No Change to the RBA Cash Rate

At its meeting today, the Board decided to leave the cash rate unchanged at 2.0 per cent.

The global economy is expanding at a moderate pace, with some softening in conditions in the Asian region, continuing US growth and a recovery in Europe. Key commodity prices are much lower than a year ago, reflecting increased supply, including from Australia, as well as weaker demand. Australia’s terms of trade are falling.

The Federal Reserve is expected to start increasing its policy rate over the period ahead, but some other major central banks are continuing to ease monetary policy. Volatility in financial markets has abated somewhat for the moment. While credit costs for some emerging market countries remain higher than a year ago, global financial conditions overall remain very accommodative.

In Australia, the available information suggests that moderate expansion in the economy continues in the face of a large decline in capital spending in the mining sector. While GDP growth has been somewhat below longer-term averages for some time, business surveys suggest a gradual improvement in conditions in non-mining sectors over the past year. This has been accompanied by stronger growth in employment and a steady rate of unemployment.

Inflation is low and should remain so, with the economy likely to have a degree of spare capacity for some time yet. Inflation is forecast to be consistent with the target over the next one to two years.

In such circumstances, monetary policy needs to be accommodative. Low interest rates are acting to support borrowing and spending. While the recent changes to some lending rates for housing will reduce this support slightly, overall conditions are still quite accommodative. Credit growth has increased a little over recent months, with credit provided by intermediaries to businesses picking up. Growth in lending to investors in the housing market has eased. Supervisory measures are helping to contain risks that may arise from the housing market.

The pace of growth in dwelling prices has moderated in Melbourne and Sydney over recent months and has remained mostly subdued in other cities. In other asset markets, prices for commercial property have been supported by lower long-term interest rates, while equity prices have moved in parallel with developments in global markets. The Australian dollar is adjusting to the significant declines in key commodity prices.

At today’s meeting the Board again judged that the prospects for an improvement in economic conditions had firmed a little over recent months and that leaving the cash rate unchanged was appropriate. Members also observed that the outlook for inflation may afford scope for further easing of policy, should that be appropriate to lend support to demand. The Board will continue to assess the outlook, and hence whether the current stance of policy will most effectively foster sustainable growth and inflation consistent with the target.

 

RateSetter sees monumental growth from broker channel

From Australian Broker Online.

Leading peer-to-peer (P2P) lender RateSetter has seen significant growth in broker referrals, with almost one third (30%) of its business now coming through the third party channel.

Speaking to Australian Broker, the chief executive of RateSetter, Daniel Foggo, said that the broker channel is an important avenue of growth for the P2P lender, which specialises in providing personal loans, and he expects business referred through brokers to make up around half of its business volumes in the next year.

“We have 50 brokerage firms referring applicants to us, which reflects around 50 different brokers. They are now referring about 30% of our business volumes to us – so it is quite significant and we see it as an avenue of significant growth for us,” Foggo said.

“We identified [engaging with brokers] quite early on as an opportunity for a broker to provide another service to their customers in a very light touch way. About a year ago we initiated some conversations with brokers about the opportunity. That percentage keeps growing so we expect it to be up around 50% in a year or so.”

There are different referral models a broker can use when referring a client to RateSetter, according to Foggo, depending on how ‘hands-on’ the broker wants to be.

“The first model is very simple for the broker, they literally just send a web link to their customer and the customer thereafter fills out an application form and the broker is kept entirely up to date as to how that application is progressing,” Foggo told Australian Broker.

“The broker is also provided a portal where they can log on anytime to see the status of any application and how much money they have actually made through referring people to us.

“The next model is slightly more hands on the for the broker and in less than a minute they can actually perform a rate estimate for the customer which basically requires them to provide a name and address and some brief details and we will give the applicant an indicative loan rate and it is up to the broker then whether they proceed with the application themselves on behalf of the customer or whether the customer does it directly.”

