While not related to financial services, this article by Steven Johnson is an interesting read. It looks at digital technology has changed creative industries. At the heart of this is the question of how the risk return balance changed in the digital era. For example, is a mid budget independently produced movie a better or worse risk in the age of Netflix compared to 10 years ago? Are you more likely to sink money to produce such a movie?
The topic of whether or not Australian banks are well capitalised has been running hot. However the asset management sector has largely gone unnoticed when talking about financial system stability. In Australia, total assets held by asset managers (including superannuation funds, insurers and units trusts) are 75% of the assets held by banks. In fact the burning question at the moment when talking about asset management seems to be whether or not you need $1m to have a comfortable retirement. In addition, industry professionals vent plenty of frustration when talking about the apathy the Australian population seems to have towards saving for retirement. However this apathy could be one of the factors that mitigate the systemic risk from the asset management sector, according to this informative article from the RBA. (more…)
Recently Paul Fisher of the PRA gave a speech titled “Regulation and future of the insurance industry“. In it he says:
“Solvency II will introduce an enhanced system of governance standards – promoting the embedding of a strong risk culture, demonstrable within the day-to-day operations of insurers.”
Risk culture is big in risk management now. Prudential regulations started off being directive based, then evolved to principles based regulation. Post GFC we have beyond principles to risk culture. While companies and consultants talk about it, it is an ethereal concept.
A system of governance standards is certainly very useful as it gives a common set of principles for risk processes, policies and reporting that should exist. Rules and limits are also useful where management have requirements that are NOT subject to personal judgement. But can you “implement” risk culture?
To me risk culture exists where the organisation and people value and exercise traits such as prudence, inquiry, transparency and critical thinking. Risk culture makes standards effective. Sure, standards can help with risk culture by requiring that people do things like getting models reviewed and approved. However if people do these things only because of standards then the standards haven’t really created good risk culture…
According to the latest paper on governance from the Basel Committee, “Board members have responsibilities to the bank’s overall interests, regardless of who appoints them.” What does this mean? What are the bank’s “overall interests”? Board members are elected by the shareholders and are there to represent their interests – right? This statement seems to suggest that the authors believe there will be situations where the “overall interests” and shareholders’ interests diverge.
Previously I wrote about an approach to pricing loans, where the spread is set to cover expected losses from default, and to make a return on capital allocated. In this article I use the framework to explore the drivers of credit spreads that banks would calculate if they used the Basel IRB formula to calculate the amount of capital required.
Some banks may use regulatory capital to derive capital as this reflects the amount of regulatory capital required for the loan. The regulatory approach as specified by BCBS captures key drivers of risk such as probability of default, loss given default, systemic risk, and term.
This simple pricing approach reveals some interesting dynamics of the required credit spread. For example, with higher rated securities, the spread is driven by capital requirements and not the expected loss. Drivers of capital such as correlation between defaults and term to maturity have a larger influence.
In an earlier post, I talked about how banks set interest rates for loans compared to investors. I would like to explore the bank’s approach over a couple of posts. This post covers one approach to setting the interest rate to charge for a corporate loan.
The interest rate charged is:
- The cost of borrowing funds
- Expected cost of loan default
- Expense margin
- A rate of return on capital employed
Components of interest rate