Academic journal article Federal Reserve Bank of New York Economic Policy Review

Credit Risk in the Australian Banking Sector

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Credit Risk in the Australian Banking Sector

Article excerpt

This paper presents a brief overview of developments currently taking place in the Australian banking sector relating to the measurement and management of credit risk. Section I provides, as background, a sketch of the structure of banking in Australia. Section II considers some of the forces operating within the Australian banking and financial system to increase the significance of credit and capital management in banks. Section III outlines some of the credit risk management practices being adopted in the major Australian banks. Section IV looks at the implications of these developments and speculates on the scope for greater use of banks' internal credit risk models, or other possible approaches, for capital adequacy purposes. A summary and brief conclusion are in Section V.

I. THE STRUCTURE OF BANKING IN AUSTRALIA

The banking system in Australia can be summarised in a number of simple statistics. It comprises forty-three banking groups, with aggregate global assets totaling more than A$900 billion. Asset size, including the credit equivalent of all off-balance-sheet activity, ranges from around A$250 billion for the largest bank to around A$300 million for the smallest. As a group, banks hold more than 75 percent of the assets held by all financial intermediaries in Australia. The four major banking groups account for more than 75 percent of that total. Measured in terms of the assets of the financial system as a whole (including insurance companies and fund managers), banks now account for just less than 50 percent.

The history of banking in Australia can be summarised as one in which a long period of heavy regulation was followed by a period (dating from the late 1970s to the early 1980s) of financial deregulation. Banks dominated the system in absolute terms for many years but lost ground over the years to the newly emerging (and largely unregulated) nonbank sector. Between the late 1920s and 1980, banks' share of intermediated assets fell from around 90 percent to about 55 percent. That trend changed with the advent of financial deregulation. The long-term slide in the proportion of financial assets held by the banks was halted, and the expansion in the number of domestic and foreign banks operating in the Australian market, combined with the additional freedoms given to banks as a result of deregulation, enabled banks' share of business to rise. These trends have been widely documented and will not be examined in this paper.

In contrast to the position in a number of countries, banking in Australia encompasses all aspects of financial intermediation. Banks are the main providers of funds to households (through personal lending and lending for residential housing) as well as to the small and medium-sized business sectors. They are involved heavily in wholesale and institutional markets, including all aspects of traded markets. Through fully owned subsidiaries, they are prominent in insurance and funds management. There are no limitations or artificial barriers of substance to the type of activity that can be conducted through a bank or its associated companies, provided the activity can be classified as financial in nature.

II. RISK MANAGEMENT AND THE UNDERLYING FORCES IN AUSTRALIAN BANKING

Three sets of forces have been instrumental in generating greater interest over the past five years in risk measurement and management within the Australian banking system:

* the after-effects of the 1988 and 1992 periods, which saw some Australian banks suffer large losses (Chart 1). This experience led to a recognition that in a world characterised by financial deregulation, the potential existed for large volatility in earnings (and potentially large losses) induced by credit cycles. The product was a new-found interest on the part of bank management in ways to measure and manage credit and other forms of risk more precisely so as to avoid, as far as possible, the reemergence of such problems in the future. …

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