The Global Financial Crisis from an Australian Perspective: Great Farsighted Choices, or Good Fortune and Chance? [RMA Journal, The]

Australia and its financial institutions emerged from the 2007-09 financial crisis relatively unscathed compared to their international peers. Why? Our analysis indicates there is no easy answer to that question. However, we believe that no single factor has emerged with greater weighting than that of risk culture and appetite. These cornerstone themes continue to hold fast in the face of changing market conditions and challenging economic times.

We also learned that large financial institutions can, with seasoned risk managers in the chief risk officer (CRO) role, position themselves to be opportunistic acquirers both during a crisis and as the tsunami-like effects of major market disruptions dissipate. Smaller financial institutions do not necessarily fare so well in such dramatic times.

The underpinning Australian economy provides context for our analysis. Briefly, consistent budget surpluses and economic growth were the hallmarks of the domestic economy pre-crisis. When the global effects of the crisis were recognized, the federal government took quick action. It implemented guarantees for bank depositors' funds as well as for bank borrowings, it enacted spending programs across the building construction industry for upgrades of public facilities, it made small cash payments to individual taxpayers, and it introduced a program to facilitate the purchase of residential mortgage-backed securities. Concurrent with these interventions, Australia benefited from China's rapidly growing appetite for Australian natural resources (coal, iron ore, minerals), which has resulted in an eightfold increase in exports over a decade.

Within this particularly advantageous economic setting, we examined four principal themes:

1. Regulator behavior.

2. The shape of the industry and lessons learned.

3. Internal systems and processes.

4. Risk culture and appetite.

Regulator Behavior

Prudential regulation in Australia was the subject of the Wallis Enquiry, an extensive public examination of the country's financial system that began in 1996. The findings, which emerged in 1997, led to a separation of powers and responsibility in financial market regulation, as well as the pooling together of regulated organizations including insurers, banks, credit unions, and building societies.

Wallis oversaw the separation of regulatory risk from that of systemic risk and created two new entities: the Australian Securities and Investment Commission (ASIC, the financial markets regulator) and the Australian Prudential Regulatory Authority (APRA, the regulatory supervisor of financial institutions). Responsibility for systemic risk remained with the central bank, the Reserve Bank of Australia.

The separation of these responsibilities in the late 1990s led to the emergence of invigorated regulators that had secured a recent mandate to drive a refreshed approach to their individual areas of focus. The result was enhanced oversight of all risk areas, with increased focus on operational risk and market risk.

The Asian financial crisis of 1997 served to underscore those mandates. In addition, in 2001, APRA experienced a significant early setback with the failure of a major Australian insurance company, HIH. Much of the thrust of APRA's regulatory activity in the period that followed was distinguished by a determination that such failures would not recur. For example, APRA required the country's four major trading banks to comply with Basel II's advanced accreditation across the key risk classes by 2008. This APRA requirement was more aggressive than that which its international regulatory peers had demanded.

APRA clearly sought and achieved international recognition as a leading bank regulator, despite the relative unimportance of Australian banks internationally. In this vein, APRA took a particularly hard line on a market risk failure within a major domestic bank, ensuring that all market participants felt its presence. As a result of this attitude and approach, international regulators began to recognize APRA's robust disposition and acquired confidence in the Australian system. Bank regulation was active and authoritative and sought to lift standards across all institutions.

Shape of the Australian Banking Industry

Australian banks are comparatively large organizations, and approximately 80% of financial intermediation is conducted by the four largest banks.

Each of these four banks expanded their U.S. dollar loan books during the 1980s, primarily through syndicated lending conducted out of their U.S. offices. These offshore loan books were pared back quickly in 1990-92, when the Australian economy entered a major period of contraction and bank losses were severe to extreme.

At least one of the major banks experienced a near-death event during that time. The result of the hard-learned lessons of the 1990-92 economic contraction was that, in facing the new millennium, Australian banks chose to limit the bulk of their lending activities to the domestic economy, which rewarded them by expanding. The bulk of the expansion was in housing, and a large proportion of lending, and consequently of bank balance sheets, became housing-related. Generally, Australian banks lent conservatively, requiring cash deposits-sometimes as high as 30%. Borrower recourse was a standard condition of the loan.

The global financial crisis of 2007-09 came to be seen largely as an event that impacted non-Australian entities, with one key exception. It was viewed as another external event that was part of a chain of events to be managed by Australian banks. These events included:

* The banks' 1992 extreme losses.

