Australia’s Four Pillars may be a source of pride after weathering the global financial crisis, but as Patrick McConnell argues, they will have to match their remuneration policies with their risk taking

In the wake of the global financial crisis, regulators and politicians have belatedly recognised that “perverse incentives” - or ridiculously large salaries and bonuses - played a significant part in the excessive risk taking that triggered financial chaos.

In late November, the Australian Prudential Regulation Authority (APRA) announced its long-awaited new rules on remuneration for the directors and management of banks and insurance companies. APRA was the first regulator out of the blocks to demand that financial institutions have a “remuneration policy [which must be approved by the Board] that aligns remuneration and risk management”. However, APRA has given no specific guidelines as to how remuneration should be linked to prudent risk taking, rais ing the obvious question as to how firms will be measured on the effectiveness of their risk management.

For many years, academics have been advocating some form of risk adjusted performance measurement as the only way to measure the performance of firms, advocating con cepts such as RAROC (Risk Adjusted Return on Capital). There has, not surprisingly, been little traction in this area because banks have been very reticent to publish figures on their risk taking activities. However, help is now at hand.

November, coincidentally, also saw the publication of the first full year’s worth of data required under the so- called Pillar 3 disclosure principles of the new Basel II bank ing regulations. These new rules require banks to publish, on a quarterly basis, details of their Risk Weighted Assets (RWA), or assets adjusted for risk. We are now beginning to get a glimpse into the risk taking activities of the big Australian banks - the Four Pillars.

In another timely coincidence, November was also the annual reporting season for these banks, who collectively heaved a sigh of relief that they had managed to dodge the bullet that had seriously wounded other major global finan cial institutions in the USA and Europe. While Net Profits After Tax (NPAT) were down, much was made of the fact that underlying or cash earnings were stable - good for managers, not as good for shareholders.

The table below summarises some of the key risk-related numbers reported by the banks for the 2009 financial year, subject always to the caveat that it is difficult to compare insti tutions that have different reporting periods and standards.

The Total Capital (TC) column shows the total of so- called Tier 1 (shareholder) and Tier 2 (other) capital employed by each bank. Under Basel II regulation, banks are required to maintain “regulatory capital” at a level of 8 per cent of RWA. In practice, however, banks hold a much higher level of “economic capital” to protect against large risks and to maintain the ratings assigned by credit rating agencies. Coin cidentally, the Four Pillars are all rated highly at AA, a source of great pride to these banks, even without the support provided by the Fed eral Government's guarantee. The Return/TC column shows the return on this 'risk-adjusted' economic capital.

If the big four banks have the same credit ratings, and the methods used to calculate the associated levels of economic capital needed to manage their individual risks is monitored closely by APRA, then the Return/TC results should be close to comparable RAROC numbers. [Note if TC is too large, some capital should be returned to shareholders, if too small, it should be increased to cover the risks being taken].

Some numbers in the table are not pretty, but without more information it would be difficult to apportion blame or praise (though CBA appears to have had a stellar year). The point is not to pillory management but to sug gest that we are beginning to see ways of measuring just how good boards and management are at managing risk. For example, whereas it could be argued that new management at NAB and Westpac cannot be held respon sible for the figures in one year, a similar argument would not apply to Board members, many of which have been at the helm during good years and bad. From these figures, how can the board members at NAB and ANZ justify the relatively high level of their non-executive remuneration? For example, does the sizeable golden handshake handed to ANZ’s recently retired chairman Charles Goode reflect good risk taking?

Based on the new Basel disclosure regime, regulators, rating agencies, investment analysts and academics should work together to identify the additional information and calculations needed to monitor risk-adjusted performance and from that the appropriate level of remuneration in each bank.

The table also illustrates just how alike the Four Pillars are: roughly the same size, same capital, same risks, same returns and almost the same business model. They are like four sumo-wrestlers jammed in a tiny lift, constantly jostling for minor advantage, while effectively locking out competitors.

In the light of the global crisis, it would be churlish to criticize the Four Pillars regime, which seems to have worked, although whether by luck or judgment remains to be determined after the dust settles. At bot tom, the policy seems designed to ensure that no one of the four banks can grow “too big to fail”. In other words, the Australian economy is betting on adequate diversification of bank boards and management, rather than diversification of financial assets.

If, as it might appear, jobs at the big banks may be interchangeable, how can we assess the performance required of Boards and senior man agement at these critical institutions? And, how does one compare the per formance of one bank against another - just how efficient are banks at managing the risks that they take?

It is unlikely that politicians will have an appetite for changing the Four Pillars at the present time, but, is it about time that there was a Productivity Commission report into their efficiency at managing risk?