Six Years After The GFC, The Lessons From Lehman Brothers Shed Light On The Challenges For Australian Banks

Getty/ Jeff J Mitchell

Lehman Brothers collapsed on September 15 2008, six years ago this week.

While avarice, financial obfuscation and (sometimes wilful) ignorance were the main causes of the collapse in the mortgage-backed securities market, which eventually took Lehman Brothers down and caused the GFC, a large part of the blame can be attributed to a belief that things had changed, and that both the economy and markets had undergone a “great moderation” as Former Fed Chair Ben Bernanke coined it back in 2004.

This belief in sanguine markets and sustainable asset prices lead to an over-reliance on financial models which consistently told risk managers that there was little or nothing to worry about in the large positions their banks were carrying in pre-GFC days.

But the ensuing catastrophe showed these models were flawed, and that things that should never happen in the life-time of the universes – statistically anyway – can happen and, shockingly to those risk managers, recur again and again.

I’m reminded of the mistakes of risk management made in the pre-GFC world when I listen to the debate about Australian housing and the amount of bank capital that Australia’s major banks should be holding.

The bank regulator APRA has already awarded the Australia’s majors with the acronym D-SIB, domestically systemically important bank, for which the prize is an additional level of capital they must hold. But, there are calls for even more capital to be added to their balance sheets as a result of their too-big-too-fail status, and the capital reduction they receive as a result of their specialised modelling – what’s known as internal ratings based approach (IRB) – of their mortgage and other asset portfolios.

The Murray Inquiry’s interim report highlighted that when it comes to the mortgage books the IRB banks, the four majors and Macquarie, hold less than half the capital against these assets on average than other players in the Australian banking system.

The banks and the Australian Bankers Association hold that there is already enough capital being held.

Last week in response to the competing views and expectations that the Murray inquiry will come down on the side of APRA UBS equity bank research team released a report saying Australian banks would need to raise an additional $41.1 billion.

“We believe this means both higher mortgage risk weights and [capital] buffers despite the majors’ vehement objections,” they said.

But as APRA, the Murray Inquiry and fellow regulators around the world press it seems that Australian bankers have learnt little from the lessons of others – or indeed the over-reliance on risk models that can, as we saw so spectacularly in 2008, be seriously flawed even though they are rigorously designed, tested, and reviewed.

In its second round submission to the Murray inquiry, ANZ said that given current changes including the D-SIB charge, APRA is making the major banks pay in terms of extra capital that this would:

protect a capital level of 5.125 per cent against an extreme, one in 5000 year event. Further increasing capital requirements or loss absorbency will come at a material cost and would deliver limited additional benefit.

It is remarkable that this kind of claim can be made in the wake of the GFC and the havoc it wrought on global finance and the global economy.

Speaking at a Women In Finance Lunch in February 2010, RBA Assistant Governor Guy Debelle said part of the cause of the financial turmoil had been “a wholesale failure of risk assessment and risk management.”

He went on:

To illustrate this failure of risk assessment, I will use a quote I used in an earlier speech but it bears reiterating. In August 2007, David Viniar, the CFO of Goldman Sachs, said ‘We are seeing things that were 25 standard deviation moves, several days in a row.’

That was in August 2007, in the very early days of the crisis. The month of October 2008 following the collapse of Lehman Brothers delivered significantly more 25 standard deviation events in Viniar’s distribution of risks. October 2008 was, hopefully, a once in a lifetime event. As my colleague at the Bank of England Andy Haldane pointed out, with a normal distribution, a 25 standard deviation event actually is already a once in a lifetime event, where the life, in this case, is that of the universe!

Given the extraordinarily low probability of even one 25 standard deviation event occurring, this illustrates that the models and statistical distributions used to assess and manage risk were, in many cases, plain wrong. This applies to models used by investors, issuers and regulators.

So while the banks might have confidence back 5,000 years in the Australian economy and Australian housing, the GFC shows things that should never have happened in the life of the universe (according to financial models anyway) can, and do, happen – more than once.

Yesterday’s historic intervention in housing markets by the RBA is a case in point for how worrying the potential spike and crash in house prices might be for the Australian economy. While the RBA was focussed on the impact on households, the economy and spending rather than financial stability it was telling the Minutes noted the Board had received a briefing from Bank regulator APRA.

If ever there is a case for more capital, it seems that an over reliance on potentially flawed models combined with the current state of Australia’s housing market is it.

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