Major banks reconsider operational risk

The recent anti-money laundering allegations against the Commonwealth Bank are a timely reminder of the operating risks in running a major bank – especially with cyber-security risks escalating. 

The trouble is, when it comes to operational risk - which covers everything from fines for rogue traders, IT blow-ups, cyber hacking and breaching money-laundering laws - Australia’s big four lenders are holding much less capital than global peers.

Writing last week on CBA’s strong $9.88 billion profit - and giving the lender huge props for lowering its reliance on mortgage brokers - UBS analyst Jonathan Mott said after reviewing the big four banks’ capital position that one number stands out: the very low level of operating risk weights.

In particular, he wondered why Australia’s largest bank holds just $33.7 billion in risk-weighted assets against operating risks - the regulatory minimum - which represents just 8 per cent of its capital.

To put this into perspective, that number equates to just $3 billion in actual capital for all operational risks despite CBA running an extremely complex financial institution, which has a banking relationship with almost half of the Australian population.

“CBA states that this very low level of operating risk-weighted assets is a function of low levels of historical operating losses, a backward-looking measure," said Mott.

“We believe it is clearly inappropriate for CBA and the other major banks to use outdated assumptions from a previous era when determining how much capital it should now hold for all potential operating risks."

Increasing complexity

In the client note, Mott argued that given the increasing complexity and operating risks facing a modern financial institution, he believes CBA and other Australian banks should be holding multiples of their current levels of operating risk-weighted assets.

The kicker here is that when Mott compared CBA and the other major banks' operating risk capital against other large banks globally, it is clear how low the lenders' holdings are. For example, UK banks' operating risks represent between 11 per cent and 17 per cent of total risk-weighted assets.

US banks' operating risks represent between 23 per cent of risk-weighted assets at Wells Fargo to 33 per cent at Bank of America. Canadian banks' operating risks represent between 12 per cent to and 15 per cent of risk-weighted assets. These compare with the Australian major banks at between 8 and 10 per cent.

Underlining the higher risks digitalisation brings for operational failure, coding errors, cyber hacking etc, Mott argued that as customers become  increasingly reliant on the banks' networks for everyday payments, the cost of system outages or failures has an even larger impact on the community. 

An example is the mis-selling of insurance that has been an area of substantial losses for UK banks costing the industry £50 billion. 

“While losses in Australia from similar mis-selling claims have not been large, we see this as a potential area of risk should large losses ever be seen in the mortgage market," said Mott.

He wrapped up his advice by saying: “while this is unlikely in the near term, we believe it is an area that should get renewed regulatory attention."

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