But whilst RateSetter is seeing significant growth from the broker channel, Foggo told Australian Broker that there is still a common misconception that P2P lenders pose a threat to the market.

“I think, generally, there is a perception that P2P lenders might be a threat over time, but really, we definitely see them as being an opportunity for brokers to broaden out their offering. We don’t think [P2P lenders] are ever going to disrupt their core brokerage market of residential property but we might be able to complement it with personal loans and other areas. It really just adds another strength to the bow of the broker.”

 

Banks Continue the Mortgage Lending Party In A Fog

The latest data form APRA on the banks (ADI’s) portfolios for October 2015 tells us a little, but much is lost in the fog of adjustments which continue to afflict the dataset. In fact, APRA now points to the “corrected” numbers which the RBA publish.

Some banks have reclassified housing loans that originated as investment loans to owner-occupied based on a review of customers’ circumstances or as advised by customers. See the Monthly Banking Statistics Important Notice for more information. These reclassifications will affect growth rates for investment and owner-occupied housing loans for October 2015. Questions about specific data should be directed to the relevant bank.

The Reserve Bank of Australia publishes industry-level housing loan growth rates in Growth in Selected Financial Aggregates. Table D1 in particular contains investment and owner-occupied loan growth rates, which have been adjusted for these reclassifications. Table D1 is available on the RBA website athttp://www.rba.gov.au/statistics/tables/index.html”

The RBA data shows that investment loans are probably growing a little below 10%, and owner occupied loans at about 6%.

RBA-HL-Growth-D1-Oct-2015The monthly banking stats do not contain these adjustments, so cannot be directly reconciled. However, some interesting points are worth noting nevertheless. First is that total lending for housing rose by 7.5 bn to 1.4 trillion in the month. The RBA lending figure for the whole market (including the non-banks) was 1.5 trillion.  This is another record.  Investment lending sits at 37% on these numbers.  Net movements for OO loans was up 2.73%, whilst investment loans fell 2.95%.

Beyond that, if we take the APRA data at face value, then Westpac continues to reclassify loans. In the monthly movements we see more than $15bn swung into the owner occupied category, with an adjustment to the investment side of the ledger. There were smaller movements in the other banks, but some of this looks like further adjustments.

APRA-MBS-Oct-2015-1So the current market shares are revised to:

APRA-MBS-Oct-2015-2In our modelling of the monthly movements, based on the APRA data, where we sum the monthly movements for the past year (and include adjustments where we can), it appears Westpac is now in negative territory for investment loans, and that the growth rates for the other majors is slowing. The imputed annual market movement is 4.4% against the RBA data above of just under 10%.

APRA-MBS-Oct-2015-4For completeness we also show the owner occupied movements. These too are impacted by reclassifications, and the imputed growth rate is 10%, compared with 6% from the RBA.

APRA-MBS-Oct-2015-3 The net effect of all this is that there is no true information about what individual banks are doing in their loan portfolios. Having tried to talk to a couple of them to clarify the story, I discover they are not willing to share additional data and refer back to the [flawed] APRA data.

The convenient “fog of war” will continue for some time to come. There is also no way to cross-check the RBA adjusted data, and no underlying detailed explanations. We are just supposed to trust them!

 

 

Housing Lending Up Again In October to $1.5 trillion.

The latest RBA credit aggregates for October 2015, released today are not easy to interpret because of the myriad of adjustments.   Housing loans have more reached $1.5 trillion, another record.  But are these numbers trust-worthy?

At the aggregate level, total credit rose a seasonally adjusted 0.61% in the month, or 6.11% in the past year. Lending to business grew 0.84% in the month, and 5.88% in the last year. Business lending as a proportion of all lending sits at 33.2%, from an all-time low of 32.9% in July, but clearly business investment continues to be constrained. Housing grew 0.58% in the month, and 7% in the past year, whilst personal credit fell 0.89% in the month and 0.27% in the year, a sign that households remain cautious.

