Question

1. a) Distinguish between “intrinsic risk” and “concentration risk” in the context of banks’ credit risk management. Give examples to illustrate their differences.

b) The “mortgage introducer” program used by National Australia Bank and many other Australian banks was heavily criticized during the 2018 Banking Royal Commission. Provide insights as to why this initiative in mortgage lending may have adverse consequences for a bank’s credit risk exposure.

Answer 1

Modern ibanks iare isubject ito ia idiverse iset iof imarket iand inon-market irisks. iA isafe ibanking isystem iis icritical ito ieconomic igrowth iand ithe istability iof ifinancial imarkets; ihence ithe imanagement iof ithis irisk ihas ibecome ia icore ifunction iwithin ithese ibanks. iWithout ithe imanagement iof icredit irisk iwithin ibanks, ibanks iopen ithemselves ito ipotential ibankruptcy iwhich iwould ihave ia isignificant iimpact ion ithe iwhole ieconomy.

Credit irisk ican ibe idefined iin imany iways, isuch ias; ithe i‘possibility iof iloss iarising ifrom ithe ifailure iof icounterparty ito imake ia icontractual ipayment’ i.It iis ialso ibroadly iconceived ias ithe iprobability iof ithe inon-repayment iof ifinancial iresources igranted iby ia ibank ito idebtors ior ieven ithe irisk iof idefault ion ia idebt ithat imay iarise ifrom ia iborrower ifailing ito imake ithe irequired ipayments.

There iare itwo idifferent itypes iof icredit irisks ithat ia ibank ineeds ito iaccess: iindividual iloan icredit irisk iand iportfolio icredit irisk. iThe irisk ithat iis irelated ito ia iportfolio iof iloans isuch ias ia igroup iof idifferent iindividual iloans ior idifferent iloans ispread iout iacross idifferent iindustries iand ibusiness isectors iis iknown ias iportfolio icredit irisk. iThis icredit irisk iis imade iup iof itwo ifactors: iintrinsic iand iconcentration irisk. iIntrinsic irisk iis ithe irisk iof ilending ito idifferent itypes iof iindustries, iand iconcentration irisk iis iwhen ithere iis ia irisk iof ibeing iinadequately idiversified. iWhereas, iindividual iloan irisk iis ithe iinherent irisk iof ia isingle iloan. iFinancial iinstitutions iare iable ito ialleviate ior iminimize icredit irisk ithrough idiversification iof ia iportfolio iof iloans, ithereby idecreasing ithe iunsystematic irisk ithat ian iindividual iloan iattracts.

i i i i i i i i i i i i i i i i i i i i i i i iConcentration irisk iis ia ibanking iterm idescribing ithe ilevel iof irisk iin ia ibank's iportfolio iarising ifrom iconcentration ito ia isingle icounterparty, isector ior icountry. iThe irisk iarises ifrom ithe iobservation ithat imore iconcentrated iportfolios iare iless idiverse iand itherefore ithe ireturns ion ithe iunderlying iassets iare imore icorrelated.

Concentration irisk iis ithe irisk ithat ian iinvestor iwill isuffer ifrom ilack iof idiversification, iinvesting itoo iheavily iin ione iindustry, ione igeographic iarea ior ione itype iof isecurity. iConcentration irisk iis ithe irisk iof iloss iarising ifrom ia ilarge iposition iin ia isingle iasset ior imarket iexposure. iAn iexcessive iconcentration ican igive irise ito iliquidity irisk ior imarket irisk ilosses.

Concentration irisk iis ia ibanking iterm idenoting ithe ioverall ispread iof ia ibank’s ioutstanding iaccounts iover ithe inumber ior ivariety iof idebtors ito iwhom ithe ibank ihas ilent imoney. iThis irisk iis icalculated iusing ia i“concentration iratio” iwhich iexplains iwhat ipercentage iof ithe ioutstanding iaccounts ieach ibank iloan irepresents. iFor ie.g.; iif ia ibank ihas i5 ioutstanding iloans iof iequal ivalue ieach iloan iwould ihave ia iconcentration iratio iof i0.2; iif iit ihad i3, iit iwould ibe i0.333.