* The 1997 Asian financial crisis.

* The creation and impact of new regulators.

* Basel II's introduction.

* The cessation of loan securitization markets in July 2007.

The Australian domestic banks had quite simply become accustomed to adversity and change, be it from exogenous or endogenous sources. As a result, the Australian banks mostly tended to stick to their knitting. They had learned the lessons of a contracting economy, they had managed through the Asian crisis, and they had dealt with new regulators and new regulation. They were also blessed with an expanding domestic economy from 1993 to 2007 that provided a large and steady source of economic activity that required basic, but certainly not market-leading, loan underwriting capability.

The global crisis's principal impact on Australian banks related to liquidity and funding. Although there were rea68 sonably sized credit failures, there was less of an impact from credit risk or operational risk. The crisis was also responsible for banks reviewing their margin lending loan books that facilitated financing for equities. These products had been a sizable and lightly managed growth component within the scope of market risk. Over time, the less immediate issues of operational and reputational risk failures related to nonbank financiers emerged, causing a number of banking system participants some embarrassment.

Because of the Australian economy's structure, by 2007 more than 40% of banking system assets were financed by overseas borrowings. The banking system was very vulnerable to potential crises, relating either to single names or to the obligors' country of origin. The federal government recognized this risk in the early stages of the crisis and proactively provided guarantees of both deposits and borrowings, using the country's AAA rating, which was never threatened. (The government guarantee on deposits of up to $1 million is still in place.) The government also provided significant emergency liquidity to the banking system. This financial assistance, coupled with the robust and continuing profitability of the major banks and their strong balance sheets, saw the country and the banking system through the worst. (All four major banks retained AA ratings right through the crisis.)

This is not to say that it was smooth sailing for all market participants during the crisis, particularly some of the smaller institutions. The Commonwealth Bank of Australia, as a result of the HBOS parent organization's pressing need to raise cash, acquired the HBOS-controlled Bank of Western Australia. Meanwhile, Westpac Banking Corporation acquired St. George Bank in 2008 with some speculation as to St. George's ability to continue to fund itself economically. Both transactions proceeded smoothly and without market disruption.

Other smaller-scale market participants carried loan books that were largely housing-focused and locally funded, including a significant reliance on securitization markets. The securitization markets basically shut down in July 2007 and led all financial institutions to increase their liquidity holdings substantially. For a time, cash markets were quite constrained and central bank assistance was evident (see figure on previous page). The previous vigorous competition between the banks and the nonbanks disappeared.

With access to securitization markets almost at a standstill, the major banks were left in almost complete command of the residential mortgage market. This competitive disruption has yet to be reversed. The nonbank sector took a heavy blow: Many major nonbank participants closed their books and, in some cases, sold all or part of their existing loan portfolios.

Banks' Internal Systems and Processes

Australian banks regularly reviewed their systems and processes in the chase for enhanced profits during the late 1990s and early 2000s. The result was an associated boost in investment in risk and financial systems and processes, pushed by regulatory change emanating from Basel II and Sarbanes-Oxley.

The continuous pursuit of improved bottom-line profits resulted in a progressive, but significant, restructuring of all banks' internal operations, which included staff layoffs, and a risk appetite that avoided speculative areas of the domestic and international economies.

Because the Australian banking system produced consistent profits, it was able to continue lending during the crisis, although on a somewhat more selective basis. This lending was particularly helpful to the wider economy.

Australian banks were also early to recognize, identify, and adopt the concept of operational risk. As early as 1995, 70they were investigating the reasons why profitability leakage was occurring, sometimes at alarming rates. While the specific operational risk discipline has developed and grown, those early lessons made valuable contributions to the integrity of systems and processes.

Those lessons also became embedded in a number of the Australian banks. For example, outsourcing contracts sought to achieve operational cost savings by transferring responsibility for processes to third parties, but banks quickly learned that the mere conduct of processing by third parties did not transfer risk, particularly reputation risk, which remained with the bank. Therefore, controls over those processes, along with regular monitoring of the performance of third-party processors, were thrust upon banks as being operational risk matters that required skills sets different from those traditionally held.

It has been the robustness of Australian banks' systems that helped avoid the worst impacts of the crisis.

Risk Culture and Appetite

Risk culture became more prevalent and observable in Australian banks when the CRO role was broadly adopted as a group-wide model, and the CRO became largely a direct report of the chief executive officer. This structural change gave the CRO a seat at the executive table and ensured that all strategic decisions were taken with input from the risk team.