Credit-Aggregates-Oct-2015Turning to housing finance in more detail, and this is where it get complex; lending for owner occupied loans rose 2.62% in the month, representing 9.41% growth in the past year, while investment lending fell 2.8% in the month, and grew 3.03% in the year. But there are so many adjustments in these numbers, as the banks reclassify more loans, thanks to a combination of internal review, and customer request. Specifically, the differential movement in investment loans is making people check their loans are correctly classified, and RBA estimates $30bn of loans have been switched. Investor loans on book comprise 36.35% of all housing, down from its recent heights of 38.55% in July. The only thing we can be sure of is the numbers will move again next month. I discussed the recent RBA comments on this issue recently.

Housing-Aggregates-Oct-2015The RBA makes the following caveats:

All growth rates for the financial aggregates are seasonally adjusted, and adjusted for the effects of breaks in the series as recorded in the notes to the tables listed below. Data for the levels of financial aggregates are not adjusted for series breaks. Historical levels and growth rates for the financial aggregates have been revised owing to the resubmission of data by some financial intermediaries, the re-estimation of seasonal factors and the incorporation of securitisation data. The RBA credit aggregates measure credit provided by financial institutions operating domestically. They do not capture cross-border or non-intermediated lending.

Following the introduction of an interest rate differential between loans to investors and owner-occupiers a number of borrowers have changed the purpose of their existing loan; the net value of switching of loan purpose from investor to owner-occupier is estimated to have been $30.6 billion over the period of July 2015 to October 2015. These changes are reflected in the level of owner-occupier and investor credit outstanding. However, growth rates for these series have been adjusted to remove the effect of loan purpose changes.

The APRA ADI data is also out today, and we will look at this later.

Mobile Microfinance: Delivering Financial Inclusion to the World’s Poor

From Juniper research.

As outlined in Juniper’s recently published research report, Mobile Financial Services: Developing Markets 2015-2020, the mobile device is becoming the core enabler for the world’s poor to seek financial inclusion, with users of such services set to grow to 283 million by 2020.

Enabling the World’s Poorest

The unbanked populace in developing regions are being introduced to financial services through the use of mobile money platforms. This extends from simply sending remittances, to being able to receive life-saving services and provisions through sophisticated mobile money transactions, which include such offerings as loans, savings, and insurance.

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Barriers to Financial Inclusion in Emerging Markets

The mobile device has proven a game-changer in financial development for poorer nations due to a number of reasons.

Firstly, the fact that consumers can register with their mobile device through widely available outlets and branches in local stores, means that people are no longer required to travel long distances. Thus avoiding the use of poor transport systems, and travel over long distances, to reach major cities to register with a bank.

Additionally, Microfinance providers themselves face a hurdle with regard to the initial start-up costs associated with their services. In many developing nations profit is not feasible by traditional methods and, as a result, MFIs (Mobile Financial Institutions) have been reluctant to set up shop. The mobile form of finance delivery offers cheaper start-up costs, and far reaching services.

Juniper’s Mobile Financial Services research discusses the further implications that mobile banking poses for developing nations, as well as the current trends and key services on offer in this sector. For an overview of the microfinance industry download the white paper Microfinance with Macro Potential.

APRA On Securitisation

APRA has released a consultation paper on proposed revisions to the securitisation regime in Australia, including the explicit recognition of funding-only securitisation. The likely net effect will be to encourage greater use of this vehicle by banks as part of their capital management programmes.  The proposals also reflect the Basel III changes. APRA invites written submissions on the proposals by 1 March 2016.

The Australian Prudential Regulation Authority (APRA) has released for consultation a discussion paper on its proposals to revise the prudential framework for securitisation for authorised deposit-taking institutions (ADIs). APRA is also releasing a draft Prudential Standard APS 120 Securitisation (APS 120).

