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I was forwarded a link to an article earlier today for comment. Reading it, I just felt like putting my head in my hands and crying – how could a financial journalist write something like this and get it so wrong? It looks like he has taken a press release or a letter to APRA from an LMI (Lender’s Mortgage Insurance) provider and tried to rework it – while misunderstanding it.

I thought writing this up into a piece here would be a good start – but where to start? Can I question his journalism, use of stats or factual issues first? Maybe paragraph by paragraph.

The first two paragraphs are error free – good start, but these seem to be just a rewording of the press release / letter.

The third and fourth start the rot. A 50% risk weight the capital required to be held for a $100 loan is not $50, as stated, but $4 ($100 *50% * 8%). The 8% figure is the full risk weight capital ratio, and is not changing under the new regime. If you are interested in why 8%, my take on it is here. He has also totally missed the new operational risk capital amount, so the drop will not be from 50% to 35%, even for the safest, it will be (probably, but not certainly) a drop from 50% to a number that depends on the operational risk calculation. Read the rest of this entry »

Glenn Stevens, Governor of the RBA, has had a speech distributed by the BIS in today’s email alert. It covers the Australian economy, with particular reference to the market waves last week.

The speech is here. It is worth a read but, to summarise, from my reading he agrees with everything I have said over the last few days – the credit problem arising from this is distributed through the system but is small in total. The problem is that no-one is sure where it is – causing liquidity to dry up.

The real economy is unaffected.

Oh – and if you know anyone wanting to move to Australia (and in particular Western Australia or Queensland) that has any marketable skills at all let them know that we need them. Look here.

Not having received any phishing emails for a while I thought this had died down. Receiving two this morning, though, started me thinking about them again. With all the publicity these have received I wonder how many people still get taken in by them.

Today’s effort was better than most (at least the spelling was right, if not the syntax).

It looks like the target this time (Westpac) was on the ball, though. Their website had a copy of the email up quick smart this morning, the domain being used for the attack is not responding and Firefox is warning that the site has been identified as set up to collect personal details. I really think this is about all the banks (and web browsers, for that matter) can do.

Hopefully it will soon get to the point where the number of marks out there gets so low as to not make it worthwhile to set these sites up as this is the only way to stop this permanently.

Latest from APRA on Basel II – information in two areas.

Margin Lending

Margin lending is where an institution lends you money to go trading in shares, secured by a claim on the shares you purchase and requiring that you have a certain proportion more value in the shares than they have advanced to you. The problem (at least as APRA see it) is that most of this type of lending is sufficiently secured that no capital would be needed to back it under the Basel II rules, rather than the full capital weight needed under Basel I (full weight being 8%).

In 2005 APRA flagged this up as an issue – essentially they said they disagree with no capital weight being applied. The reality is, of course, that in most cases no capital is needed – the chances of a loss are very low. As the experience of the last week has shown, though, that can change rapidly at times and, if liquidity is squeezed, getting more security to cover losses can be tricky.

After a good look at it APRA have done as expected here, cutting the capital required substantially – but not to zero. Their approach is that you can use either a risk weight of 20% (i.e. a 1.6% capital allocation) or a model for secured exposures. A simple outcome and an improvement from the current one.


One of the alphabet soup of acronyms that often intimidate newcomers to the Basel II space is “ECAI”. These are the External Credit Assessment Institutions – known in the real world as rating agencies. They appear throughout the accord, mostly in the standardised areas, and their ratings can be used to assess credit risk and therefore affect the capital numbers. Early on in the process (back in the dark days of pre-2003) there was a big debate about the use of these at all. Basing regulatory capital on a rating issued by an agency seemed dangerous. After the sub-prime problems (where even AAA rated bonds have suffered at least liquidity issues) this may have been a sensible debate.

Nevertheless, they are in the Accord, so every regulator has to come up with an acceptable list. With no domestic agencies of any real size APRA have taken the sensible course and (drum roll) used the list issued by the US SEC (guidelines here)- the “Nationally Recognized Statistical Rating Organizations” or NRSROs:

If you are dealing internationally you are also allowed to use those accredited by the host country supervisor.

This also looks like a sensible move – if you are confident that the SEC will not make a major blunder, and there are no domestic ones to add to the list, a good approach is to outsource responsibility. I just hope the SEC does not decide to change the acronym.

As I mentioned in my last post, from an Australian perspective I feel the market reaction to the whole US sub-prime thing to be somewhat overblown. The total quantum of the losses is simply not large enough to warrant the market drops we saw last week and Friday’s adjustments in the US and today’s in Australia have restored some sense into the pricing of the underlying assets.

While I am normally a believer in semi-strong market efficiency there are times when sentiment can get ahead of sense and I feel that happened last week.

The reasons behind it I feel are clear – while there were some large losses where individual firms the market generally was not informed of where those losses were and, worse, some firms had previously issued wrong information to the market on their exposure. The result was that liquidity dried up as no-one really wanted to get into anything they could not really be sure of – which, with a fully integrated financial system, was not very much.

I feel there are several lessons from this:

  1. Firms trading in the riskier end of the market need good (or very good) internal information on the positions they are running. If you are running riskier positions that is fine – but you need to be able to get accurate and timely information out to the market in the event that the market turns down. Macquarie announcing they had no real issues and then later correcting this is a good example of the violation of this principle.
  2. Even for firms with safe assets you need to have robust treasury operations – Ram’s problems are particularly pertinent here. Borrowing with short term debt at floating rates to lend long and fixed is OK – provided the risks are managed well and you have enough capital to see you through the inevitable gaps. Good risk management here is to ensure that you have a wide variety of funding sources and that very little of your funding matures on any one day. As Rams found out it may just be the wrong day.
  3. As discussed elsewhere, relying on the Greenspan (or now Bernanke) put is a perilous thing. The US Fed could just as easily decided that this was a good correction, moving asset prices and credit spreads closer to sensible levels.
  4. If you keep sufficient liquidity hanging around for a rainy day you can make a pretty handsome buck doing some bottom feeding when things like this happen. Buying at the pit of the market (the ASX at least) on Thursday to sell today would have made a good trading profit for a few days’ tension.