Prior to the change, the most senior risk personnel within Australian banks were chief credit officers. Following wider recognition of operational risk and market risk as discrete disciplines, the CCO role was retained, but the wider management role was expanded and redefined and the CRO role was born.

These organizational moves elevated the status of the risk family within the wider business of banking. Depending on the manner in which these changes were implemented, the voices of risk people began to be heard. Business recognized the value that risk personnel added. A clear understanding also developed regarding the business's responsibility for risk management.

Australian banks' CROs were not only experts in credit risk; they were ready to adapt and expand their knowledge base by embracing the newly defined CRO role. They also embraced their newfound roles as strategy advocates. Their move from the back office to the C-suite was relatively seamless, reflecting both their individual capabilities and their organizational maturity and knowledge.

In relation to risk appetites, it bears repeating that, historically, around 60% of Australian banks' assets have been funded by domestically sourced liabilities. The remainder of the funding task has been sourced from offshore borrowing.

This historical funding approach has continually exercised the minds of asset and liability committee chairs and has been a concern of chief risk officers. Australian banks, particularly the smaller ones, relied heavily on securitization markets to fund their business expansion. With the cessation of the securitization markets in July 2007 and subsequent offshore bank failures in 2008 and thereafter, enhanced domestic deposit-raising and alternative funding sources became a priority.

The introduction in 1986 of compulsory superannuation (retirement) savings for all unionized workers across the economy had served to exacerbate the historical funding gap that Australian banks had to cover in order to balance their books.

Compulsory superannuation resulted from a push by the union movement in recognition that only 39% of the workforce had some form of retirement savings, that access to those savings depended on age, gender, occupation, and employment status (full or part-time, permanent or casual, or contractor), and that only 24% of women had retirement savings.

Between 1992 and 2002, compulsory retirement savings increased from 3% of salary to 9%, all of which was employer-funded. Today, Australian retirement savings exceed $1.3 trillion.

Australian banks had expanded amid awareness of domestic funding constraints, exacerbated by the diversion of retirement savings into equity and property markets, both domestic and international. Banks had grown wary of international markets from the expansion of their U.S. dollar loan books during the 1980s. Accordingly, their cultures and risk appetites set by their CROs were largely conservative in nature, but willing to entertain transactions that recognized, but still restricted, concentration risk to manageable levels. The crisis therefore was not an overly significant credit issue, but more of a liquidity/funding matter for Australian banks.

Conclusion

The combination of vigorous regulation, banks' conservative growth appetites, sound systems, and funding constraints has produced a banking industry that has weathered the financial crisis well in contrast to other banking systems around the world. Still, the skies above are not always blue. There are many who argue that Australia has a housing bubble that is about to burst.

Nominal housing prices have increased 60% since 1986. In real terms, the gain is around 260%. The ratio of consumer debt, which is principally housing-related, to disposable income has increased 800% since 1970. This means that the cost of entry into the housing market has become largely prohibitive and the flow of new entrants into housing has slowed dramatically.

Furthermore, the proportion of housing investors to owner-occupiers is high in Australia: Around 35% of all transactions are investor-related. The failure of investors, who hold such a large part of the market, to behave rationally during a sustained pause or reduction in house prices could be the trigger that accelerates house price declines.

There are also smaller banks, building societies, and credit unions that need to address their access to both capital and liquidity. Recent moves by APRA to possibly allow banking organizations to issue bonds covered by a maximum of 8% of their local assets may help with the funding task they face, but 8% is a long way short of the gap in local funding created by the absence of securitization markets. The federal government has sponsored a limited securitization capability not available to the large banks to encourage smaller banks and nonbanks to lend.

Across the entire banking market, the banks' intermediation function between depositors and borrowers has been made more difficult by the large gap in funding that must be covered by offshore borrowings. The banking regulator is now seeking increased levels of both capital and liquidity in order to be prepared for continuing uncertain times worldwide.

Given the less-than-certain outlook for banks, there is high demand for experienced eyes to scan the economic horizon for the next risk event. Meanwhile, across other regulated entities there is growing emphasis on the need to maintain robust risk cultures and commensurate risk appetites.

