Confusing message from Standard & Poors

“We continue to remain the only bank in the Asia Pacific region with a
long-term AA rating,” boasted National Australia Bank’s 2003 annual
report.

The tautology of four months ago acquired a faint air of desperation
after last Friday’s downgrade to AA- by ratings agency Standard &
Poors.

Commonwealth Bank, Westpac and ANZ all have long-term ratings of AA-, and short-term ones of A-1+ from S&P.

Quoting “material and multiple breakdowns in NAB’s risk management
processes and weaknesses in the bank’s corporate governance” as reasons
for the downgrade, analyst Craig Bennett says the bank appears
committed to addressing its risk management problems, but this will
take time to implement and embed in its culture.

NAB’s “robust core franchise in retail and business banking,
diversified business base, and strong financial profile” is
characterised by its strong asset quality and revenue-generating
capabilities, says Bennett.

So if the picture is one of a fundamentally strong company with recent
problems that are fixable in time, why leave the short-term rating of
A-1+ unchanged while downgrading the long-term rating?

If NAB effects the improvements in risk controls and cultural change
that S&P believes it will, isn’t the increased risk in the short-
and not long-term?

Is Stewart’s halo slipping?

Several commentators have noted that the combination of circumstances
and timing has given new NAB chief executive John Stewart an
extraordinary amount of power at the top of Australia’s largest bank.
His openness with analysts and the media contrasts sharply with the
reserved approach of his predecessor, but anything less than complete
honesty will be regarded with suspicion – and there were a couple of
slips during last Friday’s presentation of PricewaterhouseCoopers’
report into the currency options fiasco.

Although Stewart’s claim that the errant traders “appear to have been
motivated, at least in part, to protect their bonuses” was supported by
the PwC report, there was a marked reluctance to explain what the other
part may have been.

Questioned about possible pressure from management to achieve higher
profit targets, Stewart’s response that “he didn’t think so” appears to
contradict PwC’s finding that management’s “principal focus in
overseeing the currency options desk appears to have been on the
reported results, with less attention devoted to risks and the nature
of transactions being undertaken.”

Stewart’s almost complete lack of exposure to foreign exchange trading
operations makes it highly unlikely that he appreciates the pressures
to perform that are routinely part of a trading room environment and
how these affect the behaviour of traders.

His second brave call, was asserting that the cultural attitudes
criticised by PwC were limited to pockets of the bank and were not a
systemic problem throughout the organisation. In fact, PwC say that
although their investigation focused on one business unit, “it has
given us access to the workings of the Board, its committees and some
group-wide functions, such as finance, internal audit and, importantly,
risk management. This access has allowed us to form a view of certain
aspects of the National’s governance and culture.”

There is no qualification that their findings about governance and
culture are restricted to foreign exchange options desk. It is
difficult to accept that someone who has been employed by NAB for just
a handful of months, spent most of those in the UK and the last couple
focused on foreign exchange trading issues, can possibly give
assurances that the same cultural problems do not exist elsewhere in
the group.

NAB’s capital adequacy at risk?

National Australia Bank is one of a handful of Australian banks
permitted – on the strength of their risk management capabilities – to
operate with the lowest level of capital backing for its market risk
exposures.

At least, it has been until now.

Last week’s damning report by consultants PricewaterhouseCoopers into
the bank’s foreign exchange option losses casts a shadow over this
privileged exemption from more stringent regulatory requirements.

A bank’s capital is the primary source of its financial soundness and
regulators everywhere ensure that their charges maintain levels of
capital appropriate for the risks arising from their operations. When
the Basle Committee on Banking Supervision, which sets global
regulation standards, proposed a specific amount of capital should be
maintained against possible losses from market risks, it accepted that
there are vast differences in the risk management capabilities of banks
around the world.

Small deposit taking institutions are likely to have a less
sophisticated approach to managing their exposure to interest and
exchange rate movements than large multinational banking groups.

A two-tier standard for calculating the capital required for market
risk exposures was the result, with a standard method of risk
measurement available for smaller banks. The calculations involved are
simpler, don’t require sophisticated computer systems and adopt a
conservative approach to assessing market risks.