Credit iconcentration irisk imeans ipart iof icredit irisk ithat imeasures ithe irisk iconcentration ito iany isingle icustomer ior igroup iof iclosely-related icustomers iwith ithe ipotential iof iproducing ilosses iwhich iare isubstantial ienough ito iaffect ithe ifinancial isoundness iof ia ifinancial iinstitution.

The iterm i“concentration irisk” iin ithe icontext iof ibanking igenerally idenotes ithe irisk iarising ifrom ian iuneven idistribution iof icounterparties iin icredit ior iany iother ibusiness irelationships ior ifrom ia iconcentration iin ibusiness isectors ior igeographical iregions iwhich iis icapable iof igenerating ilosses ilarge ienough ito ijeopardize ian iinstitution’s isolvency.

Concentration irisk ican ibe iconsidered ifrom ieither ia imacro i(systemic) ior ia imicro i(idiosyncratic) iperspective. iFrom ithe ipoint iof iview iof ifinancial istability i(macro iperspective), ithe ifocus iis ion irisks ifor igroups iof ibanks iwhich, ifor iexample, iemerge ifrom ia ijoint iconcentration iin icertain ibusiness ilines ior ia ijoint iregional iconcentration iin ilending. iEconomic idisruptions iwhich iaffect ithe igroup iof ijoint iborrowers ior ithe iregion ican itherefore ijeopardize ithe isolvency iof ian ientire igroup iof ibanks iand ithus iput ifinancial istability iat irisk. iBy icontrast, ithe iprimary ifocus iin iinternal irisk imanagement iand ifrom ia isupervisory ipoint iof iview iis ion iconcentration irisk iat ithe ilevel iof iindividual iinstitutions i(micro iperspective). iThis irisk iis inot ilimited ito icredit iportfolios iand imay istem ifrom ivarious isources.

i i i i i i i i i i i i i i i i i i i i i i i i iIntrinsic iRisk ifocuses ion ithe irisk iinherent iin icertain ilines iof ibusiness iand iloans ito icertain iindustries. iCommercial ireal iestate iconstruction iloans iare iinherently imore irisky ithan iconsumer iloans. iIntrinsic irisk iaddresses ithe isusceptibility ito ihistoric, ipredictive, iand ilending irisk ifactors ithat icharacterize ian iindustry ior iline iof ibusiness.

1. Historic ielements iaddress iprior iperformance iand istability iof ithe iindustry ior iline iof ibusiness.

2. iPredictive ielements ifocus ion icharacteristics ithat iare isubject ito ichange iand icould ipositively ior inegatively iaffect ifuture iperformance.

3. Lending ielements ifocus ion ihow ithe icollateral iand iterms ioffered iin ithe iindustry ior iline iof ibusiness iaffect ithe iintrinsic irisk

Concentration irisk iis ithe iaggregation iof itransaction iand iintrinsic irisk iwithin ithe iportfolio iand imay iresult ifrom iloans ito ione iborrower ior ione iindustry, igeographic iarea, ior ilines iof ibusiness.

Answer2.

National iAustralia iBank ifaces ia imultimillion-dollar ipenalty iafter iadmitting ito i255 ibreaches iof icredit ilaws, ias iit ilooks ito isettle ia ilawsuit ifrom ithe icorporate icop iover ia iscandal iinvolving iits iuse iof imortgage i"introducers".

In ia icase ithat iwas ilaunched ifollowing iscrutiny ifrom ithe iHayne iroyal icommission, ithe iAustralian iSecurities iand iInvestments iCommission i(ASIC) iin iAugust itook ilegal iaction ialleging iNAB ibroke icredit ilaws iin irelation ito i297 iloans iwhich iwere iwritten iafter ireferrals ifrom iunlicensed i"introducers".

