Australia and the Implementation of Basel II Operational Risk
Sydney is famous for its sunny beaches and vibrant iconic buildings, such as the Sydney Opera House and the “big coat hanger”, our massive steel viaduct that connects the north marketing district with the financial centre. But there is a four-pillared building that is less well known but equally photographed for its representation of Australia’s financial landscape. Right in the heart of Sydney’s central business district is Martin Place, the headquarters for the Reserve Bank Authority (RBA), Westpac, Macquarie Bank and the Commonwealth Bank (CBA).
The CBA is New South Wales’s original government bank and is now Australia’s largest retail bank. Its marble four-pillar facade looms over Sydney’s financial centre as a message of policy that is still in place. Altogether there are four large national depositor banks and a handful of state-based financial institutions that focus primarily on domestic lending. Australia also has a tight regulation known as the Four Pillars, which insists that the four major banks operate separately. In practice it is the nemesis of the organisations that it binds: the CBA, National Australia Bank (NAB), Australia and New Zealand Banking Group (ANZ) and Westpac. Interestingly the Four Pillars also defines how these institutions divide up their market, collaborate when pricing their products, differentiate their products, and how they delineate their adversity to risk.
ANZ banking group’s chief executive, John McFarlane, recently stated that the Four Pillars banking policy will eventually end. It is inevitable that the policy has to fold as global pressure builds. The trigger for Frank Cicutto’s resignation as CEO of the National Australia Bank was the $360m currency trading loss in 2004. However, NAB’s track record of the $4bn hammering it took on HomeSide, its US mortgage business, and the poor returns on its portfolio of small British banks, did not help. Many financial experts question why NAB and other Australian banks venture abroad, often to the cost of taxpayers in lost revenues. And many claim that the answer lies in the government’s Four Pillars policy, the rational of which is to sustain competition, diversity and stability locally. However, as size and breadth of balance sheets matter in varied international banking practices, the big four – CBA, NAB, ANZ and Westpac – are compelled to propel working capital overseas. This is also one contributing factor for driving home-host issues in respect to Basel’s capital accord that the Australian Prudential and Regulatory Authority (APRA) will have to focus on, but before we dissect the big four’s risk frameworks let’s discuss this regulatory body briefly and why it came about.
APRA was established on 1 July 1998 and is responsible for the prudential regulation of banks, life insurers, general insurers, building societies, credit unions and superannuation within Australia and is fully funded by the industries that it supervises covering about 85 per cent of the assets in Australia’s financial system. It sets and monitors compliance with standards, including capital requirements, for the prudential management of banks and other deposit takers.
Before APRA, the Australian financial system was controlled by firm-based and industry-wide protective measures. However, after a collection of failures from all areas of the Australian financial sector in combination with the output from a financial system inquiry instigated by the Coalition Government in June 1996, it became apparent that a stand-alone prudential regulator was needed. The purpose was to provide responsiveness for potentially major systemic instabilities within what is a large landscape and small market. APRA is the watchdog for ensuring the big four set about creating operable frameworks that estimate regulatory capital in a testable manner and it has set a minimum benchmark for the big four.
Primarily, APRA is not keen on any bank using an Internal Ratings Based approach for the measurement of credit risk unless that institution considers Advanced Measurement Approach for operational risk. In respect to operational risk though, Australian businesses are relatively proactive with their management styles and this is reflected in the standard known as ASNZ4360, which was set down by the Council of Standards Australia on 2 April 1999. While this criterion is industry unspecific, it does outline what activities a firm should be engaging to construct a generic structure that gives a better decision-making model by referencing greater insight into risks and their impacts. It clearly states on the first page, “To be most effective, risk management should become part of an organisation’s culture”.
The Basel Accord seems to come in threes. Firstly there are the three pillars of the accord: calculation of minimum capital, regulatory review and market disclosure. Second, the overall goal sets about describing the risk position of a financial institution and focuses on three broad schools of risk: market, credit and operational risk. Third, there are also three key ways for the calculation of regulatory capital in the operational risk camp – the Basic Indicator Approach, the Standard Approach and the Advanced Approach.
The Basic Indicator Approach calculates capital requirement based on a fixed percentage alpha currently 15 per cent of gross income. In the Standard Approach, capital is still based on gross income but the firms’ activities are divided along business lines, each with their own percentage beta charge. The Advanced Measurement Approach (AMA) allows banks to determine their operational risk capital requirement according to an internal model, providing it meets certain requirements.
APRA expects all four major banks of Australia to reach AMA in the estimation of exposure and interestingly some of the state-based banks have also selected this approach for their operational risk measurement framework. St George, a New South Wales based large domestic home lender is boasting that it is putting an application into APRA in the second quarter of this year, for a first pass on its AMA framework. Suncorp, in the state of Queensland and also operating in a similar space to St George, will be targeting AMA as a second pass once it has bedded down its foundation framework, this certainly seems a sensible and very realistically achievable milestone. Interestingly, both these organisations have been going through expansive growth, picking up market gaps dropped by the big four and they are favourites with depositors who prefer the warm and friendly service they deliver.
