Don’t miss this latest #bankingRC investigation by Nathan Lynch. Nathan has kindly allowed us to publish outside Thomson Reuters’ paywall in the public interest.

When the HBOS Group collapsed in 2008, UK taxpayers were left to fund a £17 billion bank bail-out. It was a prudential disaster that contributed to the break-up of the UK’s Financial Services Authority (FSA). In Australia meanwhile, Bankwest’s “appalling lending record” was even worse than in Dear Ol’ Blighty. During the $2.1 billion Bankwest takeover, APRA ensured this fact never came to light. Unfortunately, someone had to foot the bill for Australia’s biggest prudential regulatory failure since HIH Insurance. Please read this story in conjunction with his earlier investigation, ‘Smart Laundromat: the inside story of CBA money-laundering scandal’.

BRENDAN STANFORD IS A TOUGH GUY. A classic law enforcement character. He’s sociable, friendly, funny, but with the kind of tenacity underneath that’s forged in the furnace of the Australian Federal Police. Brendan’s what you’d call a salt-of-the-earth bloke. He’s a former pub owner, a father and a leukaemia survivor.

Brendan has seen a lot during his working life. But the toughest thing he’s ever had to endure was watching the decline of his brother Michael, his business partner, following the Commonwealth Bank’s takeover of Bankwest in 2008.

The Stanford brothers had gone into business together, with the aim of buying and resurrecting country pubs. They believed that historic pubs were the lifeblood, the town square and the social heart of rural communities. Without good pubs, country towns could be lonely places.

The brothers’ first foray had been a success. Brendan bought the pub, in Cessnock, NSW, and Michael worked there. They ran it for five years and sold at a profit. Soon after Brendan and his brother saw an opportunity to buy the Coronation Hotel, in Portland, as partners.

In 2006, Brendan and Michael made the fateful decision to finance their purchase through Bankwest. The Perth-based bank had recently been taken over by HBOS and was on an aggressive east coast expansion campaign. The bank’s goal was to grow quickly and challenge the four pillars, making it a serious player in Australian banking.

The bank was offering attractive terms to win new business customers. The Stanfords signed up to a $1.2m business loan, secured against a hotel valued at $1.6m, at an 80 per cent LVR. The loan term was 20 years.

The day they signed up for that loan was the day they, unwittingly, lit a fuse that would lead to their financial and emotional destruction.

“A tale they won’t believe …”

As Brendan bravely recounted his story before the royal commission yesterday, the pain of recollection was written across his face. Despite the difficult memories, he stayed composed. Stayed strong.

Brendan told of how his brother handled the negotiations with Bankwest in 2009, while he was undergoing treatment for leukemia. He told of how his sister-in-law offered to provide $400,000 to “de-risk” the loan to prevent a fire sale of their underlying asset. He told of how there was no market for pubs like his, despite an extensive marketing campaign, as savvy buyers were holding out for the next distressed asset sale from a former Bankwest customer. He told of how the bank eventually moved in and sold the pub, along with its pokie licences, for $525,000 — after costs, it was a pittance more than they had offered to tip in to keep the facility open.

It wasn’t until the counsel assisting asked about the impact on his brother, however, that Brendan choked up. Commissioner Kenneth Hayne requested a break.

When they returned 10 minutes later, he was asked the question again.

“From the time this was instigated I saw him struggle. Even after it all happened I saw him depressed for a few years.

“That’s why I’m here today because … he couldn’t come in,” Stanford said, trying to paper over the cracks in his voice.

A “troublesome” business

The financial services royal commission’s hearings into the treatment of Bankwest customers have been particularly emotional. The bankruptcies, the suicide attempts, the family breakups and the impact on children are all reminders that banking collapses do not just rip up balance sheets. They destroy real people’s lives.

Australia may not have nationalised its banks, like the UK did. But in the gross mishandling of the Bankwest collapse, it certainly nationalised the trauma.