Introducers iare ipeople iwho ipocket ia icommission ifor ireferring icustomers ito ia ibank, ibut ithey ican ionly ipass ion ithe iclient's iname iand icontact idetails, ias ithey ido inot ihold ia icredit ilicence.

ASIC ialleged ia igroup iof iintroducers iworking iwith iNAB iwent ifurther iand iprovided idocuments iincluding icompleted iloan iapplications, itax ireturns, iand ieven ifalse ipays ilips iin isome icases.

A istatement ifiled iby iNAB iwith ithe iFederal iCourt ithis iweek isaid ithe ibank iadmitted ito i255 iof ithe i297 ibreaches iof ithe iNational iConsumer iCredit iProtection iAct ithat iwere ialleged iby iASIC.

NAB iacknowledged isome iof iits icustomers iwere iexposed ito ithe irisk iof itaking iout iunsuitable iloans ias ia iresult iof ithe iconduct.

The ibank's istatement ito ithe icourt ialso ipointed ito ithe isteps iit ihad itaken ito ideal iwith ithe iscandal, iincluding isacking ibankers iand iultimately iscrapping ipaid ireferrals ifrom iintroducers iin iMarch ithis iyear.

The ibank iand ithe iregulator iwill inow ienter italks iover ithe iremaining i42 ialleged ibreaches ithat iit ihas inot iadmitted ito. iNo ipenalty ihas ibeen iset, iwith iFederal iCourt ijudge iMichael iLee ito idecide ion ithe ifine ito ibe ipaid iby ithe ibank, iin ihearings iexpected inext iyear.

Under ithe ilaw, ithe imaximum ipenalty iper ibreach iis i$1.7 imillion ito i$1.8 imillion, iwhich iadds iup ito ia ipenalty iof i$433 imillion ifor i255 ibreaches.

However, iASIC ideputy ichairman iDaniel iCrennan isaid iin iAugust ithe imaximum ipenalties iwent i"well ibeyond" iwhat ia icourt iwould iimpose, isaying isuch inumbers iwere i“quite ihypothetical i– ithey’re inot ithe itype iof ipenalty iyou iwould iactually iget ifrom ia icourt”.

NAB's ichief icustomer iofficer ifor iconsumer ibanking, iMike iBaird, inoted ithe ibank ihad iannounced ithe iclosure iof iits iintroducer iprogram, iand iit iwas icompensating iaffected icustomers.

“As iwe ihave isaid ipreviously, ithe iprogram ihad iinherent irisks iand iultimately ifell ishort iof icustomer iand icommunity iexpectations," iMr iBaird isaid.

“We iwant icustomers ito ihave ithe iconfidence ito icome ito iNAB ibecause iof ithe iproducts iand iservices iwe iprovide i– inot ibecause ia ithird iparty ireceived ia ipayment ito irecommend ius."

A ispokesman ifor iASIC isaid ithe iregulator iwas i"pleased" iwith iNAB's iresponse ito ithe iallegations iso ifar, ithough ithere iwere i"still ia inumber iof iissues ito ibe iresolved".

"ASIC icommenced ithe iproceedings ito ihighlight ithe irisks ifaced iby iconsumers iwhen ibanks iengage iwith iunlicensed ithird iparty iintroducers iengaging iin icredit iactivities. iIt iis iimportant ithat ithe icredit iinstitutions iunderstand ithese irisks iand icomply iwith iobligations iintended ito iprevent ipoor iconsumer ioutcomes," ithe ispokesman isaid.

"The iparties iare iworking ihard ito ireach ian iagreement ion ithose ioutstanding imatters. iAny ipenalty iimposed iwould ibe ia imatter ifor ithe icourt ito idetermine, iand iASIC iwill inot ispeculate ion ithat ioutcome," ihe isaid. iBetween i2013 iand i2016, iNAB ipaid ialmost i$100 imillion iin icommissions iunder iits iintroducer iprogram, iwhich igenerated i$24 ibillion iin iloans.