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Regulation, credit risk dominate banking worries

Regulation, credit risk dominate banking worries

By Stuart FaggOVER REGULATION, political interference and credit risk are the topics keeping bankers awake at night, according to a major global study. The Banking Banana Skins 2006 report,…

By Stuart Fagg

OVER REGULATION, political interference and credit risk are the topics keeping bankers awake at night, according to a major global study.

The Banking Banana Skins 2006 report, which is authored yearly by UK think tank CSFI and includes Australia, found that bankers globally rate over regulation as their biggest risk, followed by credit risk.

“There is a body of opinion, notably among regulators, that chooses not to see over regulation as a risk. After all, it can be said, banks don’t collapse as a result of excess regulation,” said Andrew Hilton, CSFI’s director. “That is arguably true. But regulation is not a free good; it is added to the cost of every single financial product, and if it is excessive, that excess means we will all earn less from (and pay more for) the financial services that we purchase.”

However, there is growing concern that governments are increasingly keen to influence how banks operate. In Australia, for example, the Federal Government has embarked on a campaign to ‘cut red tape’ and tackle over regulation, particularly in financial services. However, since then, it has created an additional regulator in Austrac, which will supervise anti-money laundering. Many banks had previously complained of the difficulties in dealing with multiple regulators.

“It’s a balancing act,” said Michael Codling, banking and capital markets leader at PricewaterhouseCooopers, which sponsored the study. “You are unlikely to have all parties happy at all times. The question right now is have they got the right balance of cost and benefit. On political interference, I’m not sure about Australia, but the survey would indicate that respondents saw growing political interference by governments seeking to influence banks’ behaviour.”

While credit risk was seen as the second biggest problem for banks globally, in Australia it was ranked considerably lower. However, according to Codling, there is little reason for complacency on credit risk. “I suspect that the banks over here have had a very benign environment for some time now,” he said.

“Certainly since the early 1990s, banks have strengthened their credit risk management practices and generally speaking, business balance sheets are strong and so I suspect they don’t see any immediate large concerns. However, it is recognised that in Australia, there has been a slackening in credit standards with some weakening in loan covenants with banks going higher up the risk curve to capture more revenue. There’s also a common view that there will probably be a turn for the worse in the credit environment. I was surprised not to see it in the top ten. I wonder whether the Australian respondents have given it enough weight.”

He added that while major banks are relatively well-positioned for a downturn, others could feel the impact sooner. “The larger banks are well-provisioned and they have de-risked to some degree in recent times in terms of the way they use their limits,” Codling said. “If and when there is a turn for the worse, it might be the hedge funds and private equity firms that feel the pinch first. There’s a view that they have been more aggressive in structure and pricing and some of those funds and firms are generally highly leveraged and therefore vulnerable to rises in interest rates.”

The third most pressing concern for banks globally was derivatives. Among analysts and consultants, derivatives were seen as the biggest worry while chairman, CEOs and directors ranked it second. Concerns among bankers and risk officers were less pressing.

Derivatives have had something of a troubled past - the major rogue trading scandals of recent years, Nick Leeson at Barings Bank and National Australia Bank’s forex options incident have all featured derivatives, and legendary investor Warren Buffett called them “financial weapons of mass destruction” — but the International Securities and Derivatives Association reported growth in the volume of outstanding privately negotiated derivatives of 105 per cent in 2005.

Several survey respondents expressed concerns that if economic conditions deteriorate, the derivatives market could be destabilised, largely due to poor understanding of its complexities. Michael Mainelli of risk consultants Z/Yen said that the complexities of credit derivative products “make us realise that it is almost impossible to keep an overview of this immature market”. Another respondent said that main board directors still did not understand the detailed workings of “esoteric financial instruments”.

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