of this growth that comes after Westpac has been seeking to lift its rate of new lending aggressively over the last year in response to the recovery in mortgage lending and an anticipated bounce-back in business lending. Profits were also enhanced by a further decline in the charge for bad debts, which fell 23% to $197m. (To be noted: NAB is the only major bank that has not expanded earnings, due to problems in its British business.) NAB new CEO Andrew Thorburn announced he’s settling the

class action on fees for $38m “because it was the right thing to do for customers and the business”, leaving 8 other banks facing 272,593 accounts registered for the class action.

> The class action, which is over types of "dishonour" fees for late payments, is targeting all of the big 4 banks, with the case against ANZ as a test case. Earlier this year, the Federal Court found ANZ's late credit card fees were unlawful, but several other types of fee were legal. ANZ and plaintiff law firm Maurice Blackburn are both appealing the ruling: a decision is expected over the coming months. NAB decided to move on, in line with its prior choice to be the first and only bank to abolish overwhelmed fees on credit cards. Since 2010, NAB's credit card late payment fee has been $5 - ~$15 less than major competitors. International banking: US, UK and Swiss regulators ordered 6

banks (UBS, Citi, JPMorgan Chase, RBA, HSBC, BofA) to pay $US4.3B to settle a probe into the manipulation of benchmark foreign-exchange rates by their traders.

> The insight is that trans-national regulation is progressing and finding its foot - as also demonstrated by the global mood to crack down on Tax evasion. However those penalty numbers are to be put into perspective with the size of the FX market: $US5.3 trillion traded each day, the world’s biggest financial market, 40% of which is processed in London (by comparison, the global bond market is $US272B and the global equity market $US216B). This also means that the fine is ~8% of a daily global trade, which analysts say is too little to provide the incentive to comply: the misconduct ran in 2008-13, more than a year after US and UK authorities had cracked on Libor rigging. And this, despite global banks paying $US50B in fines in 2013, and $US31B in 2012. This means that criminal investigations now being pursued are likely to lead to sanctions for individuals if regulators want to escalate. Signals from the Equity Market: Analysts warn that with low

interest rates and sub-trend economic growth, the only real interest in the market is for high yield dividend paying stocks: and this season has been marked by companies returning an extra­ordinary $15.9B to shareholders in dividends. However behind this cash redistribution in dividends, top-line growth is shrinking across industries: meaning that companies are starting to stretch themselves. Dividends grew 7% while earnings grew just 3.5% over the past financial year. And dividends can’t keep going up if the underlying earnings growth is slow.

> Analysts believe we are approaching a tipping point for

domestic-facing businesses who have probably pulled every lever they can, unless they continue to do asset sales: eg Wesfarmers’ (who sold its insurance business) and Telstra’s big capital releases are from asset sales, not cash generation. A consequence would be a significant sell-off facing the big banks, Telstra, consumer staple stocks Woolworths and Wesfarmers, and the utilities. A ‘so what?’ from this ‘Equity lens’ is a clear reinforcement - if needs be - of the imperative to have a growth strategy and a clear intent to resolve this stretch between Yield (dividends) and Income (top-line).

OTHER INDUSTRIES Deloitte released a notable report “Get out of your own way -

Unleashing productivity” highlighting the cost and causes of red tape in business and its impact on productivity. (see deep drive) Serendipitously echoed by a McKinsey interview of Nobel Prize Robert Solow arguing that as the demographic transition takes place across the world and population growth becomes slower, growth with have to come from productivity (a worthwhile read)

> A question facing businesses is to truly understand the determinants of productivity increase within the service sector (as opposed to the goods-producing sector where it is more transparent due to the ‘supply chain’ aspect of it). This is exactly the type of fundamental questions that our ‘service revolution’ is addressing, albeit via more ‘applied’ practical projects than Nobel prize dialectic. Pi-Top, the world's first 3D-printed laptop smashed its crowdfund

campaign target: the aim of the project is to make "hardware as accessible as software" by combining a ‘Raspberry Pi’ Circuit Board with a 3D printed structure.

> Beyond the fun revival of the homebrew DIY computer making (but in mutated form) it is noticeable because it signals that 3D printing is maturing to the ability to produce digital objects.

MACROECONOMICS Following the Luxembourg Leaks, Tony Abbott calls for global

action on profit shifting. Last week, a widespread tax minimisation scheme involving giants such as IKEA and Amazon was revealed. Eg IKEA Australia earned ~$1B in profits since 2003; most of it was exported tax-free to Luxembourg/ Netherlands. It declared just $103m profit and paid $31m in tax.

> In a nutshell, a typical structure involves a Luxembourg subsidiary with the sole purpose of lending to its sister companies. Funds are raised at interest rates reflecting the credit rating of the corporate group, eg 1%. The subsidiary then lends the money to its sisters in high-tax countries (like Australia) at, say, 9%. As a result the interest payments made by the Australian company effectively erode its tax base in Australia. All the more annoying for the govt that Australia is more dependent on company tax than most other G20 countries. A month marked by the APEC and G20 conferences, and China

President Xi Jinping’s rise: in a grand reference to History, his strategy is to rebuild a “new inland and maritime silk road” to link China and the Mediterranean: 1) to boost inland domestic growth, 2) to reduce dependence on freight lines dominated by European shippers and exposure to sea lanes patrolled by the US navy, and 3) to counter Russia’s attempt to rebuild the sphere it had in the Soviet era. To do so China is creating a Silk Road Investment Bank and Fund, and forging ahead on international agreements such as the surprise deal with the US to limit greenhouse gas emissions:

> A key insight here is the real geostrategic play, creating US-Chinese future leverage on other countries by enforcing trade standards (and sanctions) if they don’t join the effort - such as what they do with EU Agri (the French cheeses!), cars etc. More in this ‘Espresso Radar’

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DEEP-DIVE: Red Tape in Australia: “Get out of your own way – Unleashing productivity”

A reader's digest of the 4th report from the Deloitte series “Building the Lucky Country” (link to webpage)

Zero-Sum game: Deloitte says the growth of Australia's compliance workforce is so big that it has offset the decline in back-office workforce

1 - Deloitte starts with the macro context Australia has a problem. A rising retirement rate among baby

boomers and falling export prices have Federal Treasury warning that, unless things change, growth in the nation’s living standards will drop 50% compared with decades past.

