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ANALYSIS AND CORRECTION: A tale of ORCs and an under-resourced Reserve Bank

Monday 10th June 2019

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Reserve Bank governor Adrian Orr says the prudential part of his organisation, the part that oversees the banking system, is under-resourced.

“We need more resource. We’ve said that very often. That was, in part, one of the outcomes of the IMF’s (International Monetary Fund) financial sector assessment program,” Orr said when delivering the central bank’s latest Financial Stability Report (FSR) last month.

Previous governors have also unsuccessfully requested more resources, Orr said.

“We’re getting all of the signals now that perhaps more resource is a useful thing for a central bank.”

One such signal is last month’s censure by RBNZ of ANZ Bank over its failure to use RBNZ-approved internal models – a censure which led to former Bank of New Zealand chair Kerry McDonald calling for the resignation of ex-Prime Minister Sir John Key as ANZ’s chair.

Resource constraints were behind RBNZ's decision in 2016 to suspend approvals of most changes to the internal models the four major banks use to risk-weight their assets in calculating how much capital they need.

It wasn’t until ANZ released its latest disclosure statement that this suspension of approvals was revealed.  

It says it was first told of the suspension in November 2016, with suspensions for all but high-priority model changes made indefinite the following May.

This matters for two reasons.

Firstly, there is the role these internal models play in keeping banks’ balance sheets strong enough to withstand financial system and real-world shocks.

Because they are allowed to use these internal models, the big four are known as “internal ratings-based” or IRB banks while the other New Zealand banks have to use standardised models.

In theory, the IRB banks have better systems allowing them to more accurately calculate actual risks based on their own histories, rather than using the one-size-fits-all standardised models.

RBNZ highlighted the advantages of being an IRB bank back in February when it said ANZ needed only slightly more than half the capital to back each $100 of mortgages than does the government-owned Kiwibank. 

However, because IRB models are based on banks’ actual experience, they require constant updating and hence need to be presented to RBNZ for approval when any changes are made.

But the ANZ New Zealand subsidiary had decided to first decommission its operational risk capital (ORC) model after September 2014 and then to begin using a modified version of that ORC model from December 2014 without first getting RBNZ approval.

Then in June 2016, ANZ asked RBNZ to approve yet another ORC model, one that RBNZ still hasn’t approved, but which the Australian Prudential Regulation Authority approved in September 2015, some nine months before ANZ thought to seek RBNZ approval.

As RBNZ said in its FSR, operational risks include IT disruptions or failures, fraud and cybercrime.

ANZ should not have been using any models that were unapproved by the New Zealand central bank.

However, RBNZ wasn’t told that ANZ had been using an unapproved ORC until April this year. 

Although it was only one of 45 internal models ANZ uses to calculate its capital requirements – a fact not clear from RBNZ’s censure statement and which may have made the failure seem even more serious than it was - the breach was sufficiently grave to warrant censure from RBNZ.

The second reason it’s come to matter is that incomplete disclosure of these circumstances allowed BusinessDesk to err in its characterisation of this chain of events in a story withdrawn from publication on May 29 and which is only able to be corrected now after extensive discussions with RBNZ and ANZ.

RBNZ had confirmed to BusinessDesk that the suspension of model changes was “due to resourcing priorities” but what wasn’t clear until after that story ran was that RBNZ had been approving some “higher priority” model changes.

“Each IRB bank has had one or more of its higher priority changes reviewed and approved by us since 2016,” RBNZ subsequently told BusinessDesk, implying that ANZ’s model request was not flagged as high priority.

There’s no doubt ANZ was in the wrong and that its directors had been signing off its accounts on a regular basis saying that the bank was complying with all RBNZ requirements when it wasn’t compliant.

“The bank accepts that this was not in compliance” with a condition of its registration as a bank, ANZ said in its disclosure statement.

As a result, RBNZ ordered ANZ to revert to using the standardised model from March 31, which meant increasing the capital the errant ORC had been used to calculate by $277 million to $780 million.

Obscure and highly technical these ORCs and other models certainly are, but the price tag for using unapproved models is undeniably high.

In mid-November 2017, RBNZ announced that Westpac was using 17 unapproved models, out of 35, and that it had used as many as 21 unapproved models since 2008 when it became an IRB bank.

Westpac’s penalty was that it has to carry an additional $1 billion of capital until it remedies all these unapproved models, something its latest disclosure statement tells us it is "making good progress with.”

While ANZ’s disclosure statement was the first time the suspension of approvals of model changes relating to a core part of the banking sector’s activities had become public, Orr dismissed the idea that this was significant.

“I don’t think it’s been a national secret,” he said. “I’m feeling a little bit disappointed with having to go over and over this issue unless I can see a particular reason to it,” he said.

However, Orr’s predecessor, acting governor Grant Spencer, and current deputy governor Geoff Bascand had answered a series of questions about IRB models in November 2017, immediately after the Westpac announcement, but did not mention then that the RBNZ had ceased approving most model changes a year earlier.

Spencer said then that the other three major banks, ANZ, ASB Bank and BNZ, were compliant and had received approval for all their internal models.

“We’ve been approving models of the four IRB banks, which are the four majors,” Spencer said at that media conference.

“There’s been the issue with Westpac which Geoff (Bascand) might elaborate on but the others are getting their models approved and we don’t have issues with those,” he said.

“We have been checking and we’re confident that there’s no repeat of the Westpac issue with the other three banks.”

People within the banks had said at the time of the Westpac incident that RBNZ had been taking up to 18 months to approve individual models or changes to models, another indicator that the central bank was under-resourced.

Asked at that 2017 press conference whether the RBNZ was certain that the other three banks were compliant, Bascand said that “in terms of the other banks, we don’t have cause for suspicion. We’re encouraged that some of them are looking at their own compliance levels and are undertaking what should be their own due diligence and attestation about their compliance.”

Spencer added that RBNZ recognised there was an obvious question about why it had taken so long to identify the Westpac issues.

“We did revamp our approach to approving internal models back in 2014 where we required a compendium, an actual file, where all these models are so we know which ones are approved and which ones aren’t,” Spencer said.

“So that process was toughened up in 2014 and we think that is working better now,” he said.

Nevertheless, the central bank was going to have another look to ensure any non-compliance was picked up at an earlier stage,” Spencer said then.


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