Credit Risk Analysis of Australian Banks

Introduction

Modern banks are subject to a diverse set of market and non-market risks. A safe banking system is critical to economic growth and the stability of financial markets, hence the management of this risk has become a core function within these banks. Without the management of credit risk within banks, banks open themselves to potential bankruptcy which would have a significant impact on the whole economy: the lending parties, chain of suppliers or stakeholders. (WÓJCICKA-WÓJTOWICZ, 2018)

Provide a theoretical definition of credit risk and give one example in the context of bank lending. Contrast between individual loan credit risk and portfolio credit risk.

Credit risk can be defined in many ways, such as, the ‘possibility of loss arising from the failure of a counterparty to make a contractual payment’ (Jajuga, 2004). It is also broadly conceived as the probability of the non-repayment of financial resources granted by a bank to debtors (Grabczan, 1996), or even the risk of default on a debt that may arise from a borrower failing to make the required payments (Kraska, 2004). Despite these different definitions, they all have one thing in common, ‘the fact that a counterparty (borrower) might not repay the financial means that were lent to them’ (WÓJCICKA-WÓJTOWICZ, 2018). An example highlighting the importance of credit risk within banks is the lax lending standards of banks in the lead up to the 2007–2008 financial crisis. This all started with sub-prime mortgages in the US, which then led to a number of borrowers being unable to repay their loans. (RBA website)

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There are two different types of credit risks that a bank needs to access: individual loan credit risk and portfolio credit risk. The risk that is related to a portfolio of loans such as a group of different individual loans or different loans spread out across different industries and business sectors is known as portfolio credit risk. This credit risk is made up of two factors: intrinsic and concentration risk. Intrinsic risk is the risk of lending to different types of industries, and concentration risk is when there is a risk of being inadequately diversified (Lange et al., 2015). Whereas, individual loan risk is the inherent risk of a single loan (Lange et al., 2015). Financial institutions are able to alleviate or minimise credit risk through diversification of a portfolio of loans, thereby decreasing the unsystematic risk that an individual loan  attracts.

Choose one ratio that captures credit risk and find annual (yearly) data to calculate and graph this ratio for the top four Australian banks over 2014-2018. Conduct trend and peer analyses based on your graph, and comment on these banks’ credit risk.

The loan loss reserve is a balance sheet account that represents a bank’s best estimate of future loan losses. If the bank suspects that a borrower won’t pay back its default due to financial problems, a loan loss provision will be created in order to offset those potential bad debts. The higher this ratio is, the more the bank suspects that many of its borrowers won’t be able to fund their debts, thus creating a higher credit risk for that bank.

Trend Analysis

ANZ – ANZ bank dropped their loan loss provision nearly every year excluding 2015-2016 in which there was a 1% increase. From the years 2016-2017 and 2017-2018, the decrease in this loan loss provision was as much as 6% for both years.

NAB – NAB bank stayed fairly consistent with their loan loss provision over the 4 years with 2014 and 2018 having the same ratio of 60%. Between the years 2016-2017 they didn’t alter their ratio at all, as it stayed at 58% of total gross loans.

Commonwealth – Commonwealth bank had a large initial decrease of 8% between the years 2014-2015, and then consistently lowered their provision loss ratio from their before reaching 48% of total gross loans in 2018. However, 2016-2017 was an outlier having experienced no decrease.

Westpac – Westpac bank also experienced a decline in provision loss reserves over gross loans between 2014 to 2018, with 2014 starting at 54%, and 2018 ending with 40%. However, in 2015-2016 they increased this ratio by 2%.

Peer Analysis

Overall, the major four banks have been improving their credit risk between 2014-2018, with a decrease in loan loss provision ratio in every single bank besides NAB being an outlier keeping their ratio the same at 60%. This indicates that banks are more closely controlling their credit risk now than in the past, this could be due to higher regulatory standards imposed by APRA. Overall Westpac had the lowest loan loss provision ratio with it being 40% in 2018, meaning Westpac would be expecting less defaults than the other banks causing Westpac to have the lowest credit risk of all four banks. On the opposite end of the spectrum, NAB had the highest loan loss provision ratio in 2018 with a ratio of 60%. This means that NAB probably has lax lending standards compared to other banks, causing them to expect more future losses from borrowers. Commonwealth had the largest percentage drop between the years 2014-2018 as compared to the other four major banks, possibly due to the increased importance of credit risk in the banking sector.

