Westpac Banking Corporation is an Authorised Deposit-Taking Institution (ADI) that is expected to regularly disclose information regarding its risk management practices (Westpac Group 2016). A thorough analysis of Westpac’s risk management techniques and processes is important to draw conclusions regarding the appropriateness of the applied approaches in order to address risks commonly faced by this type of financial institution. In the Pillar 3 report, Westpac has disclosed its financial and risk management information related to the period ending on 31 March 2016 (Westpac Group 2016). This information is important because it offers a background for risk assessment and an evaluation of the techniques employed by the institution (Saunders & Cornett 2014). The purpose of this report is to analyze the usefulness of Westpac’s Pillar 3 report in the context of the financial market and with reference to the quality of the provided information. The report will also provide an important discussion about the techniques for risk measurement and management currently applied in Westpac, and it will identify the strengths and weaknesses of one of the techniques with a focus on the observed risk management processes. Certain recommendations to improve Westpac’s approach to risk measurement and management will also be provided.
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Assessment of the Usefulness of Westpac’s Pillar 3 Report in Relation to the Market
According to the requirements of the Australian Prudential Regulation Authority (APRA), such financial institutions as Westpac are required to disclose aspects of their activities on a regular basis. This procedure allows APRA to monitor the financial state of banks, analyze their risk management strategies, and prevent a financial crisis in the discussed market (Ferran, Moloney & Payne 2015; Westpac Group 2016). Therefore, the Pillar 3 report should include certain sections and information to provide APRA and the market with all the required details (Saunders & Cornett 2014). In order to draw conclusions regarding the financial state and adequacy of Westpac as an ADI subject, it is important to focus on the following sections of the report: capital adequacy, capital instruments, risk exposures, risk assessment techniques, and risk management techniques.
Within Westpac’s Pillar 3 report published in March 2016, it is possible to identify the following data: introductory notes, a discussion of risk types, a description of approaches to controlling and managing risks, and a discussion of the committees’ structures. The report also includes a capital overview and a discussion of the leverage ratio. The most important part of the report presents an analysis of credit risk exposure, management, and mitigation, a discussion of securitization, a description of the market risk, and an analysis of liquidity risk management (Westpac Group 2016). Furthermore, operational, equity, and interest rate risks are also assessed in the report with a focus on strategies that may address or mitigate them.
The provided data are important and useful in terms of demonstrating which approaches are followed by Westpac in order to identify, assess, and address risks that may threaten the financial stability of the institution. First, the report provides information regarding the capital adequacy and instruments applied in Westpac. According to the data, the institution’s common equity Tier 1 (CET1) was 10.5% in March 2016 (Westpac Group 2016). This figure emphasizes Westpac’s capital stability. However, in August of that same year, Westpac revealed that the “third-quarter non-interest income was about 5 percent below the first-half quarterly average of $1.48 billion following lower market revenue and higher insurance claims” (Bennet 2016, para. 2). The report also stated that the changes realized according to the revised residential mortgage exposures could affect the numbers (Westpac Group 2016). Mortgage risk weights seem to influence Westpac’s performance and capital stability significantly (Janda 2016).
Furthermore, similarly to other banks in Australia, Westpac faced “future earnings forecasts being cut” (Macquarie rates WBC as a downgrade to neutral from outperform 2016, para. 2). Thus, it is possible to state that not all risks were taken into account and that the institution’s performance was overestimated. Moreover, in spite of the fact that Westpac provided detailed information regarding the impaired loans, these data points were not analyzed in detail to predict the potential loss (KPMG 2016). More attention should be paid to forward-looking statements provided in the report to assess the situation. Still, the report presents enough information to conclude that the loans were paid and that Westpac’s capital adequacy remained stable rather than neutral.
At this point, it is possible to state that the Pillar 3 report is rather useful in terms of understanding the risk exposures of Westpac. However, to become adequate as a tool to inform the market, the Pillar 3 report needs improvement as the data presented in it was not oriented to forecasting further changes and declines in Westpac’s position, as noted by analysts in the market (Bennet 2016; KPMG 2016; Janda 2016). Therefore, to contribute to understanding the risk prospects and risk management in Westpac, it is necessary to pay more attention to identifying potential risks that can significantly affect earnings in the near future. The lack of such risk forecasting can impede Westpac’s development of effective risk management strategies. Furthermore, if the market does not receive complete information regarding the financial institution’s status, its reputation can be affected significantly due to negative changes in analysts’ evaluations and rates.