APRA’s objective in revising the prudential requirements for securitisation is to establish a simplified framework, taking into account global reform initiatives and the lessons learned from the global financial crisis. One of these lessons was that securitisation structures had become excessively complex and opaque, and that prudential regulation of securitisation had become similarly complex.

APRA first consulted on initiatives to simplify its prudential framework for securitisation in April 2014. Following consideration of the issues raised in submissions, APRA has amended its proposals in some areas. APRA’s amended proposals include:

  • dispensing with a credit risk retention or ‘skin-in-the-game’ requirement;
  • allowing for more flexibility in funding-only securitisation; and
  • removing explicit references to warehouse arrangements in the prudential framework.

These amended proposals are expected to assist ADIs to further strengthen their funding profile and provide clarity for ADIs that undertake securitisation for capital benefits.

In December 2014, the Basel Committee on Banking Supervision (Basel Committee) released its updated securitisation framework (Basel III securitisation framework). The changes aim to enhance the Basel Committee’s existing securitisation framework and to strengthen regulatory capital standards.

APRA’s latest proposals incorporate the new Basel III securitisation framework, with appropriate adjustments to reflect the Australian context and APRA’s objectives, and will be applicable equally to all ADIs. Subject to consultation on this discussion paper and draft prudential standard, APRA proposes to implement these changes in line with the Basel Committee’s effective date of 1 January 2018.

In proposing revisions to its securitisation framework, APRA has sought to find an appropriate balance between the objectives of financial safety and efficiency, competition, contestability and competitive neutrality. APRA considers its proposals will deliver improved prudential outcomes and provide efficiency benefits to ADIs, particularly through the explicit recognition of funding-only securitisation within the prudential framework.

APRA invites written submissions on the proposals in this discussion paper by 1 March 2016. APRA also intends to release a draft prudential practice guide (PPG) and reporting standards and reporting forms, for consultation in the first half of 2016. APRA expects that the final prudential standard, PPG, reporting standards and reporting forms, will be released in the second half of 2016.

Background

Q: What is securitisation and is it important in Australia?

A: Securitisation is a form of funding where a ‘pool’ of assets, often residential housing loans, is separated from the originating ADI into a special purpose vehicle (‘SPV’). Cash flows from the pool of assets are used to make payments to investors in debt securities issued by the SPV. These payments are effectively secured by the pool of assets, hence the name “securitisation”.

The debt securities issued to investors will typically have a different order of priority claim over the assets in the pool. The senior class will have first claim, while more junior (or subordinated) class(es) will be utilised to absorb losses in the event of non-performance by some or all of the assets. The senior class of debt securities is therefore normally considered to be of lower risk than that of the underlying pool of assets, and this allows ADIs to source funding on attractive terms.

Sometimes an ADI will arrange for only the senior class to be sold to investors. Alternatively, where an ADI arranges to sell the junior class(es) to investors, they have transferred substantially all the credit risk of the pool to external investors. In these circumstances an ADI may also obtain regulatory capital benefits as APRA will, subject to meeting the specific requirements of APS 120, no longer require the ADI to hold capital against the credit risk of the pool.

Having a robust securitisation market therefore allows ADIs to strengthen their funding profile, and can offer capital management benefits as well. For smaller ADIs that may not have efficient access to unsecured wholesale debt markets, securitisation can be a valuable source of funding and, potentially, capital efficiency. As such, securitisation can support competition in the banking industry.

Q: How has APRA simplified the prudential framework?

A: APRA’s main proposals relating to the simplification of the prudential framework for securitisation are:

  • the explicit recognition of funding-only securitisation. A simple structure facilitates a strong funding-only regime, where the originating ADI retains the junior securities and obtains funding from third parties through the sale of the senior securities. The explicit recognition of funding-only securitisation will assist ADIs to further strengthen their funding profiles;
  • well defined thresholds for capital relief securitisation, which better articulate the requirements to be met for regulatory capital relief; and
  • streamlining the approaches to determining regulatory capital requirements for ADIs’ securitisation exposures, and harmonising them for ADIs using standardised or internally-modelled risk weights.