Find and discuss two (2) examples from the 2018 Banking Royal Commission to illustrate how some banks’ misconduct can increase their credit risk exposure.

In 2017, the Federal Government established a Royal Commission into the Australian Financial Services Industry. This Royal Commission exposed serious misconduct and poor regulation within Australia’s big four banks. (academic source). Below are two examples of how banks’ misconduct has led to their increased credit risk exposure.

Lax lending standards coupled with lenient regulating government bodies such as APRA and ASIC have led to an increase in banks’ credit risk. In the past several years, banks have been granting unreasonable mortgages, giving credit cards to individuals who were not in a stable financial position, and granting colossal loans to families with unattainable repayment plans (website). These banks clearly failed to correctly assess the ‘sustainability of a loan borrower’ (website), which is essentially the ability for the borrower to repay their debts. This wilful blindness undoubtedly led to flawed decision making (website) on the banks’ behalf, resulting in risky lending between banks and borrowers.

The first case of bank misconduct discovered by the Royal Commission leading to increased credit risk exposure was the Carolyn Flanigan v Westpac case. Ms Flannigan’s daughter lost ownership of her home after Ms Flanigan was offered ‘words of comfort’ (website) and told that ‘her daughter was able to afford repayments on the Westpac loan’ (website). However, Westpac had many inconsistencies in the loan application; for example, listing Carolyn Flanagan as a part-time employee and shareholder of the proposed franchise business,which was untrue. Westpac also didn’t have a copy of the whole franchise agreement and also didn’t bother to check where the $165,000 loan was going as the bank did little inquiry of how the loan was secured.The second case of misconduct that the Royal Commission discovered was the illegal misconduct that banking staff at the National Australian Bank (NAB) participated in. It was found that they were involved in alleged bribery, forged documents and fake payslips to secure a greater number of loans as a result of an incentive program to sign up more customers (website Guardian). This type of misconduct led to some staff resigning or being fired from their position at their allocated bank branches. These types of falsified loans (website Guardian) led to consumers having to be reimbursed for the home loans and credit cards that were forged under their name.

Conclusion

Credit risk is one of the most significant risks which banks are exposed to. It can be followed by many negative effects, which are experienced not only by the bank itself, but also by other participants in the financial market. Therefore, it is important that banks take this risk into consideration when managing the bank and regulatory bodies such as APRA. These bodies are crucial to uphold strict regulatory standards and to maintain confidence for consumers of the banking system.

References:

• <Montesi, G., Papiro, G., Ugolini, L., & Ammendola, G. (2018). Credit risk forecasting modelling and projections under IFRS 9. Journal of Risk Management in Financial Institutions, 12(1), 79–101. Retrieved from http://search.ebscohost.com.ezproxy.lib.monash.edu.au/login.aspx?direct=true&db=bth&AN=135618765&site=ehost-live&scope=site>
• <WÓJCICKA-WÓJTOWICZ, A. (2018). Credit Risk Management in Finance. A Review of Various Approaches. Operations Research & Decisions, 28(4), 99–106. https://doi-org.ezproxy.lib.monash.edu.au/10.5277/ord180407>
• JAJUGA K., On systemizing credit risk models, [In:] Business bankruptcy in Poland in the years 1990 –2003. Theory and practice, D. Appenzeller (Ed.), Zeszyty Naukowe AE, No. 49, Poznań 2004.
• GRABCZAN W., Managing banking risk, Fundacja Rozwoju Rachunkowości w Polsce, Warsaw 1996 (in Polish).
• KRASKA M., Credit scoring i credit rating. Applications in commercial banking, Biz. Fin., Warsaw 2004.
• JAJUGA K., On systemizing credit risk models, [In:] Business bankruptcy in Poland in the years 1990 –2003. Theory and practice, D. Appenzeller (Ed.), Zeszyty Naukowe AE, No. 49, Poznań 2004.
• GRABCZAN W., Managing banking risk, Fundacja Rozwoju Rachunkowości w Polsce, Warsaw 1996 (in Polish).
• KRASKA M., Credit scoring i credit rating. Applications in commercial banking, Biz. Fin., Warsaw 2004.