Discussion
1. Jenny Corbett
John Laker’s paper addresses four main themes:
i. the changing nature of risks in banking, particularly during a period of economic expansion;
ii. the evolution of risk management;
iii. the movement to risk-based prudential supervision; and
iv. developments in economic capital modelling.
http://www.rba.gov.au/publications/confs/2007/pdf/laker-disc.pdf
It describes the journey that both banks and regulators have taken in recent years to improve their assessment and management of risks, and concludes that although progress has been made there are subtle new risks now facing depository institutions. Moreover, the long period of good times may not be conducive to dealing with these risks appropriately. The paper ranks the risks facing Australian banks in descending order of importance as credit, operational, market and liquidity risks. Although credit risk may be thought of as low in a banking system with such a high share of mortgage lending as in Australia, Laker notes that most of the risks remain on banks’ balance sheets because they make relatively little use of securitisation. Operational risk – one of the largest risks facing banks – is mainly concerned with low-frequency, high-impact events, with its precise nature changing with technology and business models. For example, the risk from outsourcing now looms large. In the assessment of the paper, liquidity risk, though growing through the greater use of wholesale funding, is currently well managed.
The paper identifies two more subtle risks that are not the focus of regulatory (or Basel) attention but may warrant closer attention. ‘Strategic risk’ – which is distinct from operational risk – involves changes to the business environment. In the Australian context this arises from changes to household saving and deposit behaviour and increased competition for banking business. ‘Agency risk’ can be of the ‘classical’ form, arising from misaligned incentives between principals and agents. It may also arise in the form of governance risk whereby interests of stakeholders (depositors and shareholders) may not be served by boards and managers (for example, by awarding excessive salaries). Both of these will need more attention in the future.
In assessing the response to these risks the paper argues that risk management systems are getting better. For example, internal systems are generally improving and boards are paying more attention to risk management. Partly as a result of changed regulatory requirements, there is a better system of risk identification and measurement in place and more use of risk modelling. Although the paper’s description of changing risk management processes inside banks is interesting, it is too limited. It would be useful to have a more systematic way of judging how extensively these improved systems are being implemented and whether or not they make a difference to performance. This is not merely a curiosity but is important in revealing whether we have the means to judge the success of the regulatory philosophy described in the second half of the paper. It should be possible for the Australian Prudential Regulation Authority (APRA) to provide a broad-brush picture of the extent to which depository institutions use various techniques, without breaching confidentiality. If this information were broken down by the size of institutions it would also be possible to assess whether it matters for outcomes. One can imagine a matrix showing different types of institutions and their use of different types of risk management systems. Over time this would provide a view of the improvements in the quality of internal governance.
Next I would like to discuss some of the risks that are missing from the list in John’s paper. For example, is the paper too sanguine about risk in the Australian banking system given the sector’s concentration, reliance on mortgages, falling margins and the growing gap between lending and the deposits that have traditionally funded them? These conditions look somewhat like Japan’s banks in the 1990s – and we know what happened there. In Japan there was a decline in high quality corporate borrowers, which led banks to seek alternative higher-risk borrowers. However, because their traditional lending was mainly collateralised by apparently high-quality fixed assets (most often land) Japanese banks had not developed sophisticated credit assessment methods. As the value of the collateral fell, the failure to understand the real quality of the borrowers became critical. The result is history. Can we be sure that our internal governance structures are sufficient to withstand such a squeeze? This is why measurable data on internal structures would be valuable.
Another source of concern is the potential for cross-border contagion, given Australian banks’ increasing dependence on wholesale international liabilities. Although this and other papers presented at the conference argue that this risk is mostly hedged, and that the only significant source of cross-border contagion would be New Zealand, the International Monetary Fund has identified it as a vulnerability (IMF 2006). While technology risks are mentioned under operational risk for individual institutions, there may also be a systemic concern about the growth of electronic finance. Not only do new technologies open new avenues for fraud, they also mean that new players can enter conventional markets easily. Although any deposit taking activity immediately brings an institution under the supervision of APRA, the non-regulated sector continues to grow. Since it is hard, even impossible, to anticipate the types of new products and services that may be offered there will certainly be regulatory lag in deciding who should be covered by which regulator.
There is considerable scope for research on whether disclosure and reputation effects alone will be sufficient to ensure efficiency and soundness in these sectors. Furthermore, new technology encourages new linkages between the regulated and unregulated sectors and enormously increases the speed with which shocks can be transmitted across the system. All this puts pressure on regulators to be extremely fleet of foot. The description of risk management included in this paper is not intended to go beyond Australia, yet it does purport to reflect the operation of a ‘best-practice’ system. So, to what extent do these lessons extend to other systems? Most of the papers at the conference use evidence from banking systems of English-speaking economies. While they do not all resemble each other that closely (Australia stands out in many respects), they are more similar to each other than to banking systems in the neighbouring Asian region........
References
Čihák M and R Podpiera (2006), ‘Is One Watchdog Better than Three? International Experience
with Integrated Financial Sector Supervision’, IMF Working Paper No WP/06/57.
IMF (International Monetary Fund) (2006), ‘Australia: Financial System Stability Assessment’,
IMF Country Report No 06/372.
.read more http://www.rba.gov.au/publications/confs/2007/pdf/laker-disc.pdf