Banking is all about measuring and managing risk: the risk of borrowers defaulting, of interest rates changing and, for the largest systemically important financial institutions, of financial markets moving. And yet, bankers and regulators are locked in a fundamental debate about how to measure risk to assess each bank’s capital needs.
At the heart of this debate is the process of risk-weighting assets to decide how much capital banks need to hold against them. This was the central innovation of the global Basel II agreements on capital regulation compared with the previous Basel I deal, but there are growing complaints that banks are manipulating the process to minimise their capital requirements. At one stage in 2011, the divisions among national supervisors meeting at the Basel Committee on Banking Supervision became so severe that they called in an external peace-maker in the form of the International Monetary Fund (IMF). Researchers at the IMF assessed whether there were sharp divergences in the way different banks and their home supervisors calculated risk-weighted assets (RWAs) and, if so, what could be done about it.