Back to my favourite topic. If you are going to run risks you need to know what they are. Information is everything.

No real time at the moment for a full post, but if you watch this and do not think it is over the top we will have to disagree.

Some judicious work is a good idea – this sort of reaction is not.

While I do not believe the sub-prime style problems are likely to happen in Australia as the Australian mortgage market does not have many of the types of deals that have caused the problems (at least not in the institutions I see regularly) it does show why the proposed disclosures under APRA’s version of Basel II Pillar 3 (APS 330) need to change.

The problems flowing through the markets at the moment are not a direct result of the sub-prime issues for the simple reason that the losses are not huge overall – less than 1% of US GDP in total. Even worst case this should not affect corporate profits overall by much. The problem is that the markets do not know where they are concentrated. Until these issues are fully flushed out the uncertainty will remain.

The problem here then is not so much the actuality of the losses, but the uncertainty. The result is that liquidity dries up as counterparties stop trusting each other, dealing slows down and spreads increase. The solution is good, accurate and timely disclosure.

The disclosures for the advanced banks are already good enough. There is enough information in Table 4 (both of APS 330 and Pillar 3) for proper analysis of the likely exposures of the banks going down that path. This should be enough (as discussed in my previous piece on this) to stop or slow down the contagion we see at the moment from spreading to those advanced banks not genuinely afflicted.

As most would know, though, it is not the larger banks that are actually originating these loans – it is the ones that would be going standardised.

The market disclosures for standardised institutions under Basel II in Australia should be increased to include most of the elements of Table 4 and perhaps Table 8 so that the information is published, checked and used regularly by all market participants. The neutering of Pillar 3 by APRA for the smaller participants is of no use to anyone.

OK – bit of a sensationalist headline, but the point I would like to make here is a valid one. The current drops in the markets can easily (and correctly) be put down to a big failure in risk management – in one or more of credit risk (for the institutions originating the loans), market risk (for companies buying the dodgy paper) and operational risk – where the institution’s systems simply miss the risks involved.

Each of these can, and have, resulted in poor management or trading decisions, resulting in losses.

The point I would like to make here, though, is that these errors in risk management should become less likely over the next few years as the larger banks increasingly use their advanced risk management systems to genuinely allocate capital based on risk across their groups. A large bank here or there may get it wrong, but these sorts of systemic frights should become less likely.

Current Position

The problem at the moment (under Basel I) is simple – a housing loan is a housing loan is a housing loan. There is no difference in treatment between a loan secured by residential real estate where the loan to valuation ratio (LVR) is 20% and the borrower has many times the income to pay the mortgage off and one with an LVR of 80% and the borrower has bearly enough income to cover the repayments and feed the kids. Given the risks in the second one the bank has to price it higher than the first.

The incentives for banks chasing high returns, therefore, is to load up on poor quality, but high-paying, debt. The costs before you consider credit losses are the same. If you consider credit losses unlikely then you can load up on these – and even start dropping the price to sell more.

Effects of Basel II

Why do I consider that this will be less likely in the future? The answer is simple. Basel II forces the banks going advanced to consider, and price, capital for credit losses explicitly. The models being used to do this need to have at least seven, more normally as much as ten, years worth of data, covering at least one credit cycle.

The smaller ones, going standardised (or, in the US, staying with Basel I) will be in the same space they were before – so they will still be originating the loans – but most of them rely on funding from the bigger banks through securitisations, so the funding should cut off before the number gets too large. A few of them may go due to poor lending practices, but the big ones should not be at risk.

So – this should be the last great risk management failure.

Note the use of “should be” – rather than “will”. I need to manage my own risks.

Interesting question raised on Finextra today (OK – yesterday, then – in Oz the timing thing can be annoying) on the question of whether banks should start blogs about themselves – allowing feedback direct from customers and other interested parties.

I know this has been raised many times before, and a few (very few) banks are actually doing it. The question is how you would actually go about it. From what I can see the risks to a bank are fairly finely balanced – in that being perceived as being open and friendly is a good thing, but also that banks (rightly or wrongly) will always have a few, noisy, detractors – ranging from dissatisfied customers (or former customers) – to those who for political or ideological purposes simply detest banks.

The logical answer to this is to have a moderated discussion, but, given the blog is an official one, the moderation would have to be reasonably heavy or there would have to be humans on the bank’s side posting responses reasonably quickly. Either that or it simply does not allow comments – but this would then make it boring beyond belief.

Unmoderated it would be highly risky; if moderated it loses the spontaneity of a blog; with humans actively monitoring it would be expensive and as just another media channel – boring.

The options can then be summarised, to me at least, as being highly risky, expensive or boring – or, at worst, two of the three.

This is an article that first appeared in The Sheet.

Over the last three years, APRA’s primary focus in the regulation of banks, building societies and credit unions has been the transition from the old international regulatory standards on bank capital known as Basel I to the new regime, Basel II.

Basel II is due to come into effect in Australia from January next year, which means that the first APRA returns under the new standards will be for the January month end – or about six months from now.

The problem for all banks is that none of the new standards have yet been issued in final form, leaving APRA a busy few months to get them finalised and an even busier few months after that for banks to get them implemented.

For convenience in discussing what is to come I will use the groupings APRA uses when releasing their responses to submissions. Read the rest of this entry »

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