Q: How will APRA’s proposals assist in facilitating a larger funding-only securitisation market?

A: The explicit recognition of funding-only securitisation, including the flexibility for bullet maturity structures that include a date-based call option, are likely to increase the potential size of the term securitisation market by attracting a broader investor base. These structures have not been permitted within the prudential framework previously.

Q: Why is APRA proposing not to include a ‘skin-in-the-game’ requirement in the prudential framework?

A: Skin-in the-game requirements are intended to address the misalignment of incentives whereby lenders may lack motivation to originate higher quality loans, since they may not have exposure to the loans once they are in a securitisation. A variety of skin-in-the-game requirements have emerged internationally and introducing an additional Australian requirement would run contrary to APRA’s objective of creating a simplified framework. In addition, Australian ADIs already have linkages to their securitisation — such as servicing of the underlying loans and entitlement to residual income — that reinforce incentives to maintain the quality of lending standards.

Q: How is APRA proposing to treat warehouse arrangements?

A: Warehouse arrangements allow ADIs to aggregate assets into pools before securities are issued to third parties. This can enable some ADIs to improve access to wholesale funding markets and raise funds at more competitive rates. The current regulatory requirements for warehouse arrangements have, however, created a gap in the prudential framework, such that less capital is held in the banking system relative to the risk retained in the system.

APRA is seeking submissions on viable approaches that maintain the benefits of warehouse arrangements but also address the gap in the prudential framework. In the absence of any such submissions APRA has indicated it will take a principles-based, rather than rules-based approach and will remove explicit reference to warehouse arrangements in APS 120. In these circumstances warehouse arrangements can still be entered into, but would need to meet the relevant requirements in APS 120 to be considered a securitisation.

Banks Still Hooked On Mortgage Loans – New Investment Loans Up 19%

The latest APRA Property Exposure data, to September 2015 provides an additional perspective on the loan books of the ADI’s. Overall property exposures are a record $1.35 trillion, up from $1.33 trillion in June, and up 9% on September 2014. Within the mix, owner occupied loans rose from $810 bn to $841 bn, up 8.9% from 2014; in response to the changed lending environment, whilst investment loans for residential property fell from $517 bn to $514 bn, the first fall in a long long time (APRA data goes back to 2008), but still up 9.1% from September 2014.  Within the data we can see the adjustments which the ADI’s have made as they reclassify loans. A process which is not yet complete.

APRA-Ptpy-Sep-2015-6Investment loans comprise 37.9% of all loans, a fall from 38.9% last quarter, but still worryingly high, and higher than the regulators previously had thought.

APRA-Ptpy-Sep-2015-5Looking at some of the key characteristics of loans on book, 40% of loans (by value) have offset facilities, and 35% are interest only loans. There appears to be a slight slowing in the growth of interest only loans, reflecting the changed lending environment, and a slowing in investment lending.  But see below for data on new loans.

APRA-Ptpy-Sep-2015-4The volumes of new loans being written is still strong, with close to 100,000 being written each month. Owner-occupied loan approvals were $219.0 billion (59.8 per cent), an increase of $13.1 billion (6.4 per cent) from the year ending 30 September 2014;
investment loan approvals were $147.0 billion (40.2 per cent), an increase of $23.4 billion (19.0 per cent) from the year ending 30 September 2014.

APRA-Ptpy-Sep-2015-7The LVR splits show the bulk of loans are in the 60-80% band, and there is a fall in the LVR above 90% being written.

APRA-Ptpy-Sep-2015-2The distribution chart below shows this well, and also shows that around 24% of loans are still be written above 80% LVR – at a point in the cycle where house prices in Sydney and Melbourne are probably close to their peaks, and values are falling in some other states.

