1.What is bank loan portfolio credit risk?

Bank loan portfolio is an asset which consists of large and small loans. Large loans such as foreign and commercial loans, and small
loans like consumer loans. This portfolio is exposed to the risk of borrowers cannot meet their obligation to repay the loans. Large loans
have more impact than small loans, therefore theyre likely to be renegotiated (Liu & Ryan, 1995).
According to Wernz (2014), a default is considered to have occurred with regard to a particular obligor when either or both of the two
following events have taken place:

The bank considers that the obligor is unlikely to pay its credit obligations to the banking group in full, without recourse by the

bank to actions such as realizing security (if held).

The obligor is past due more than 90 days on any material credit obligation to the banking group. Overdrafts will be considered
as being past due once the customer has breached an advised limit or been advised of a limit smaller than current outstanding.

To conclude, credit risk of the bank loan portfolio is when borrowers default on their loan.

2.What is the difference between a general reserve for credit losses and
specific provision?
According to Prudential Standard APS 220 about Credit Quality No 59 (b), APRA set the level of general reserves for credit losses will
have regard to the level of General Provisions for Doubtful Debts which an ADI was previously required to hold (APRA, The Australian
Prudential Regulation Authority (APRA), 2008). APRA (2008) states, an ADI must report specific provisions and a General Reserve for
Credit Losses that, together, are adequate at all times to absorb credit losses in the ADI's business, given the facts and circumstances
applicable at the time.
So General Reserve for Credit Losses is simply a percentage of an ADI bank loan portfolio that are reserved to absorb credit losses. It is
not tax deductible according to the Australian Accounting Standards. The ADI must deduct from its Common Equity Tier 1 Capital for
the General Reserve for Credit Losses. This is only to the extent that such an amount has not already been charged or appropriated
against its profits (e.g. that portion of collective provisions raised by an ADI which are eligible to be included in a General Reserves for
Credit Losses) (APRA, Banking (prudential standard) determination No. 12 of 2012, 2012).
In specific provisions, an ADI must establish and apply its own policies and procedures for determining impairment of facilities and
associated provisions relying on its own methodologies, supported by robust internal controls and in accordance with Australian
Accounting Standards (APRA, Banking (prudential standard) determination No. 12 of 2012, 2012). While in GRCL, ADI are regulated to

have a reserve to absorb credit losses, here they need to make their own rules under regulation of Australian Accounting Standards.
Specific provisions are used to absorb credit losses for specific creditors that certain to be default on their loans, while GRCL is a reserve
for bank loan portfolios as a whole.

3.(i) Graph on two separate lines (1) loan loss reserve/gross loans, (2)
impaired loans (NPLs)/gross loans from 2006 to 2013. Please include the 4
major Australian banks and 2 smaller banks from the following options
(Suncorp-Metway Ltd, Bendigo and Adelaide Bank Ltd, Bank of Queensland
Ltd)

Loan Loss Reserve / Gross Loans (%) Comparison

1.60

1.40

1.20

1.00

Loan loss reserve / gross loans (%)

0.80

0.60

0.40

0.20

0.00
2013

2012

2011

2010

2009

2008

2007

2006

Year

Source: Bankscope (https://bankscope-bvdinfo-com.ezproxy.lib.monash.edu.au/version-2014911/Search.QuickSearch.serv?

_CID=1&context=J4EJ8RHRQ0KC35Y)

Impaired Loans / Gross Loans (%) Comparison

1.80
1.60
1.40
1.20
1.00
Impaired Loans / Gross Loans (%)

0.80
0.60
0.40
0.20
0.00
2013

2012

2011

2010

2009

2008

2007

2006

Year

Source: Bankscope (https://bankscope-bvdinfo-com.ezproxy.lib.monash.edu.au/version-2014911/Search.QuickSearch.serv?

_CID=1&context=J4EJ8RHRQ0KC35Y)

