Differences Between Bank Credit Risk and Bank Capital Risk

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"able of #ontents

Executive Summary.........................................................................................................................2

1.0 Differences between bank credit risk and bank capital risk.................................................

2. Differences between lendin! to individual via residential "ome mort!a!e to ot"er type of

consumer lendin!.............................................................................................................................#

.0 $omparison between %ustralian &ank and '( &anks..............................................................)

.1 *esidential +ort!a!e loans to ,ross loans -ercenta!e/......................................................)

.....................................................................................................................................................)

.2 on erformin! oans -percenta!e/.....................................................................................

. +a3or c"an!es in residential loan over 4ear 2005 to 4ear 201#...........................................5

.# %ustralian &anks 6s '.( &anks credit 7uality -from non8performin! loan ratio/................9

#.0 :mpact of introducin! compre"ensive credit reportin! -$$*/ in %ustralia............................10

$onclusions....................................................................................................................................11

*eferences......................................................................................................................................12

%ppendix........................................................................................................................................1#



E$ecuti%e &ummary

;"is reports aims to interpret %ustralian &anks -w"ic" includes ational %ustralia &ank limited<

$ommonwealt" &ank of %ustralia< %ustralia and ew =ealand &ankin! and >estpac &ankin!

$orporation/ and 'nited (in!dom &ank credit 7uality. ;"e report will first distin!uis"es t"e

differences between bank credit risk and bank capital risk. :n t"e second part of t"e report< it will

distin!uis"es t"e difference between lendin! to individual borrower via a residential "ome

mort!a!e compare to ot"ers type of consumer lendin! from lender?s perspective.

:n order to portrait a clearly view in comparison of %ustralian &ank and 'nited (in!dom &ank<

five banks were c"osen and divided into two !roups. &anks included in %ustralia banks are

ational %ustralia &ank limited< $ommonwealt" &ank of %ustralia< %ustralia and ew =ealand

&ankin! and >estpac &ankin! $orporation w"ile 'nited (in!dom bank include &arclays &ank.

;wo ratio are bein! analy@e from %ustralian &ank and '( bank w"ic" are residential loan as a

percenta!e of total loans and non8performin! loan ratios. % data from 4ear 2005 to 201# were

taken as data. %ll t"e data for t"ese five banks are !enerate from A&ankscopeB.

%s %ustralia is introducin! compre"ensive credit reportin! -$$*/< t"e impacts of $$* are

discussed in t"e last part of t"is report.



'.( Di)erences between ban! credit ris! and ban!

capital ris!

&ank credit risk is t"e potential loss bank would faces or suffers if bank borrower w"ic" also

known as counterparty fails to meet its obli!ations by payin! interest on t"e loan and repay t"e

amount borrowed -t"e principles amount/ in accordance wit" a!reed terms. -,%* < 201#/

$redit risk also refers as default risk. -6aratto< 2011/. :t is t"e sin!le lar!est risk t"at most of t"e

bank face and arises from t"e possibility t"at loans or bonds "eld by bank will not be repaid

partially or fully. -Saunders< 1CC#/ ;"e &asel $ommittee on bankin! division reports -&asel

$ommittee on &ankin! Supervision< 1CCC/ t"at credit risks e7ual to a measure of unexpected

credit losst"e difference between t"e expected value and an extreme loss value of t"e

probability distribution of a credit portfolio?s potential future value. -(upiec< 2002/

&ank capital risk is t"e potential risk s"are"olders< creditors and depositors of bank faces in

terms of bank insolvency by "avin! insufficient capital and reserves to buffers and supports its

financial risk< operational risk and environmental risk. S"are"olders "ave an interest in return on

t"e capital t"ey invest in bank "ence bank capital risk s"ould be low w"ile for creditors and

society it is important t"at bank maintains sufficient buffer or risk capital to cover potential

losses. -Swedbank< 201#/. Fi!"er bank capital risk "appen w"en capital in t"e bank cannot cover

losses brid!e cas" flow and pay off creditors. -+aisel< 1C9/. ;"e measurement of bank capital

is $apital %de7uacy *atio -$%*/ w"ic" also known as $apital to *isk ->ei!"ted/ %ssets

*atio -$*%*/ w"ic" set minimum re7uirement on t"e si@e of buffer based on "ow muc" risk

bank assume -Gatima< 201#/. $apital %de7uacy *atio is expressed as a percenta!e of a bankHs

risk wei!"ted credit exposures.