Westpac’s Risk Management Techniques
It is important to understand how traditional and innovative risk measurement and management techniques can be applied in the market. In this context, the focus is on the use of innovative or state-of-the-art techniques and models. Westpac has adopted a complex system of risk measurement and risk management that is known as the Three Lines of Defence approach (Westpac Group 2016). In the context of this system, Westpac has also applied a range of other techniques and strategies that are helpful in terms of identifying and addressing different types of risks.
The Three Lines of Defence approach is a recently developed framework that is useful for managing risks at different stages. According to this model, the first line of defense is associated with risk identification and management provided by officers who realize internal control in an institution (Ward 2016). The second line of defense is related to managing risks by developing and adopting certain policies that are necessary to monitor processes and report risks. According to the third line of defense, the focus should be on concrete actions or functions (Hopkin 2014). In Westpac, risk management activities are performed by specialists who evaluate the appropriateness of risk management approaches related to the first and second lines of defense.
In addition to the Three Lines of Defence framework, which itself can be viewed as a state-of-the-art approach, Westpac also applies different traditional and new techniques to achieve higher results in risk management. To address credit risks, the Credit Risk Management Framework has been developed, and it is based on the Credit Risk Rating policy adopted in Westpac (Westpac Group 2016). In the context of this framework, risk managers have implemented both transaction-managed and program-managed approaches to analyze credit requests and conduct risk analyses for different types of customers. Another approach taken by Westpac is a focus on the evaluation of collateral positions to draw conclusions regarding risk exposures (Westpac Group 2016). Comparing these models with such techniques as calculations of the probability of default or risk-adjusted return on capital models, it is clear that the models used by Westpac are more complex (Hull 2013; Saunders & Cornett 2014).
In order to calculate market risks, Westpac has applied a model based on assessing the value at risk (VaR) limit. According to Saunders and Cornett (2014), the VaR model is one of the most popular recent techniques used to evaluate market risks with a focus on the role of business strategies and interest rate changes in addressing possible market risks. Furthermore, this approach is also applied in Westpac with a focus on scenario analysis, which is actively used today to predict changes associated with risks (Westpac Group 2016). In order to measure and manage liquidity risks, Westpac has applied another specific model, the Liquidity Risk Management Framework. Despite the fact that the institution refers to traditional methods of measuring, managing, and mitigating risks, much attention is also paid to innovative approaches such as the use of a ‘going concern’ model (Westpac Group 2016). According to this model, “wholesale debt maturities are added to planned net asset growth to provide an estimate of the wholesale funding task across a range of time horizons” (Westpac Group 2016, p. 74). This approach allows the organizational management to focus on the most efficient evaluation of risks.
Much attention should also be paid to the institution’s approach to operational risk management. In order to measure and manage risks associated with internal processes and external factors, Westpac uses techniques such as Advanced Measurement Approaches (AMA) and the institution’s own Operational Risk Management Framework (Westpac Group 2016). This framework includes a focus on governance, risk monitoring, risk control management, the identification of key indicators, incident management, and the use of scenario analysis. In combination with the AMA capital model, this approach is rather innovative and effective. The reason is that AMA is traditionally viewed as an appropriate method to address operational risks in comparison to basic indicators and standardized approaches (Saunders & Cornett 2014). Similar frameworks developed by Westpac are also used to manage equity and interest rate risks. According to the complex Three Lines of Defence approach, the focus of these frameworks is on governance, the application of policies, and the implementation of risk control and mitigation activities at different lines of defense.
Strengths and Weaknesses of the Technique Applied in Westpac
In order to discuss the strengths and weaknesses of the risk management techniques used in Westpac, it is necessary to concentrate on the organization’s technique for addressing operational risks. In spite of the fact that the applied AMA model is one of the most popular approaches to managing operational risks in banks, in Westpac, this model is utilized within the context of the Three Lines of Defence approach (Westpac Group 2016). This fact points to the innovative nature of Westpac’s method of working with operational risks.
Specific Features of the Westpac’s Technique
According to Westpac’s definition, operational risk is “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events” (Westpac Group 2016, p. 7). In this financial institution, the Three Lines of Defence approach is applied through the development of certain frameworks and the organization of committees to address various types of risks with reference to different lines of defense. Westpac’s Board Risk & Compliance Committee is responsible for “approving key policies supporting the Operational Risk Management Framework and monitoring the performance of operational risk management and controls” (Westpac Group 2016, p. 8). Executive risk committees monitor risk profiles. Furthermore, Westpac’s Operational Risk Committee oversees the framework and policies, identifies risks, and determines activities and steps to address them (Westpac Group 2016).