This week’s hearings have also raised serious questions about the integrity and performance of Australia’s prudential regulator, the secretive Australian Prudential Regulation Authority (APRA). The commission heard on Tuesday that Bankwest’s level of impaired loans and “troublesome loans” had rocketed prior to its acquisition by Commonwealth Bank in October 2008. The HBOS-owned authorised deposit-taking institution (ADI) was sold to CommBank for A$2.1 billion — half of its pre-crisis valuation — at the peak of the global financial crisis.

For the sake of confidence in the banking system, however, APRA never disclosed just how bad things had become at Bankwest.

The royal commission heard that CommBank launched an internal review shortly after its acquisition to determine Bankwest’s level of impaired and “troublesome” loans. The review, dubbed Project Magellan, was set up to get a clearer idea of the quality of the loan book that CBA had taken on. CBA had assumed liability for these loans when it acquired the bank. The sale was expedited in a de facto bail-out approved by APRA, the ACCC and the federal government. They had little choice.

The prudential regulator set a number of conditions on the acquisition, such as surrendering the Bankwest ADI licence back to APRA as soon as possible. As with Westpac’s “takeover” of St George, the deal was structured to conceal any concerns over the institution’s solvency. It was also structured to provide the maximum reputational protection for APRA.

Around the same time in London, the parent bank HBOS was being folded into Lloyds. This was part of a £17 billion bail-out that left the UK government holding a 43.4 per cent stake in the new entity.

The deal-making with CBA was, by comparison, an act of genius. At CommBank it was overseen by some of the institution’s rising stars, including general counsel David Cohen and the new head of strategy Ian Narev, among others.

The rescue of Bankwest was executed exceptionally well. The deal was done swiftly, discretely and without resorting to a taxpayer-funded bailout. The transaction was approved by Wayne Swan, the federal treasurer, on the Thursday before Christmas, 2008.

“I have taken this decision after a comprehensive assessment of its impact on the national interest, with conditions that support a strong and competitive Australian banking system. These conditions will also ensure the best possible outcomes for both customers and employees of CBA and Bankwest,” he said at the time.

That same week, as pre-Chrissy beers flowed in the Coronation Hotel, the Stanford brothers had no idea they would soon come to embody the hollowness of the government’s assurances.

New chief in town

On that same day, one week before Christmas in 2008, CommBank named its new captain at Bankwest. The acquirer had appointed Jon Sutton, the former head of agribusiness lending at CBA, as Bankwest’s national managing director. Sutton understood regional customers deeply and was given the public mandate of “enhancing and developing the Bankwest brand”. It all sounded very promising for the once-proud Western Australian bank and its customers.

It soon became apparent that the “acquisition” was

not destined to go as smoothly as the media releases

(dropped a week before Christmas) had suggested.

Soon after joining Bankwest, Sutton sent an internal memo lamenting the quality of its business lending book. It was “poorer than original expectations and we are … actively de-risking the exposure,” he wrote in a memo to the CBA board risk committee.

Under Project Magellan, CommBank raked over the Bankwest portfolio. It was looking for loans that were not yet in arrears — but likely to run into trouble.

Cohen, who went on to become the chief risk officer at CommBank, told the royal commission that Project Magellan set out to review at least 60 per cent of Bankwest’s business customers.

“It was a combination of internal people and external people seconded in to assist,” he said.

“Broadly speaking, each of the reviews uncovered some concerns around the level of provisioning.”

In an unusual move, the project team also included receivers, members of the profession that stood to win lucrative work if people defaulted on their loans.

Back in August 2012, Cohen appeared as the face of CBA at the Senate Inquiry Into the Post-GFC Banking Sector. At the time he was confident that there was no misconduct on CBA’s part. In December 2015, he appeared before the Parliamentary Joint Committee and again asserted that Bankwest and its new owner had acted fairly (cf video below).

Recently, however, his views have changed. Cohen told the royal commission on Tuesday he had recently discovered that the bank lacked the skills at the time to make proper risk assessments in relation to “troublesome” loans. This had become apparent during his preparation for the royal commission, the CBA senior manager said.

In cases like the Stanfords’, he said CBA now recognises that the customers were mistreated.

“In this case, the lack of discussion with the borrower, the lack of explanation about why a sale was the only option, I think that was not reasonable,”

he said before the Hayne Inquiry.