*. Di)erences between lending to indi%idual %ia

residential home mortgage to other type of consumer

lending

:n t"e bank perspectives lendin! to individual via residential "ome mort!a!e is considered as

secured loan as compare to ot"er type of consumer lendin!. -,itman< Ioe"k< J &illin!sley<

201/. %s residential "ome mort!a!e is secure wit" residential property< t"e said property serves

as collateral for t"e mort!a!e loan and can repossessed by lender s"ould t"e buyer fail to make

payment ot"er type of consumer lendin! are considered eit"er secured or unsecured loan as

some of t"e consumer lendin! are tie wit" collateral like auto loan w"ile personal loan are

approve wit" no collateral. *esidential mort!a!e loan amount are corresponds to a well8defined

proportion of t"e total investment bein! made.

endin! to individual borrower via residential "ome mort!a!e lender is facin! lon!er repayment

period t"an any common type of consumer lendin!. *epayment period for residential "omemort!a!e is at least ten years and above w"ereas most of consumer loans are typically s"ort term

and must be paid off wit"in five years. -Foni!man J Sotelino< 201)/.Fence< lenders face !reater

interest rate risk in wit" residential "ome mort!a!e w"ic" lend out at fixed interest rate lenders

less interest rate risk wit" floatin! interest rate "ome mort!a!e compare to fixed rate. -Dorsey J

*ockwell< 200)/

:n order to protect t"e lender or bank a!ainst potential loss from residential "ome mort!a!e<

lender or bank will re7uires individual borrower or "ome owner to maintain ade7uate property

insurance a!ainst storms< fire or ot"er calamities. +ost of t"e time< banks will collect insurance

premium of property insurance from "omeowner to make sure its security is covered w"ile for

ot"er consumer lendin! insurance is not re7uired by t"e bank -$enter for Ginancial ;rainin!<



200C/.*esidential "ome mort!a!e loan application process is muc" lon!er time and more

involved t"an ot"er consumer loan. &ank or lender need to process mort!a!e loan application in

more detailed as t"e transfer of real property brin!s into play and more le!al issues t"an a simple

contract in ot"er consumer loans. -*yan J *yan< 201)/

+.( #omparison between Australian an! and - an!s

.1 *esidential +ort!a!e loans to ,ross loans -ercenta!e/



2005 2009 200C 2010 2011 2012 201 201#0.00

10.00

20.00

0.00

#0.00

)0.00

0.00

50.00

90.00

*esidential +ort!a!e oansK,ross oanser cent

Graph 1 : Residential Mortgage Loans/ Gross Loans (Per Cent)

.2 on erformin! oans -percenta!e/



2005 2009 200C 2010 2011 2012 201 201#0.00

1.00

2.00

.00

#.00

).00

.00

5.00

9.00

C.00

10.00

on8erformin! oan

er cent

er cent

Graph 2 : Non Preforming Loans to Gross Loans (Per cent)

. +a3or c"an!es in residential loan over 4ear 2005 to 4ear 201#



,rap" 1 of residential mort!a!e loans to !ross loans from 4ear 2005 to 4ear 201# clearly

indicates t"at bot" %ustralian &ank -includes ational %ustralia &ank limited< $ommonwealt"

&ank of %ustralia< %ustralia and ew =ealand &ankin! and >estpac &ankin! $orporation/ and

'nited (in!dom &ank -&arclays &ank/ s"ows t"at t"e !eneral trend of residential mort!a!e

loans are movin! upward and t"ere is a si!nificant c"an!es in residential mort!a!e loan durin!

t"e year of 2009.

;"ere a few factors contributes to t"e ma3or c"an!es in residential loans over t"e years. :n t"e

be!innin! of 4ear 2005< t"ere is stron! !rowt" in t"e "ousin! sector< !reat competitions in

mort!a!e market and banks leads to "i!"er approval of mort!a!e loan and loosen lendin!

practice amon! !lobal banks. -*eserve &ank of %ustralia< 2005/ Fence< t"e percenta!e of residential loan in all t"ese five banks appealin! to be "i!" in year 2005.

;"e ma3or c"an!es "appen in year 2009 leads to ma3or decline in residential mort!a!e loans.