APRA-Ptpy-Sep-2015-3 Data on the characteristics of the new loans shows a fall in new interest only loans being approved (but still more than 40% of new loans are interest only, and as we know these contain more potential risks later). The proportion via brokers sits at 47.7%, just a tad lower than last quarter, but it shows how important the broker sector is, in terms of originating new loans. There are a small number of new loans still being approved outside standard serviceability, at 3.6% in the past quarter, slightly lower than then 3.8% in June, but still higher than in previous times. Given the tighter lending standards, this is a concern. Only 0.4% of new loans are low documentation loans via the ADI’s though more are being written via the non-bank lenders, and so are not caught in these figures.

APRA-Ptpy-Sep-2015-1

ING DIRECT to launch new upfront commission model

ING DIRECT has announced a new upfront commission model that will come into effect from 1 January 2016.

The simplified commission model will be structured around individual accounts as opposed to the current model’s focus on aggregator volumes and conversion rates, ensuring transparency for brokers and alignment with the bank’s primary bank strategy.

Mark Woolnough, Head of Third Party Distribution, commented: “We reward our customers for their loyalty and for supporting our business strategy to be the main bank for Australians. It made sense to do the same for brokers, resulting in our new, simplified commission model which will reward the type of business that best supports our primary bank strategy – lower LVR, Orange Advantage home loans.”

The minimum upfront commission will remain unchanged at 50bps (+GST) with the maximum increasing to 80bps (+GST) until 30 June 2016.

ING DIRECT’s new commission model was finalised following consultation sessions with aggregators and will apply on new residential loans with new to ING DIRECT security property settled from 1 January 2016.

HBOS report does little to tackle systemic problems

From The Conversation.

Remember the 2007-08 banking crash? In the build up to it, UK bankers made vast profits and their executives collected big bonuses. After the crash, they were bailed out by taxpayers, which led to increased government borrowing. We have all been suffering a never ending programme of austerity ever since.

One of the biggest banks to fall was HBOS, which traded under the brands Halifax and Bank of Scotland. No ordinary bank, it had a market capitalisation of over £40 billion at its peak in 2007 and was the UK’s largest lender. But the financial crisis exposed the bank. It had to be bailed out to the tune of £30 billion and almost 50,000 employees have lost their jobs.

The official investigation into what happened has taken seven years. Two reports, at a cost of £7m, have now been published by the Bank of England. The first is a 407-page report on the demise of HBOS. The second is a 144-page assessment by Andrew Green QC on whether the decisions taken on enforcement by the former regulator, the Financial Services Authority (FSA), were reasonable.

The first report paints a picture of reckless risk-taking by the HBOS board, which despite warnings continued with its growth strategy. The report said that the HBOS board had a “flawed and unbalanced strategy and a business model with inherent vulnerabilities arising from an excessive focus on market share, asset growth and short-term profitability”. And the FSA’s supervisory approach is described as “highly unsatisfactory”.

The UK’s approach to punishing the bad behaviour in its banking industry that led to the financial crisis has been lacklustre at best. While Iceland has sent 26 financiers to prison for their misdemeanours, not one senior banker in the UK has gone on trial over the failure of a bank.

The Bank of England’s reports into HBOS took seven years to complete and cost £7m. shutterstock.com

The reports call for investigations into as many as ten senior executives and possibly the barring of them from working for a financial company, though it may be too late to impose any fines. Any attempt to impose retribution after such a long delay is bound to be contested by HBOS executives. So expect long legal battles.

Overall, the reports are disappointing. They are more noticeable for their silence and lack of attention to systemic problems.

A system-wide problem

A major regulatory problem in the UK is the revolving door through which industry grandees become regulators and vice-versa. Are they defenders and promoters of industries or umpires and prosecutors? For example, James Crosby, HBOS’ chief executive until 2006 became a non-executive director of the FSA in 2005, and from 2007-2009 was also its deputy chairman. The report is silent on such relationships.

