Swedish Banks Face Tougher Internal-Model Rule as FSA Sees Risks

Sweden’s banks face tighter rules on internal models used to calculate capital needs as the financial regulator responds to risks that capital buffers are being set too low.

While the watchdog wants capital requirements to continue to be risk-sensitive and will therefore still allow the use of internal models, “at least in part,” it has seen signs that banks are pushing down their own requirements, it said in a report on Tuesday.

“Banks have to some extent worked on what is known as risk-weight minimizing, which means that they take advantage of the scope for interpretation in the regulations on internal models to minimize the capital requirement,” the FSA said. The watchdog “therefore considers that the regulations for internal models should be tightened.”

Swedish banks are already subject to some of the world’s strictest capital requirements and boast common equity Tier 1 capital ratios that are among the highest in Europe. With Sweden’s demands twice as high as the EU’s minimum requirements, the country’s banking sector “has a good resilience to shocks,” according to the FSA. Still, it has warned that capital demands may need to be raised further and is now targeting how banks use internal models to measure risk.

Over time, regulation for those models will be tightened through international agreements and European legislation. But the Swedish regulator is in the meantime “investigating various means of quickly improving the management of model risks and dealing with certain specific weaknesses in the construction of the internal models,” it said.

The move comes after the FSA found that the average risk weights for company exposures have declined to just above 30 percent, from about 60 percent in 2007, as banks have improved their risk management, but also as a consequence of risk-weight minimization.

“If they are well-designed, risk-sensitive capital requirements give a more accurate picture of a bank’s capital needs,” the FSA said. “Moreover, they create strong incentives for healthy risk taking and good control of the measuring, reporting and management of risks in the balance sheet. The disadvantage is that models can be wrong and that the banks will also have strong incentives to utilize the models to push risk weights further down than is justified by the actual level of risk.”

Concerns about rosy risk assessments are growing against a backdrop of an overheated housing market. Swedish policy makers have warned that soaring property prices and record private debt burdens pose a risk to financial stability and the economy. The regulator on Tuesday said the development “entails an increase in the risks to economic stability” and that it is “therefore necessary to be prepared to take further measures.”

It has already introduced a mortgage cap and raised capital requirements and risk weights for banks and is planning to introduce an amortization requirement in the summer of 2016. In addition, the FSA may cap household borrowing as a percentage of income, it said.

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