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Vertical integration

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Imagine going to a doctor who is employed by a single pharmaceutical company. The doctor is financially incentivised to promote the company’s drugs and compensated on the number of scripts she writes. This distribution arrangement creates a conflict of interest and leads to the over-prescription of medications that are not the most appropriate for you and other patients.

In a similar way, the current Royal Commission into Australia’s financial services sector has exposed weaknesses in (some) distribution arrangements put in place by the major banks using their vertically integrated business models. This is a corporate structure where a company owns more than one stage of the supply chain (eg, production and distribution) such as a food manufacturer owning a chain of supermarket outlets.

[Another example of vertical integration can be found in the oil industry where petroleum companies extract and refine crude oil and then sell it at company owned petrol stations. Starbucks is even more integrated - it buys and roasts all its own coffee and sells it through company-owned stores.]

Australia’s Big Four banks all operate vertically integrated business models. Under this model, investment advice and insurance products are now part of the same business as conventional deposit and loan services. This creates a conflict of interest between the customer’s best interest and (bank) subsidiaries encouraging people to buy their financial products.

Vertical integration has been a hot topic since the big banks moved into wealth management over 20 years ago, allowing them to manufacture products and then use an army of financial advisers to sell them. This structure has put the spotlight on the allegiance that financial planners have to their employer over recommending the best product for the client.

In the words of financial commentator, Michael Pascoe:

… the big banks’ vertically integrated wealth management business is finished. Without that integration - the ability of bank tellers to channel punters to bank-controlled advisers who guide them through bank-owned platforms into bank-produced products - it’s hard for banks to tie up valuable capital in wealth management. It was a rich ride for ticket clippers while it lasted.

A review conducted earlier this year by the Australian Securities and Investments Commission (ASIC) found that many financial planners at major banks and the AMP failed to act in their customers’ best interests when advising people to put their retirement savings with an in-house superannuation fund.

ASIC found that financial advisers at the big banks favoured their own products, ignored the best interests of customers 75 per cent of the time and - in one in 10 cases - the advice on super left customers in a “significantly worse financial position”.

Three of the Big Four banks also have vertically integrated themselves into another aspect of financial services - mortgage broking. CBA, NAB and Westpac fully or partly own third-party businesses in the mortgage market. Yet again, there have been accusations of conflicts of interest with mortgage brokers allegedly pressured to push products to achieve volume targets, regardless of their suitability for the customer.

It can be argued that retail banks around the world have always been vertically integrated due to their modus operandi of manufacturing savings and loan products and distributing them through their branch networks. But the more recent trend to vertically integrate non-core activities - like wealth management and insurance - has exposed weaknesses in this model.

Integration has fast become the dirty word of the finance industry. It has tainted the sector and called into question the future of institutional ownership of distribution in the Australian market. A possible outcome of the Royal Commission is that the vertically integrated business model may be substantially diminished or even banned.

It’s clear that the Australian financial services industry is at an inflection point and is about to see a strong push towards dis-integration via divestment. The big banks have already started to unwind their vertical integration and will ultimately exit from select lines of business. The banks have learned the hard way that no one can truly serve two masters.

The federal government has flagged vertical integration in the financial services sector as a key area for reform in order to put an end to misaligned incentives and conflicted remuneration. The era of the one-stop-shop bank may well be coming to an end. My sense is that simplicity and transparency will shape future banking models - the exact foundations on which mutual financial organisations like Gateway operate.

Now there’s a model that passes the pub test!

Paul J. Thomas, CEO


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CEO Paul Thomas