CBA's cool Cohen admits Project Magellan mistakes https://t.co/T3za8Fh1w9 via @FinancialReview — ?Sandi Keane (@Jarrapin) June 1, 2018

Reducing exposure

In 2009, it must be remembered, there was a very different banking climate. Major banks around the world had collapsed under the weight of high-risk lending.

In response to Project Magellan’s findings, the CBA executive risk committee decided to reduce its commercial property exposure by A$1.8 billion. This was largely achieved by “de-risking” the Bankwest commercial property book, which had represented more than half of its lending activity under HBOS.

Cohen said, with hindsight, the credit processes that Bankwest used were “not as diligent” as those that Commonwealth Bank applied. It also discovered the continuing management of business banking customers throughout the life of their loans was out of kilter with CommBank’s day-to-day management of business relationships.

Dr Andy Schmulow, a regulatory specialist, academic and consultant, said the royal commission was offering an unprecedented insight into the dangers of light-touch prudential regulation.

“It’s unacceptable that APRA allowed Bankwest to get to the point it was at prior to the CBA takeover. My sense is that they covered themselves by offering Bankwest to CBA on preferential terms so there wouldn’t be an Australian bank default at the height of the financial crisis. That refutes the whole narrative that Australia did incredibly well and our banking system was so well regulated,”

he said.

Dr Schmulow, who is a leading authority on prudential regulation, said the arbitrary targets for “de-risking” the Bankwest commercial loan book were a significant concern. He said this suggested that the bank may have acted unreasonably, or even unconscionably, when terminating some of these banking relationships to reach a predetermined figure.

Dr Schmulow believes there needs to be an inquiry into the apparent failures at APRA during this period.

Re APRA probe into #CBA. Who funds APRA? Er, CBA (& other banks). Just sayin' — Michael West (@MichaelWestBiz) August 28, 2017

Australia’s own sub-prime disaster?

APRA never revealed how bad things had been at Bankwest. But four years after the collapse of HBOS, the UK Parliamentary Commission on Banking Standards inadvertently blew APRA’s cover story to pieces. The UK inquiry conducted a sweeping inquiry into the group’s international activities. It found that HBOS’s impaired loans in Australia had reached a staggering 28 per cent (adjusted for currency). This was higher than the HBOS default rates in the UK and among the highest rates for the group internationally.

The Bankwest impaired loan rates were appalling even by the standards of Ireland, which had suffered a catastrophic financial crisis. When compared with Ireland’s banks, Bankwest’s default rates were exceeded only by Anglo Irish Bank and HBOS itself. Bankwest’s impaired loan rates would have exceeded those of Allied Irish Bank (22 per cent), Bank of Ireland (9.4 per cent), Danske (17.9 per cent), ILP (6.1 per cent), KBC (6.7 per cent) and Ulster (17.5 per cent).

The inquiry heard evidence that, in Australia, HBOS sought to double its national market share. It wanted to become a new rival to the “four pillar” banks that dominated the market.

“In Australia, the impairments … totalled £3.6 billion, equivalent to 28 per cent of the value of the loan book there at the end of 2008, an even higher loss as a proportion of loans than incurred by the corporate division in the UK. This loss is all the more striking in view of the comparative resilience of the Australian economy in the global downturn. In this period, the Australian banking sector remained profitable and no entities received any public capital support during the crisis,” the UK report said.

James Crosby, then head of HBOS, said at the time the losses in Australia were indicative of an “appalling lending record”.

The UK report found HBOS Australia took the “relatively quick and easy path to expansion without acknowledging the risks inherent in that strategy”. With Bankwest’s rapid expansion plan, it concentrated on sectors such as pubs, clubs, hotels and property development in regional areas that exacerbated its default rates.

Audacious expansion, aggressive contraction

Professor Justin O’Brien, head of financial regulation at Monash University, said the royal commission had shone a light on APRA’s failure to rein in Bankwest during its aggressive expansion in the lead-up to 2008. The unspoken question at the Hayne Inquiry, which lies outside the royal commission’s scope, is how and why the Bankwest loan book could become so impaired in the first place, he said.