However, for banks with large trading books, the standard method would
require significant capital to support their market risk exposures and
they are offered an alternative approach. They are permitted to use
their own internal risk models, if they meet certain criteria laid down
by their regulator.

For Australian banks, these criteria are specified in the Australian
Prudential Regulation Authority’s Prudential Standard APS 113. Banks
that satisfy the criteria are permitted to calculate their daily
capital requirement as a multiple of their average risk exposure over
the previous sixty days.

The multiple is set between three and five depending on APRA’s
assessment of the bank’s risk management systems. APRA can further
adjust this multiple upwards should “back-testing” of the bank’s risk
model show that it does not accurately predict the actual trading
profit and losses of the bank. NAB is currently believed to operate on
the lowest multiple of three, requiring the least amount of capital to
cover its market risk exposure.

The minimum criteria for using an internal model include: satisfying
APRA that the bank’s risk management systems are sound and implemented
with integrity; that the bank has sufficient staff skilled the use of
sophisticated models – not only in the trading area but also in the
risk control, audit and back-office areas; and that the models have a
proven track record of accurately measuring risk.

APRA requires the bank’s directors and senior management to be
“actively involved in the risk control process and regard risk control
as an essential aspect of the business to which significant resources
need to be devoted.”

Actual value at risk (VaR) exposure must be analysed and reported daily
against risk limits. The integrity of the risk management systems and
the accuracy of the VaR calculations must be reviewed at least
annually. Several of PwC’s findings about NAB’s risk management systems
and practices cast doubts about its ability to meet the required
criteria, including:

  • management knowing for three years that the VaR calculated by the risk systems was unreliable and not notifying the board
  • no urgency in resolving the problems
  • an almost two year suspension of daily VaR reporting for currency
    options due to doubts about calculations without notice to the board
  • no formal model validation or back-testing for the VaR model for currency options
  • inappropriate follow up by the board audit committee of the risk information it did receive
  • inadequate follow up of adverse reports from auditors and APRA.
    NAB will be desperately trying to convince APRA that these problems are
    confined to the currency options book and do not extend more widely to
    its market risk management controls. Should it be unable to do so, APRA
    has several options available. It could increase the multiplication
    factors used to calculate the NAB’s capital requirement or require it
    to base its calculations on VaR limits, instead of its actual
    exposures. In either case, more capital backing would be required and
    there would be a cost to shareholders if either a share issue is
    required or a planned buy-back has to be cancelled.

Although APRA’s ultimate sanction is to disallow the use of the
internal risk model altogether, such a decision about the country’s
largest bank could have horrendous consequences for both NAB and the
wider Australian banking industry.


Peak industry body’s light tough goes unnoticed

Conspicuous by its absence from the melee of regulators currently
surrounding National Australia Bank is the Australian Financial Markets
Association.

The peak industry body for Australia’s over-the-counter financial
markets is a vociferous advocate of light-handed self-regulation and
opponent of legislative market regulation. However, so far, its
touch over NAB’s currency options fiasco has been so light as to go
unnoticed.

Corporate membership of AFMA requires both the bank and its employees
to adhere to the sprit of the Association’s codes of conduct and ethics
as well as abiding by strict letter of them. Employees of members
acquire AFMA accredited status by passing a knowledge examination and
having their employer certify that their practical skills qualify them
for membership.

NAB is a long-standing AFMA member and several of the bank’s staff
whose departures were announced last Friday are believed to hold AFMA
accredited status.

Although last week’s PricewaterhouseCoopers report on NAB’s foreign
exchange losses provides prima facie evidence of breaches of AFMA’s
codes by both the bank and some of its former staff, it appears that
the peak body has no formal processes for either monitoring compliance
or disciplining offenders.

Responsibility for monitoring accredited employees behaviour is
assigned to their employer and there appears to be no mechanism for
punishing code breaches by a member bank.

This presents AFMA with something of a dilemma as it ponders the
content of the PwC report. If NAB has broken its code of conduct and
AFMA takes no action, its light-handed regulation could be seen to be
ineffectual and invite scrutiny of its role in regulating Australia’s
OTC markets. If on the other hand it takes action against NAB, it would
be setting a precedent and risk alienating its largest member.

A spokesperson for AFMA was unavailable for comment.

Peter Fray

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