With investors claiming that Basel explanations of risk weighting models are indecipherable, confidence in these measures has been lost. If it is not restored, capital may have to be regulated using much harsher methods.

Assigning risk weights to assets to calculate capital ratios is the central plank of the Basel capital accords. The trouble is, investors and regulators alike seem to think the plank is rotten.

The European Central Bank has said it may use its stress-test exercise to challenge the risk weightings assigned by banks. Stefan Ingves, chair of the Basel Committee on Banking Supervision (BCBS), has delivered what amounts to a series of warnings indicating that a higher crude leverage ratio – capital adequacy calculated without risk weights – could be used as a stick to beat banks if there is no sign of a reduction in the sharp variability in risk-weighted assets (RWAs).

Investors complain that explanations of risk-weighting models under pillar three of the Basel agreement – the public reporting pillar – are indecipherable and impossible to compare. One analyst talks about a “crisis of RWAs”. Instead of assuming that banks with lower risk weights are taking fewer risks, investors believe these banks are just fiddling the figures. Banks with higher risk weights – in theory, banks with higher risk balance sheets – are counter-intuitively seen as more conservative.

If confidence in RWAs is not restored, investors and regulators will increasingly look only at leverage, not at risk weightings. This could be very painful for the European banking sector and wider economy. Average mortgage risk weights in the UK are 15%, equating to a capital requirement of 1.5% if banks aim for a relatively safe Basel ratio of 10%. If the leverage ratio becomes the binding constraint, that means banks would have to double the capital assigned to mortgages. That means doubling mortgage spreads, or halving the bank’s margin on mortgages, or some combination of the two.

Banks are rightly appalled at the prospect, and their customers should be too. But action to avoid it seems rather half-hearted thus far. The BCBS itself is preparing a paper on improving pillar three disclosures. If bank executives want their capital to be regulated using a risk-sensitive measure, they need to take the lead and advocate a compromise that will save RWAs. Benchmarks may be a dirty word right now, but a set of published benchmark risk weights overseen by regulators would retain a framework that encourages advanced risk management while giving investors a more reliable idea of which banks are trying to stretch the models too far.

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