The main strength of using the Three Lines of Defence approach as the primary framework upon which other risk management techniques are applied is in ensuring that the board and committees are able to control risk management and mitigation at all stages. This approach guarantees complex and effective monitoring of risk identification and control (Hopkin 2014). When risks are identified, decisions regarding their management are made based on financial analyses and the results of internal and external audits. In this way, the internal control provided by the board and committees is expected to be effective in terms of identifying, measuring, and managing different types of risks, including operational ones (Saunders & Cornett 2014).
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While referring to the main principle of the Three Lines of Defence approach, Westpac has applied the Advanced Measurement Approaches (AMA) model, which can be viewed as rather new in the field of managing risks in financial institutions. The reason lies in its higher quality in comparison to basic indicators and standardized approaches (Saunders & Cornett 2014). The AMA model is a basis for managing Westpac’s operational risks in the context of the implemented Operational Risk Management Framework. In this way, the AMA model is a state-of-the-art technique because it is based on an analysis of internal data for the purpose of developing effective management activities that are realized under supervisors’ control (Saunders & Cornett 2014). Thus, “the Advanced Measurement Approach offers three alternative methodologies for capital reserve calculations for the most sophisticated and largest banks in the world” (Saunders & Cornett 2014, p. 487). This model requires an assessment of the financial institution’s regulatory capital in terms of internal and external losses, as well as expected and unexpected losses.
The strength of using the AMA model in Westpac is in referring to the scenario data in order to predict certain expected and unexpected losses. Moreover, while applying this model, it is possible to evaluate the effectiveness of the framework, indicators, governance, risk control, and risk management in the context of internal and external changes (Westpac Group 2016). An analysis of Westpac’s capital, according to the AMA model, demonstrates that weighted risk assets in 2016 increased by $1.3 billion (Figure 1). This change is associated with increases in the total capital required to address operational risks. However, if Westpac fails to apply the AMA technique effectively and such an increase in assets is insignificant, it is possible to expect financial losses because operational risks affect the activities of financial institutions at different levels (Saunders & Cornett 2014).
There are also weaknesses in the AMA model. The variant that is used by Westpac within the Operational Risk Management Framework and the Three Lines of Defence approach are rather complex. Alternative models proposed by analysts are often viewed as simpler and more efficient (Saunders & Cornett 2014). However, these models are not as risk-sensitive as the AMA technique. Furthermore, in spite of such weakness as the reference to historical data, the AMA model applied in Westpac is actually rather innovative because it enables the identification of risks and the calculation of capital within the framework with reference to concrete key indicators, incidents, and scenarios. To summarise, the strengths of Westpac’s technique for managing operational risks are in the high-risk sensitivity, efficiency, use of scenarios, and high-quality assessment. Still, weaknesses are found in its focus on complicated procedures to make calculations and in relying on primarily historical data.
Recommendations on Improving Westpac’s Risk Management Processes
Given the identified weaknesses of the AMA model in the context of the Operational Risk Management Framework, it is possible to propose two improvements. These recommendations are oriented toward improving calculations, standardizing the structure of the model, and adding more indicators, as well as enhancing the scenario analysis applied within the model. The first suggestion is associated with the necessity of redesigning the AMA model in terms of using exposure, stress, causal, and failure indicators. This approach is important to add to calculations of potential losses with a focus on key indicators (Hopkin 2014). To monitor risks and control the situation, more attention should be paid to assessing changes in the business environment and operational risk exposures. Furthermore, it is necessary to focus on calculating data related to stress and causal indicators in order to manage the situation and prevent failures.
The second suggestion is associated with developing Westpac’s approach to using risk scenarios. The data currently used in the AMA model is usually backward-looking (Westpac Group, 2016). However, it is important to focus on predicting potential losses. As a result, it would be reasonable to apply risk scenarios as simulations to forecast changes and losses in the future. The results of these scenarios need to be quantified in order to guarantee more accurate findings that can be used while developing the model. Calculations of loss frequencies should also be applied in these scenarios.
An analysis of Westpac’s approach to risk measurement and management indicates that this financial institution has applied effective techniques in order to identify and address risks. Still, in order to measure operational risks, the AMA model is used as part of the Operational Risk Management Framework and the Three Lines of Defence approach. In combination, this model is rather effective, but it does have some weaknesses that can be addressed by improving aspects of the model. Advanced techniques should be used, but they should be adapted to the needs of Westpac. As such, it is appropriate to improve the calculations while referring to key indicators and to enhance the scenario analysis to predict potential risks and losses in the future.
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