“The answers were not provided at the time by APRA, which had primary regulatory oversight. Instead the evidence comes from overseas through the British Parliamentary Committee on Banking Standards, which raised significant red flags about APRA’s capacity and complacency. As is so often the case, it was ignored … given the apparent success of the Australian housing market,” he said.

O’Brien said it was important now for the government to conduct an independent review of APRA’s level of knowledge, or consent, in relation to the de-risking of Bankwest’s “troublesome” customers.

“The unanswered question is, in aggressively de-risking the Bankwest loan book subsequent to its purchase … did either Bankwest or CBA discuss its strategy with the prudential regulator in advance? If so, did it receive an implicit or explicit undertaking that such a strategy made sense prudentially — both for the institution and the market as whole?” O’Brien said

Dr Schmulow said it was unacceptable that that APRA had engineered a bailout of HBOS-owned Bankwest in 2008 without ensuring customers would be explicitly protected. He said there were mechanisms such as the Council of Financial Regulators to ensure that conduct regulation and prudential regulation were handled collaboratively to protect all bank stakeholders, including business borrowers.

Dr Schmulow said the Bankwest case highlighted the need for an oversight body to ensure that regulators are working effectively and in the national interest.

“ASIC comes in for a lot of criticism because it is a public-facing agency. APRA, on the other hand, is shrouded in secrecy and often hides behind the Banking Act to shield itself from scrutiny. When you pull back the curtain you find a regulator that is at least as incompetent and as captured as ASIC,” he said.

“This says a lot about the flaws in our regulatory model. It confirms the recommendation from the Murray Inquiry that we need a Financial Regulator Assessment Board,” Dr Schmulow added.

The Murray Inquiry recommended that the government create a new Financial Regulator Assessment Board to report annually on how financial regulators have implemented their mandates. The inquiry said the independent oversight board should “provide clearer guidance to regulators in Statements of Expectation and increase the use of performance indicators for regulator performance.”

“The Bankwest debacle suggests that a decade after the HIH Royal Commission, which came close to recommending APRA’s disbandment because of incompetence, little if anything has been learnt,” Dr Schmulow said.

—————-

As all of this regulatory drama plays out, Brendan Stanford leaves the royal commission quietly. He isn’t escorted by a phalanx of silks. He doesn’t give a doorstop interview.

It’s an overcast day outside the Commonwealth Law Courts. Brendan pulls down his dark sunglasses. He composes himself, takes a few deep breaths of crisp Melbourne air, and walks past the cameras. He’s ready to go back to his day job.

Brendan’s a hospitality contractor these days, keeping his family afloat by working in someone else’s business.

He really doesn’t like the limelight. He didn’t want to appear before a royal commission. He certainly didn’t want to have his sorry story plastered all over the nightly news.

But he had to do this.

It was for his brother Michael. Who couldn’t make it along himself.

Author’s note:

The above report is the “alpha” to the “omega” of the Smart Laundromat story. http://michaelwest.com.au/do-not-stuff-up-this-institution-narev-told-the-inside-story-of-australias-biggest-money-laundering-scandal/

To truly understand the predicament CBA finds itself in today, you have to go back to December 2008, when the bank’s rising stars pulled off the deal of the decade.

After outsmarting APRA, the mighty HBOS, the Treasurer and two parliamentary enquiries, was it any surprise they became complacent? Seven years later, the architects of the Bankwest takeover were running the bank. It was the height of the “risk on” era at CBA. They turned a conservative bank into a profit-generating powerhouse. The dividend was sacrosanct.

But … it’s the “black swans” that always bring banks undone. In this case, they underestimated a little intel agency run by Paul Jevtovic, a former AFP officer, who’d dedicated his life to rooting out organised crime and corruption.

The rest, as they say, is history. If not for management hubris, the AML/CTF failures would have been fixed quietly and resolutely. Just as other “pillar” banks had done in the past.

——————–

Nathan Lynch is the Asia-Pacific Bureau Chief, Financial Crime and Risk at Thomson Reuters.

A slightly different version of this report was published by Thomson Reuters and is republished with their permission.