Unpacking the risk in bank portfolios

Andrew Reynolds of Ozrisk
The Sheet's analysis of the pillar three disclosures of ANZ, Commonwealth, NAB and Westpac once again draws on the commentary of blogger Andrew Reynolds at Ozrisk.

Reynolds theme with this quarter's data is an effort to determine the "riskiness" of the credit portfolios of each of the four banks.

What follows, is, in an edited form, by Andrew Reynolds.

The method used to compare the relative credit risk of the three banks is the ratio of risk weighted assets to "exposure at default".

EAD or exposure at default is the value for what the exposure would be in the event it goes into default and is likely to be close to either the current exposure or the facility limit. In this exercise its used as the measure of each bank's credit portfolio.

The reason for selecting this ratio is to pick out the effects of the PD (the probability of default) and the LGD (the loss given default) on the overall portfolio.

That is, it will provide a measure on how good the past lending decisions are currently estimated to have been, given (the APRA approved) modeling of those factors. The greater the risk weighted assets for a given level of exposure at default, the higher the PD and LGD are - and so the riskier the lending is calculated to have been.

If the RWA is close to zero as a percentage of EAD then the lending has been calculated to have been of low risk. The higher it goes, the riskier the lending has been modeled to have been.

The higher the risk weighted assets, the higher the capital load required to support that lending, so it also costs good money to have a high level RWA. The minimum capital load is eight per cent of the RWA, but all of the banks have ratios in excess of 100 per cent.

Ozrisk