Regulatory aggression has played its part in Australian banks' crisis-related outcomes, but so too have lessons learned. Good systems and processes developed in the search for increased profitability also have assisted. These factors could all be characterized as accidents of fate or good fortune had they not been combined with the telling contributions of default-wary chief risk officers who laid the foundations for the resultant stability of their organizations.

The Australian domestic banks had quite simply become accustomed to adversity and change, be it from exogenous or endogenous sources.

PROFILE: RMA Australia

Founded in 2003, RMA's Australia Chapter seeks to foster a community of risk professionals and expose Australian bankers to a wide variety of perspectives on risk issues. With 900 individual members and 18 institutional members, the Australia Chapter is RMA's largest. Unlike the others in RMA, it is organized as a national chapter and regularly holds speaker events in Sydney, Melbourne, and Brisbane.

Though its financial services industry is one of the most advanced in the world, the country's relative geographic remoteness requires its banks to make an extra effort to gain exposure to a diversity of ideas and the best global practices. Consequently, affiliation with RMA has enjoyed strong support from the executive managements of the chapter's member banks.

Members of the chapter's Managing Committee recently discussed the unique aspects of the Australian banking industry and the keys to the chapter's success with RMA Regional Manager John Baier.

Grant Lowen, CRO, Institutional Financial Services, Commonwealth Bank of Australia, remarked that getting his company to support RMA involvement and membership is easy because of the value RMA membership represents. "The monthly chapter events are the core benefit for our staff," said Lowen. "We are maintaining the caliber and relevance of the sessions, and they are usually very well supported. The CRO roundtable we hold each October is proving to be a success. The CROs see value in meeting with their colleagues, and they see that they can gain insights from one another in a reasonably safe environment."

Popular events are key to the chapter's mission, noted Robert Molyneux, group general manager of risk infrastructure, ANZ Banking Group. "Events are the flagship," he said. "We try to invite people with different views. A bit of controversy never hurts. We are a fair way away from other parts of the world, so it's important for people in the major banks to hear different perspectives on broader topics. And it's cost effective."

The chapter held more than 25 speaker events and forums in 2011, focusing on such issues as China, reputation risk, a possible housing bubble, and "Banking Banana Skins." A program devoted to managing catastrophes addressed the banks' preparedness and response to natural disasters-a topic all too familiar in this region, which recently experienced earthquakes in New Zealand and serious flooding and bushfires in several Australian states.

Most attendees at chapter meetings work in the risk area of their banks, but Lowen believes RMA programs are valuable for everyone in the institution. "I'd like other group executives to understand the value RMA adds," he said. "There is a massive opportunity to expand the membership base and our penetration and awareness."

Molyneux said that RMA Australia's future growth plans will include more activities in subgroups, including a recently convened operational risk affinity group and a credit training peer group. Plans to expand membership into related industries, including Australia's large wealth management sector, are also on the agenda. As Dirk McLiesh, group general manager, Risk, WestPac Banking Corporation, points out, the Australian investment management industry, with US$1.2 trillion in assets, is the fourth largest in the world and the largest in the Asia-Pacific region.

The global financial crisis demonstrated Australia's interconnectedness to the world financial system. Given the banks' dependence on global funding sources for liquidity, the crisis served as a reminder of the need for professional interaction and the exchange of ideas on a global basis. These are key aims of the chapter. As Karen Smith-Pomeroy, CRO-Banking of Suncorp Bank, pointed out, "Australia isn't insulated."

Molyneux, who is Australia Chapter chair, believes chapter leadership roles benefit individuals and their institutions alike. He sees his chapter involvement, in part, as an opportunity to mesh RMA chapter events with his bank's broader informational and professional development goals for its risk managers.

"The big-ticket items are fairly consistent," said Molyneux. "We've all got the same issues."

RMA's Australia Chapter organizes regular events in several Australian cities. Membership is open to employees of member institutions and professional firms. For more information, please contact [email protected] or visit www.rmaaustralia.org.

Australian banks' CROs were not only experts in credit risk; they were ready to adapt and expand their knowledge base by embracing the newly defined CRO role.

Regulatory aggression has played its part in Australian banks' crisis-related outcomes, but so too have lessons learned.

Michael Hamar and Bruce Auty are principals of The Risk Board, a risk management advisory and consultancy based in Sydney, Australia. Hamar is a former chief risk officer of National Australia Bank and former chairman of RMA Australia. Auty is a former chief risk officer of the Bank of Queensland and a former foundation committee member of RMA Australia. They can be reached at [email protected] and [email protected].