In what it believes is the first assessment of Red Tape in both Australia's public and private sectors Deloitte Access Economics says it costs a total of $249 billion a year: o Govt regulations cost about $27B/year to administer and

cost businesses $67B/year to comply with. o Red tape imposed by businesses themselves costs $155B a

year - $21B to develop and administer and $134B a year to comply with.

This research shows that senior executives and middle managers each spend more than 8 hours per week complying with internal rules. Even non-administrative staff each spend an average of more than 6 hours per week."

Those dollars are significant: a cost saving of just 10% of that total would equal 1.6% of national income, ranking its impact with some of the largest reforms Australia has ever seen.

2 - The nature of productivity and lessons from the past

In the 1980s growth came from demography (labelled ‘participation’ in this chart), then in the 1990s the Hawke-Keating reforms pushed a productivity boom (incl. floating of the dollar, finance deregulation, end of tariffs)

Then in the 2000s, growth came from a housing and consumption boom, financed by bank credit, itself funded lending by borrowing on offshore wholesale capital markets.

Unlike the Productivity Boom, the Debt-Funded Housing Boom was not sustainable, and would have ended without the timely arrival of the China-led resources boom of the Howard ear (‘Terms of trade’ in grey): a bonanza as coal and iron ore prices surged and injected capital to fuel credit. And in fact the mining boom led to a decrease in productivity (a measure of efficiency) as we started digging in places that would not be economically viable if coal and iron prices were not so high.

However we now face a challenge as there are only 3 drivers that can effect big changes in Australia’s living standards: 1. The world gives us a pay rise (the terms of trade): it is probably compromised by the global slowdown 2. A bigger share of our population works (participation): whilst there is definitely progress to be made notably with women participation

and the inclusion of Indigenous Australians in the workforce, we have probably reached a plateau 3. Our workers become more productive (productivity): this is definitely a key to boosting living standards and the area for improvement

3 - The picture per sector: Firstly, and perhaps counter to clichés, Red Tape is not exclusive to the public sector that is affected by it due to its nature, but the private sector is also catching up fast…

… and Finance with it.

The higher a sector is on the chart, the larger the share of compliance occupations in its total workforce. The further to the right on the chart, the faster the growth in the share of compliance occupations. Bubble size reflects the size of the sector in terms of output.

Back-office workers

Compliance-centric workers

Public Sector

Private Sector

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11

Growth in compliance workers’ share of workforce 2006–11

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4 - A more granular view from within the organisation Surveyed Australian businesses reveal the time spent in response to self-imposed rules – as opposed to rules imposed by government regulations. Those results are revealing:

More than 80% of the time spent complying with IT regulation is due to self-imposed rules,

while governance-related compliance is split equally between self-imposed and public sector rules

Consequences have been well documented and are part of the corportate popular culture: disenfranchised employees, false sense of security, lack of flexibility, and eventually huge costs to businesses.

In the following graph Deloitte shows the break up of those costs adding-up to the $249m Deloitte also surveyed increases in areas outside direct compliance-focused functions, such as HR, IT, Finance, Marketing,

executie affairs, legal and corporate governance. The chart depicts how the time spent on a variety of internal functions has changed over time. It is set to an index score of zero equalling ‘no change’, while a score close to 2 means ‘significantly more’. All the functions show up as positive, meaning that their burden has risen over time.

Annual cost of Australia’s rules and regulations

Change in impact of internal rules over the past decade

5 - What to do about it?

Deloitte’s ‘Chief Edge Officer’ Peter Williams coined the phrase “get out of your own way” through 5 steps steps summarised in the table below. In essence, the idea is to shift from a Risk-Based approach focused on ‘everything that might go wrong’ and generating a pelthora of rules based on speculations, to an Objective-Based approach focused on ‘what must go right’

This leads to the graph illustrating the trade-off between business objectives and rules highlighting 4 positions: 1) Exposed: Too few or inadequate rules – 2) Red tape: Too many rules 3) Productivity: striking the right balance up to the limits of the existing risk appetite - 4) Potential: lifting the risk appetite

Obviously Deloitte does not advocate ambandoning risk management or compliance: that would be ironic for a firm known

for its Audit and Risk services. This report is a conversation starter bringing an original angle on an issue felt by anyone working in any organisation. Distinctive to Australia is a decade of prosperity that has seen us reach for rules often without

weighing up their costs and benefits, and eventually diluting the impact of those that really matter. Notwithstanding that a balanced culture of risk and compliance is critical to businesses to acquire the agility necessary to superior customer service.

Share of time spent on internal rules

(rather than government rules)

$27m

o1.7%

$67m

o4.2%

$21m

o1.3%

$134m

o8.4%

Annual cost (billions)

oCost as share of national income

$249m

o15.6%

1 2 3 4 5 Capacity

Risk

Appetite