'nited States Subprime mort!a!e crisis "appen in December 2005 to Iune 200C -;"e ational

&ureau of Economic *esearc"< 201)/ was tri!!ered by lar!e decline in "ome price< "i!" default

rate in "ousin! loans and devaluation of "ousin! related securities. :t caused !lobal crisis and

"i!" "ouse"old debt !lobally. -+ian J Sufi< 201#/ :n !rap" 1< it clearly s"ows t"at t"e

percenta!e of residential loans drops si!nificantly in year 2009 in all t"e five banks compare to

2005 as t"e !lobal crisis and c"allen!in! economy conditions< falls in "ouse"old wealt"<

declinin! lendin! standard and value of "ousin! assets falls are discoura!e t"e overall "ousin!

markets. -*eserve &ank of %ustralia < 2009/.

%fter year 2009< t"e residential mort!a!e loans percenta!e for bot" %ustralia and 'nited

(in!dom are trendin! upwards. :n year 200C< fiscal and monetary stimulus are introduces in bot"

countries w"ere central bank provided li7uidity support to local banks< increase in consumer

confidence release some pressure on "ousin! asset valuation. -*eserve &ank of %ustralia< 200C/.

Fowever< in 4ear 200C to 4ear 2011 t"e "i!"er unemployment rate still wei!"t in "ousin! market

and loan write off continue to increase.



;"ere are more favorable macroeconomics conditions in %ustralia t"rou!"out t"e year of 2011 to

201< as %ustralian bank stren!t"enin! t"eir balance s"eet "avin! extra capital buffer< wit" lower

interest rate environment< "ousin! price are increasin! !radually< ti!"ten lendin! standard arewei!"t in low non8performin! loans w"ic" leads to "i!"er residential loans percenta!e for

%ustralian banks like ational %ustralia &ank limited< $ommonwealt" &ank of %ustralia< and

>estpac &ankin! $orporation. -*eserve &ank of %ustralia< 2012/ :nvestor demands in %ustralia

continue to drive "ousin! and mort!a!e market wit" low interest rate ad stron! competition

amon! lenders are translatin! into robust !rowt" in "ousin! market. -*eserve &ank of %ustralia<

201)/

:n t"e context of 'nited (in!dom< !lobal economy are intensify t"rou!"out t"e year of 2011 to

201 and t"e !rap"s s"ows t"at &arclay &ank?s residential loan increase steadily over t"e years

from 2011 to 201. Fowever< t"e euro area problems are wei!"t into 'nited (in!dom?s asset

performance are continue to deteriorate in year 201# and "ence residential loan percenta!e of

&arclay banks drops in year 201#. -*eserve &ank of %ustralia< 201#/

.# %ustralian &anks 6s '.( &anks credit 7uality -from non8performin! loan ratio/

:n order to assess banks? credit 7uality< t"e impairment c"ar!es play an important role as it is one

of t"e most volatile line items in banks? income statement. :mpairment c"ar!es is t"e net c"an!es

by calculatin! in t"e way offL bank will add up all its bad loans< estimate loan provisions< and

t"en ad3ust t"e numbers by amount of actual loan write off and recoveries in t"e period. >"en

credit environment suddenly c"an!ed< impairment c"ar!es will swin! around widely and

unpredictably. (ey indicator of impairment c"ar!es is t"e level of on8erformin! oan -/

w"ic" calculate by on8performin! loans ratio. %n increase in ratio indicates t"at

impairment c"ar!es will rise a fall of ratio indicates t"at fallin! in impairment c"ar!es.

-$"en< 201/



$redit 7uality metrics for all five banks are draw out in ,rap" 2 on erformin! loan ratio. Mver

t"e ei!"t years< all t"ese five banks are facin! rise in on8erformin! oan *atio. &y observin!

t"e !rap"< all t"ese five banks are facin! sudden spike in ratio durin! 4ear 2009 to 4ear

2010 durin! t"e !lobal financial crisis and after mat" of !lobal financial crisis. 'ntil 4ear 201#<

all of t"ese five banks ratio is still above pre crisis level of 4ear 2005.

%ll t"ese ) banks recorded low ratio in 4ear 2005 before ,lobal financial crises -w"ic"

occur 2009 to 2011/ and default risk is still low. Durin! t"e ,lobal Ginancial $risis in year 2009

to 2011 bot" %ustralian and 'nited (in!dom bank re!istered extremely "i!" ratio and t"e

ratio drops durin! t"e !lobal economy recovery in 4ear 2012 onwards.