(ii) Interpret these banks credit quality over 2006-2013

Loan Loss Reserve / Gross Loans ratio is part of 'Asset Quality' ratios of the bank and determines the quality of loans of a bank. The
higher the ratio, the more problematic the loans are and vice versa.
As seen at Loan Loss Reserve / Gross Loans graph, big four banks quality of loans are far worse than the 2 smaller banks. Especially
after GFC (2007-2008) occurred, at year 2009 to 2010 the big four banks peaked (very bad loans quality) at this graph while Bendigo
and Adelaide Bank Ltd and Bank of Queensland can keep their loans quality stable. Simply because larger banks took more risk by
investing on foreign assets to gain more returns but of course theyll have to sacrifice their loans quality as it gets riskier. When their
foreign investment collapsed, of course people will lose confident in those banks, and thus lead to a bad loans quality. Unlike smaller
banks (eg. Bendigo and Adelaide Bank Ltd), that focused on local investment, they are not affected by investments that were collapsed
outside Australia.
Different case with Bank of Queensland, seemingly weathered the bad loan cycle well, copping a comparatively low level of bad debts
compared to Suncorp or major banks. It seemed logical; BoQ was more a bread-and-butter lender and so less exposed to riskier
commercial loans (Walsh, 2012). By April 2014, the financial accounts got messy. New management painted red ink with impairment
expenses of $328 million, more than double a year earlier. Almost $166 million was for specific problems while another $162 million
was for collective provisions cover for potential problems given falling property prices (Walsh, 2012). BoQ definitely has problem home
loans, but is not alone; Westpac and Commonwealth Bank results show Queensland mortgages were worse than national averages
(Walsh, 2012).
After the GFC (2009 onwards), we can see that even big four banks can manage their impaired loans/gross loans ratio to a low level.
That means they are successfully reduce their risk. The lower figure of this ratio is more preferable as that means their loans riskiness
level is lesser.
To conclude, the best risk management as seen from both graphs is Bendigo and Adelaide Bank. They can really manage their loans
quality no matter what. They successfully be a low risk small bank compared to Bank of Queensland that was got problems after 2
years from GFC maintaining good performance. While the big four banks, of course they are pretty reasonable to have bad loans quality
because they invest in foreign assets and it collapsed.

4. (i) Outline the APRA regulations regarding to credit risk for the large major banks and contrast
them to those for smaller banks
APRA concerns about competitiveness in banking market. Smaller banks tend to lose their competitiveness due to APRAs regulation
that they need to hold more capital (Yeates, 2014). The reason behind it was smaller banks need to assess their risk using standardized
approach, while large banks can use IRB (Internal Ratings-Based) approach.

As we can see in Figure 1, the relationship between minimum capital requirements

for ADI and the calculation of credit risk either by standardised approach or IRB
approach.
Calculation of credit risk will impact how much capital that banks are required to
hold. The greater the risk calculation does mean the bank need to increase their
capital holdings. Thus it makes the bank less profitable as they cannot lend as
much money.
Standardized approach for risk assessment meaning that the ADI must classify
their assets credit risk based on risk weights specified.
Below is the summary risk weights in standardized approach (Bank for
International Settlements, 2006):
For some "unrated" risk weights, banks are encouraged to use their own internalFigure 1. Structure of International Convergence of
Capital Measurement and Capital Standards document.

ratings system based on Foundation IRB and Advanced IRB in Internal-Ratings

Based approach with a set of formulae provided by the Basel-II accord. There exist

several alternative weights for some of the following claim categories published in the original Framework text.

Claims on sovereigns

Credit

AAA to AA-

A+ to A-

BBB+ to BBB-

BB+ to B-

Below B-

unrated

Assessment
Risk Weight

0%

20%

50%

100%

150%

100%

Claims on the BIS, the IMF, the ECB, the EC and the MDBs

Risk Weight: 0%
o

Claims on banks and securities companies

Related to assessment of sovereign as banks and securities companies are regulated.

Credit

AAA to AA-

A+ to A-

BBB+ to BBB-

BB+ to B-

Below B-

unrated

Assessment
Risk Weight

20%

50%

100%

100%

150%

100%

Claims on corporates

Credit

AAA to AA-

A+ to A-

BBB+ to BBB-

BB+ to B-

Below B-

unrated

Assessment
Risk Weight

20%

50%

100%

100%

150%

100%

Claims on retail products

This includes credit card, overdraft, auto loans, personal finance and small business.
Risk weight: 75%
o

Claims secured by residential property

Risk weight: 35%

o

Claims secured by commercial real estate

Risk weight: 100%

o

Overdue loans

More than 90 days other than residential mortgage loans.

Risk weight:

150% for provisions that are less than 20% of the outstanding amount
100% for provisions that are between 20% - 49% of the outstanding amount
100% for provisions that are no less than 50% of the outstanding amount, but with supervisory discretion are reduced to 50% of
the outstanding amount
o

Other assets

Risk weight: 100%

o

Cash

Risk weight: 0%
Internal Ratings-Based approach only can be used by banks that meet certain minimum conditions, disclosure requirements and
approval from APRA that are allowed to use this approach in approximating capital for various exposures (Bank for International
Settlements, 2001).
Based on Bank for International Settlements (2006), IRB approach has two primary objectives:
o

Risk sensitivity - Capital requirements based on internal estimates are more sensitive to the credit risk in the bank's portfolio of

assets
Incentive compatibility - Banks must adopt better risk management techniques to control the credit risk in their portfolio to
minimize regulatory capital

To use this approach, a bank must take two major steps:

o
o

Categorize their exposures into various asset classes as defined by the Basel II accord
Estimate the risk parametersprobability of default (PD), loss given default (LGD), exposure at default (EAD), maturity (M)that
are inputs to risk-weight functions designed for each asset class to arrive at the total risk weighted assets(RWA)

The regulatory capital for credit risk is then calculated as 8% of the total RWA under Basel II.
So here is the contrast between the two approaches:
IRB Approach
Accurate in assessing the credit risk because the risk manager

Standardised Approach
May be over estimate the risk weight as the risk weight already

actually calculate it based on relevant information.