The HBOS report cites regulatory failures but fails to note that the UK has a fragmented and ineffective regulatory structure. The report does not address how HBOS was audited, despite the bank’s auditors being the most important group of independent professionals to regularly examine the performance and accounts of HBOS.

Instead it defers to the accounting regulator, the Financial Reporting Council (FRC) which has indicated it will look into the report. But those of us hoping for a swift conclusion will likely be disappointed. As a recent example, car manufacturer MG Rover’s collapse in 2005 amid allegations of accounting misdemeanours, was not concluded until 2015.

The report notes that HBOS had a remuneration committee consisting of non-executive directors, mostly directors of other companies. Executive pay was linked to profit targets. This encouraged excessive risk-taking. It draws attention to sharp accounting practices which boosted balance sheets and profits. At the same time, risks were poorly monitored by an audit committee consisting of non-executives. Despite the huge corporate governance failures, the report makes no recommendations about board structures or reward systems.

So despite the HBOS debacle and the banking crash little has changed. Banks remain devoted to maximising shareholder wealth even if that means taking excessive risks. Shareholders have only a short-term interest in banks as they constantly buy or sell shares to make short-term profits, and can’t invigilate mega corporations. HBOS employees and other stakeholders suffered, but there is no place for them on company boards.

Nothing has been done to protect and empower whistleblowers such as Paul Moore, HBOS’s chief regulatory risk officer, who was fired in 2004 after he warned the board of the bank’s risky sales strategy. Auditor files are still secret and they still don’t owe a “duty of care” to any individual stakeholder, or even the regulator.

The publication of the HBOS report may enable politicians and regulators to draw a line under the affair, but the banking industry still needs major reform.

Authors: Atul Sha, Senior Lecturer – Accounting & Finance, University Campus Suffolk;  Prem Sikk, Professor of Accounting, Essex Business School, University of Essex

 

New Bank Operational Risk Method May Boost Comparability

Operational risks will rise as banks increasingly rely on technology, heightening exposure to systems failure and cyber attacks. Banks also face growing compliance and regulatory risks and the overhang of unresolved litigation is still considerable in some markets.

According to Fitch Ratings, the Basel Committee’s proposed overhaul of the way banks calculate how much capital they need to cover operational risk should result in simpler, more standardised charges, allowing for greater comparability.

Banks have been calculating operational risk capital requirements for over 10 years since the implementation of Basel II, but in many cases capital set aside proved inadequate to cover substantial losses arising from misconduct fines, controls failure or fraud, for example.

The Basel Committee’s update on post-crisis reforms, presented to the G20 leaders at the recent Antalya summit, confirms that it is considering eliminating the use of internal models to calculate operational risk capital charges. Basel II introduced several methods for calculating operational risks to reflect particular risk profiles across banks, variations in operating environment and management practices. But we believe flexibility has confused market participants and contributed to a lack of transparency.

The Basel Committee is considering replacing all current approaches with a single new standardised measurement approach (SMA), and will open a one-year consultation period by end-2015. SMA will borrow from the current advanced measurement approach (AMA) by incorporating a requirement for banks to continue to collect operational risk loss data, but internal modelling will not be used to determine appropriate capital levels. Comparing operational risk capital charges currently set aside by banks using AMA has proved difficult, largely because internal models are highly complex, methodologies vary from bank to bank and calculation outputs lack transparency.

Some Basel II methods for calculating operational risk charges are predetermined by regulators, such as the basic indicator and standardised approaches, both of which link capital charges to gross income (the standardised approach allows banks to vary multipliers across business lines and units). But operational risk capital charges can also be calculated using an internal measurement approach where banks draw on data from their internal operational loss experiences. The Basel Committee, which is already driving a trend to reduce reliance on complex models in other areas, says it will consult on removing the AMA. The AMA gave banks the greatest amount of freedom to set operational risk charges, as flexibility on the modelling approach meant risk charges would differ even when applied to the same base data.