,rap" 2 clearly s"ows t"at 'nited (in!dom?s bank -&arclay banks/ "as t"e "i!"est ratio

compare to all ot"er four %ustralians bank namely ational %ustralia &ank limited<

$ommonwealt" &ank of %ustralia< %ustralia and ew =ealand &ankin! and >estpac &ankin!

$orporation. &efore ,lobal Ginancial $risis< %ustralia bank?s ratio is below 1 but &arclay?s

bank re!istered more t"an 1 percent ratio and it increase tremendously durin! ,lobal

Ginancial $risis w"ic" is five to six times more compare to %ustralian &ank. ;"e *atio reflects

t"at '.( banks are considerably risker t"an %ustralia?s bank and it "as loose lendin! practices

and t"e findin!s is tally wit" >orld &anks?s data w"ic" s"ows t"at '.(?s ratio is always

"i!"er t"an %ustralian?s &ank. -*efer ,rap" in appendix/.

%ll of t"e four %ustralian &ank is doin! well pre crisis and durin! crisis. Durin! crisis< %ustralia

?s ratio are increasin! but not as severe as '.( bank. Mut of t"e four banks< %= and %&

banks possess a !reat improvement over its ratios.



/.( Impact of introducing comprehensi%e credit reporting

0##12 in Australia

%ustralia compre"ensive crediy reportin! -$$*/ introduce on +arc" 201# wit" t"e aims t"at to

allow credit provider suc" as banks and all ot"er lenders to s"are Nne!ative8onlyB information

about consumer t"rou!" credit bureau.-Io"nson< 201/. ;"ere are five new data to be s"ared by

credit providers w"ic" are date account open credit limit type of credit date account close and

repayment "istory.

;"e !ood impacts of introducin! $$* are it will creates !rowt" in lendin! makin! lendin!

fairer and "elpin! lenders miti!ate risk - w"ic" lower ratio furt"er/. &y "avin! details

repayment "istory of borrower lender are more willin! to lend out "ence lendin! !rowt"

increase. Mt"er t"an t"at< bank will also "ave more accurate pricin! of risk premiums to

individual by usin! $$* as source of credit analysis.

$$* reports will makes lendin! markets works efficiently as t"e better information allows

lenders to be more accurately measure borrower risk and set loan terms accordin!ly. ender canreco!ni@e "i!"8risk borrowers and set appropriate "i!"er interest rate and conse7uently lower

risk borrower can en3oy attractive rates and furt"er stimulate t"e 7uantity of loans demanded.

-&aron J Staten< 2011/. So< lender can be prepared and ready in estimatin! t"eir lendin! risk of

customer base t"ey are "avin!.

$$* will also increase productivity in %ustralian economy as a recent report by olicy and

Economic $ouncil -E*$/ su!!ests t"at $$* will create !rowt" in lendin! to private sector

makin! lendin! fairer. -;urner< 6ar!"ese< J >alker < 201)/

;"e ne!ative impact of $$* is it encoura!es entry of new competitors< includin! non8bank

financial institutions< w"ic" "as stimulated vi!orous price competition and more convenient



products. Gor instance< lar!er bank w"ic" "olds lar!e client base t"at contribute full

compre"ensive data to t"e $$* is actually "andin! over t"eir client info to its competitors to

offer better rate and dilute t"eir competitive advanta!e. -&ru"n< Gara@i< J (an@< 201/.

#onclusions

;"is report explains t"orou!"ly bank credit risk are totally different wit" bank credit risks. :t also

pointed out t"at t"e lendin! practice are differ between %ustralian &ank and '( bank. ;"e

performance between %ustralian &ank and '.( &ank are 3ud!e by non8performin! loan ratio and

it clearly indicates t"at %ustralian bank "ave ti!"ter lendin! practice and "ence lower risk. :n t"e

implementin! of compre"ensive credit report it brin!s bot" !ood and bad impact to %ustralian

bank and its economy.

>ords countL 2<0C words

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Appendi$



Graph 3 : Ban!s Non Performing Ratio ("orld"ide)

Differences Between Bank Credit Risk and Bank Capital Risk

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