Using IRB can result in lower capital requirement as they are

been standardised
Standardised approach may result in higher minimum required

more specific in assessing risk

capital holdings because they assess the risk higher in order to

Require time to assess the risk because they need to process the

reduce bank risk.

The risk weight is defined, so it is faster to assess the credit risk

data first
Need a sophisticated risk management because IRB require the

Risk management does not necessarily be too complex because

bank to have it

they only required to follow what has been defined

(ii) Comment on whether the four major or smaller banks benefit from the current regulatory setting
regarding bank credit risk and why?
The current regulatory seems to benefit four major banks as they can use IRB approach. IRB approach will give larger banks lower
capital cost as they can assess their risk accurately with sophisticated method of defining their asset risks. Thus larger banks will have
a good credit rating. Good credit rating meaning they can borrow money at a lower interest rate. Four regional banks recently submit a
review regarding financial institution competition. They feel disadvantaged because of the current regulation. They gave some
evidences that big four banks are fortunate of such regulation (Hirst, Grimshaw, McPhee, & Nesbitt, 2014):

Around 9% of total national income or GDP in Australia is spent on financial services. This is high by international standards.
A high proportion of credit is being channeled into domestic housing. Small and medium size enterprises (SMEs) seeking to
innovate, cite a lack of access to funds as a significant barrier to economic growth. Concerns do exist, therefore, that there has

been some problems in terms of allocative efficiency.

The four largest domestic banks continue to increase their market share and are very profitable by international standards.
Market concentration is significant in most markets and return on equity (ROE) is high for the larger banks, despite the heavy
asset weighting towards low-risk domestic housing assets.

Consequently it will make smaller banks suffer. These regional banks believe now is the time to identify, acknowledge and discuss these
issues in a constructive way with a view to improving the system for the future. The best means of mitigating the trend towards further
concentration is to refocus banking regulation.
One of the proves that the regional banks showed was the level of their housing loan risk weight compared to the four major banks as
shown in Table 1 below.
As of 1 January 2016, APRA wants banks to set aside 3.5% of their total risk-weighted assets, up from 2.5% currently, as a buffer to help
them absorb losses instead of relying on Government bailouts (Tay, 2013).

ANZ (2014) stated that the Australian banking system has strong features that limit
instability in the event of an external shock and provide a deep capacity to respond
to a crisis. ANZ (2014) also argue that the prudential framework should not be to
force equalization of the capital requirements without regard to the risk profile, risk
management and risk infrastructure. So they believe that there is no need to
increase level of required capital holdings as it will only reduce their profitability and
nothing else. They believe that extreme financial stress event will unlikely to make
them collapse with their current level of capital holdings.
To sum up, current regulatory setting is favoring big banks as they can hold less
capital meaning they can gain more profit from lending money. Nonetheless, it adds their loan portfolio credit risk.

REFERENCES
APRA. (2008, January). Retrieved from The Australian Prudential Regulation Authority (APRA):
http://www.apra.gov.au/adi/Documents/cfdocs/Final-APS-220-November-2007.pdf
APRA. (2012). Banking (prudential standard) determination No. 12 of 2012. Australia.
Bank for International Settlements. (2001, January). The Internal Ratings-Based Approach.
Bank for International Settlements. (2006, June). International Convergence of Capital Measurement and Capital Standards. Basel,
Switzerland.
Hirst, M., Grimshaw, S., McPhee, J., & Nesbitt, J. (2014, June 5). Retrieved from Bank of Queensland:
http://www.boq.com.au/uploadedFiles/AboutUs/Media_centre/Media_releases/Covering%20letter%20to%20Comp%20Policy
%20Rev_final.pdf
Liu, C.-C., & Ryan, S. G. (1995). The Effect of Bank Loan Portfolio. Journal of Accounting Research, 33, 77-78.
Tay, L. (2013, December 23). Australia's Big Four Banks Are Unfazed By APRA's New Capital Holding Requirements. Retrieved from
Business Insider Australia: http://www.businessinsider.com.au/australias-big-four-banks-are-unfazed-by-apras-new-capitalholding-requirements-2013-12
Walsh, L. (2012, September 17). Bank of Queensland seeks bounce back. Retrieved from http://www.couriermail.com.au/business/bankof-queensland-seeks-bounce-back/story-fnfli675-1226475137430?nk=a0671930d8be98784953a6731e0cd17d
Wernz, J. (2014). Bank management and control strategy, capital and risk management. New York: Springer Heidelberg.

Yeates, C. (2014, July 17). APRA regulator's push for big banks to set aside more capital. Retrieved from Sydney Morning Herald:
http://www.smh.com.au/business/banking-and-finance/apra-regulators-push-for-big-banks-to-set-aside-more-capital-20140717zu1lk.html