Financial Alchemy Foils Capital Rules as Banks Redefine Risk
Banks in Europe are undercutting regulators’ demands that they boost capital by declaring assets they hold less risky today than they were yesterday.
Banco Santander SA (SAN), Spain’s largest lender, and Banco Bilbao Vizcaya Argentaria SA (BBVA), the second-biggest, say they can go halfway to adding 13.6 billion euros ($18.8 billion) of capital by changing how they calculate risk-weightings, the probability of default lenders assign to loans, mortgages and derivatives. The practice, known as “risk-weighted asset optimization,” allows banks to boost capital ratios without cutting lending, selling assets or tapping shareholders.
Regulators in Europe, seeking to stem the region’s sovereign-debt crisis, ordered banks last month to increase core capital to 9 percent of risk-weighted assets by the end of June. Lenders, facing a 106 billion-euro shortfall, are reluctant to plug the gap by cutting dividends or bonuses and are struggling to sell assets or raise cash in rights offerings. Politicians are trying to stop banks from the alternative, cutting back lending, because it could trigger a recession.
“By allowing sophisticated banks to do their own modeling, we are allowing the poacher to participate in being the game- keeper,” said Adrian Blundell-Wignall, deputy director of the Organization for Economic Cooperation and Development’s financial and enterprise affairs division in Paris. “That risks making core capital ratios useless.”
Spanish banks aren’t alone in using the practice. Unione di Banche Italiane SCPA (UBI), Italy’s fourth-biggest bank, said it will change its risk-weighting model instead of turning to investors for the 1.5 billion euros regulators say it needs. Commerzbank AG (CBK), Germany’s second-biggest lender, said it will do the same. Lloyds Banking Group Plc (LLOY), Britain’s biggest mortgage lender, and HSBC Holdings Plc (HSBA), Europe’s largest bank, both said they cut risk-weighted assets by changing the model.
“It’s probably not the highest-quality way to move to the 9 percent ratio,” said Neil Smith, a bank analyst at West LB in Dusseldorf, Germany. “Maybe a more convincing way would be to use the same models and reduce the risk of your assets.”
European firms, governed by Basel II rules, use their own models to decide how much capital to hold based on an assessment of how likely assets are to default and the riskiness of counterparties. The riskier the asset, the heavier weighting it is assigned and the more capital a bank is required to allocate. The weighting affects the profitability of trading and investing in those assets for the bank.
While firms submit their models to national regulators once a year, they don’t have to disclose them publicly, and risk- weightings for the same assets vary among banks, regulators and analysts say.
“There are potentially significant differences in how different banks calculate RWA,” Daragh Quinn, an analyst at Nomura Holdings Inc. in London, said in a telephone interview. “It’s a very gray area.”
The Basel Committee on Banking Supervision, which has set its own capital standards for banks worldwide independent of those laid out by the European Banking Authority, said in September it planned to review how lenders apply weightings to make sure “the outcomes of the new rules are consistent in practice across banks and jurisdictions.”
That may mean publicly identifying lenders that game the rules, said a person with knowledge of the committee’s talks who declined to be identified because the discussions are private. A spokesman for the Basel committee declined to comment.
Most U.S. banks are governed by Basel I rules, which assign standardized weightings to broad classes of assets, since the U.S. never adopted the second round of regulations.
The proportion of risk-weighted assets to total assets at European banks is half that of American banks, according to an April 6 Barclays Capital report written by analysts Simon Samuels and Mike Harrison. JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon in September described the Basel III rules, which give banks until 2019 to increase their core capital ratio to 9.5 percent of risk-weighted assets, as “anti-American.”
Vikram Pandit, chief executive officer of Citigroup Inc. has called for banks to publish details of their risk-weightings on a quarterly basis. At a speech to the Bretton Woods Committee in Washington in September, he said weightings should also be “benchmarked” to ensure consistency across the industry.
Under Basel III, which maintains the same risk-weighting methodology as Basel II, all lenders will be required to use their own models to assess the riskiness of assets and therefore how much capital they need to hold.
