Basel Probes Banks’ Diverging Views of Risk-Weighted Assets

Global regulators are weighing steps to ensure that banks take a realistic view of the possible losses on their investments, after uncovering variations in how lenders assess risk.

The Basel Committee on Banking Supervision said that a study of 32 global banks had found “material” differences in how much capital lenders thought was needed to guard against possible losses on assets such as corporate and household debt.

The variations meant that some lenders were backing investments with as much as 20 percent more capital than other banks, the Basel group said in a report published on its website today.

“The considerable variation observed warrants further attention,” Stefan Ingves, chairman of the Basel committee, said in the statement. “Information from this study on the relative positions of banks is being used by national supervisors and banks to take action to improve consistency.”

U.S. bankers, including Jamie Dimon, chief executive officer of JPMorgan Chase & Co., have claimed that flexible implementation of previous rounds of Basel rules in the European Union has allowed European lenders to hold less capital against some assets than their U.S. counterparts.

Asset Riskiness

International standards set by the Basel committee require banks to meet minimum capital requirements, measured as a percentage of their assets. The amount of capital that must be held is linked to the riskiness of the assets, with large banks allowed to use their own models to calculate the likelihood of losses. This process is known as risk weighting.

The Basel group’s review of risk models is “a step forward and will show us what kind of specific implementation there is of the Basel rules in banks,” Bundesbank Vice President Sabine Lautenschlaeger, a member of the Basel group, said in a telephone interview. “Some of the problems that arise from risk weighting can be addressed using these kinds of exercises.”

The Basel study, which focused on assets banks intend to hold to maturity, found that North American banks “generally have above-average risk weights.” Lenders from other parts of the world “did not show any strong pattern overall, as banks from those regions can be found on both ends of the scale,” according to the document.

Risk Weightings

Still, the findings show that European banks generally apply lower risk weights to their holdings of bank-issued debt than lenders based elsewhere.

While most banks’ included in the exercise had risk weightings within 10 percent of each other, there were some outliers, the report said.

The Basel group is weighing a range of possible options for ensuring that banks’ risk models are realistic, according to the report. These range from rules requiring lenders to disclose more information on how they calculate possible losses to “more explicit constraints,” such as the setting of minimum risk levels for some assets.

“The short-term policy options that the committee will consider include enhanced disclosure, additional guidance and possible clarifications of the Basel framework,” the group said. “Over the medium term, the committee will examine the potential to further harmonize implementation requirements and to put constraints” on the risk estimates produced by bank models, the group said.

Capital Requirements

Concerns about banks’ ability to reduce their capital requirements by simply changing how they measure the risk of losses on their assets have prompted investigations by regulators and calls from some supervisors for more reliance on simpler, non-risk-sensitive capital rules, known as leverage ratios.

U.S. regulators indicated this week that JPMorgan, Wells Fargo & Co. and Goldman Sachs Group Inc. will be among eight U.S. banks to face tougher leverage ratios than required under Basel rules.

The Basel committee published a draft leverage ratio in 2010 as part of a general overhaul of its bank capital standards. The group is working on the details of the measure, which is scheduled to become binding on banks from 2018. It would require banks to hold Tier 1 capital equivalent to 3 percent of their assets, with no scope for these assets to be risk weighted.

Supervisor ‘Toolbox’

Today’s review should be used as an opportunity to improve risk-weighted capital requirements, not to move away from them, Lautenschlaeger said.

“Without doubt, we need a leverage ratio, but it is only one of the instruments in a well-stocked toolbox used by supervisors,” she said. By not taking into account what kinds of investments a bank is making, a leverage ratio “incentivizes banks to have a high-risk profile,” she said.

“Taking a leverage ratio alone or making it dominant would be a mistake because you can’t compensate for the disadvantage of creating a system of unhealthy incentives,” she said.

Once the Basel group has completed its investigations, it “will have to take a stance on it all,” Ingves said in an interview earlier this week. The group will need to “think about whether the differences” in how banks measure risk “are too big, and what we, in that case, will do about that,” he said.

Risk Model

The impact of risk-model variations on banks’ capital requirements “could be material,” according to the report. Capital ratios could vary by as much as 1.5 to 2 percentage points, or 15 to 20 percent in relative terms.

“In my opinion, there is no major problem as long as the outliers can be explained satisfactorily,” Lautenschlaeger said. “I’m sure that others assess this differently, and see the variations as too large.”

It was a good sign that the “degree of variation” was broadly similar whether banks were assessed under so-called Basel I rules, which have fixed risk weightings, or Basel II rules, which give lenders more scope to use internal models, she said.

The group’s assessment of 32 banks was part of a broader study of the risk models lenders’ use on assets they intend to hold to maturity.

Corporate debt and retail investments such as mortgages are the greatest source of variations in risk weighting, according to the report.

Before it's here, it's on the Bloomberg Terminal.