But before we look at what the big four are doing, we need to scope out the Advanced Measurement Approach (AMA) field first. If a financial organisation was to select the AMA for defining its exposure and calculating its value-at-risk then, you guessed it, there are also three styles that are accepted industry wide; those being Scenario Based Advanced Measurement Approach (sbAMA), Risk Drivers and Controls Approach (RDCA) and lastly Loss Data Approach (LDA).
The Scenario Based Approach is based on the assessment of forward-looking “what-if” scenarios. The output of the scenarios are, simply put, entered into an operational risk model where regressive techniques such as Monte Carlo are used to compute regulatory capital.
Risk Drivers and Controls Approach (formerly known as the scorecard approach) uses a series of weighted questions (some of which can be interpreted as scenarios) whose answers yield a score that can be aggregated to allow the calculation of capital between business units.
Loss Data Approach puts emphasis to the computation of capital on historic loss data. Standard statistical techniques such as those that have been used by the insurance industry for years as well as some of the more complex derived functions including extreme value theory are used to compute regulatory capital. Estimation of exposure is usually performed on frequency and magnitude of event distributions separately within the Basel risk event classifications and then aggregated for a clear dimension of Value at Risk.
It is important to note that these styles of risk quantification alone will not bring a financial organisation over the line for AMA accreditation. Each bank has to meet other qualification mandates from the capture of losses, to the correlation of external events in the organisation’s risk model before APRA or any other regulator would have confidence that the bank is approaching the management of its operational risk in a ‘coherent’ manner. One of the big misdemeanours in respect to the techniques outlined above is that most banks will actually follow similar routes to construct their entire operational risk framework. All that differs with regards to sbAMA, RDCA and LDA is where the measurement emphasis is placed on the components that make up the risk model.
In Australia, the big four have all selected alternative techniques, with the first to come to the table being ANZ.
Several years ago, Dr Mark Lawrence the chief risk officer of ANZ decided to embark on a scorecard approach to measuring and managing risk, ironically about the same time operational risk was only rumoured for inclusion in the new accord. Dr Lawrence writes, “One difficulty for any bank choosing a way forward is that operational risk is in fact a catch-all title for a set of very different risks, ranging from high-frequency, low-impact transaction processing errors at one end, to low-frequency, high-impact events such as natural disasters and large-scale fraud at the other. It can be difficult to imagine that a single methodology could even attempt to capture all these diverse risks.”
ANZ commenced the program by looking at all techniques for economic capital management from scalars to benchmarks and finally statistical analysis (LDA) however, they found LDA had poor historic data for effective correlation of risks and that separate pieces of work would have to be carried out when a business unit changed its activities or strategy. Other techniques introduced a political bias in a business units’ overall capital allocation and these benchmarks had very little impact on the front line.
“Since there is no way that the business unit can change the benchmark figures, except by arguing over subjective adjustments for scale and relevance. This process tends to reward those units that are good at internal politics rather than risk management and, most importantly, does nothing to encourage actual mitigation of operational risks.” Benchmarks are useful but best applied as sanity checks over the final results.
Moving on from ANZ, who seems to have it all wrapped up, we’ll go back to the Commonwealth Bank. CBA, like its other big brother NAB, is showing signs of selecting sbAMA as its key driving factors in its event prediction models and from consideration of the gearing of these organisations such approaches should fit well. Both banks have been under considerable change, with CBA running its “which new bank campaign”, streamlining its conveyancing areas and deploying a new customer relationship management model, as well as differentiating itself from the pack by inclusion of some new lending products.
NAB has been settling after a difficult period but yet seems to be striving ahead in the SME market and still holds poll position in the small business sector. For these organisations, scenarios offer the most sensible methods for creating predictive models that are accurate. For either of these organisations to focus heavily on loss data would simply not be representative of their mode of operation.
CBA also rumours to be establishing a risk indicator framework to show which scenarios are in play and it won’t be the only Australian bank to make use of an integrated risk indicator network to prove estimation points within loss distributions.
Finally the fourth pillar of Australian banking, Westpac, this bank will be up for its first pass later on this year with APRA. With the current timetable in place and from the type of risk staff it has been recruiting alone, it is clearly evident that its emphasis will fall on the last of our techniques, LDA, and it will be using extreme value theory to derive correlations of exposure within its business units from the losses it captures. Unlike CBA and NAB and well known to Australian customers, Westpac divides its business units up by processing function and less by business type or product nature. With this in mind it will have to be very careful how it classifies losses and where it assigns the cause of events otherwise it may fall foul to internal capital arbitrage within its model.
What will be most interesting is how APRA gauges each technique as each bank differs substantially in its approach. APRA has also made it clear that regulatory capital release should not be the significant incentive for any Australian bank with respects to the Basel Accord and with a small and highly competitive market, the market disclosure components of the Basel Accord may present difficulties for Australian organisations.