“As you move to Basel III, these issues will become more ubiquitous, not less,” the OECD’s Blundell-Wignall said. “The core Tier 1 ratio is a ratio of two meaningless numbers, which itself is a meaningless number because banks can alter the ratio themselves. Basel III does absolutely nothing to address that.”
Sheila Bair, who stepped down as chairman of the Federal Deposit Insurance Corp. in June, has called Europe’s adoption of risk-weighting “naive.” The Washington-based regulator guarantees most consumers’ deposits in U.S. banks.
“It is in a bank manager’s interest to say his assets have low risk, because it enables the bank to maximize leverage and return on equity, which in turn can lead to bigger pay and bonuses,” Bair wrote in Fortune magazine on Nov. 2. “Indeed, even during the Great Recession, as delinquencies and defaults increased, most European banks were saying their assets were becoming safer.”
Some regulators, including Bair, have pushed for a leverage ratio that would require lenders to hold a fixed amount of capital against total assets.
One reason there’s a difference between risk-weighted assets and total assets is that some securities, such as certain sovereign bonds, carry a zero risk-weighting, requiring banks to hold no capital.
‘Gaming the System’
“A basic leverage ratio would be rougher, but it takes away the risk of gaming the system,” said Stephany Griffith- Jones, an economist and lecturer in financial markets at Columbia University in New York. “We need to move away from outsourcing regulation of the banks to the banks.”
European bank stocks have tumbled 31 percent this year, valuing firms at 62 percent of tangible book value. By contrast, U.S. lenders, measured by the 24-company KBW Bank Index (BKX), have fallen 22 percent, valuing banks at 73 percent of book value.
Banco Santander, based in Madrid, and BBVA in Bilbao said they’re justified in adjusting risk-weightings because Spanish regulators have held them to higher standards than elsewhere.
Spanish banks have an average ratio of risk-weighted assets to total assets of 52 percent compared with 32 percent for U.K. banks, 31 percent for French and Benelux banks and 35 percent for German banks, analysts at Keefe, Bruyette & Woods Inc., wrote in an Oct. 26 report. A higher figure suggests a riskier balance sheet or a more conservative approach to risk-weighting.
“There’s a bias that penalizes the Spanish banks -- it’s a situation of relative discrimination,” Luis de Guindos, a former deputy finance minister, said at a Nov. 4 conference. “If it’s fair and suitable, investors won’t see it badly.”
Santander said it planned to increase capital by 4 billion euros by optimizing risk-weighted assets and internal models. BBVA said the total effect of revising its model was expected to be 2.1 billion euros of additional capital.
“Santander’s core capital exceeds that of any of its continental banking competitors,” a spokesman for the bank, who asked not to be identified by name in line with company policy, said in a phone interview.
Paul Tobin, a Madrid-based spokesman at BBVA, said the bank is “catching up with practices that are common elsewhere in Europe.” After making the changes, he said, “BBVA will still be one of the banks with the highest, if not the one with the highest, density of RWAs among large European banks.”
Commerzbank Chief Financial Officer Eric Strutz said that adjusting the risk model was only one of four options being considered by the bank.
The lender needs “to look at models where our RWAs are higher than others because of market conditions,” Strutz said on a conference call with reporters Nov. 3. “Commerzbank is more at the upper end compared with other banks.”
UBI, based in Bergamo, Italy, said on Oct. 27 it’s confident of meeting the 9 percent target by converting debt, shedding assets and “the progressive changeover” to an “advanced” risk model.
Spokesmen for UBI and Commerzbank declined to comment, as did a representative of the EBA.
Investors are unlikely be satisfied by banks adjusting risk models to avoid raising capital, said Harrison, the Barclays analyst, who is based in London.
“Gaming RWAs isn’t helpful, particularly if the objective is to convince the market to invest in banks again,” Harrison said. “The risk is that it’s counterproductive, because there is even less faith in what the banks are telling you.”
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