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Europe suffers as the world gets safer

Almost every region has recorded a fall in risk-weighted assets, but the soaring impairments in Europe raise questions about how rigorous the Basel methodology really is.
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asset quality

Banks around the world reduced the risks to their asset quality in 2011. The Basel capital rules require banks to weight the assets in their portfolios by the level of risk, and in almost every region, risk-weighted assets fell as a proportion of total assets, implying that banks are getting safer.

The exception was central and eastern Europe, which already had the highest ratio of risk-weighted assets to total assets last year. This has now risen to 87.5%, a full 12 percentage points clear of the next riskiest region, the Middle East.

But as The Banker noted last year, this measurement reflects method as much as actual risk. Banks using more conservative methods, often under Basel I criteria where there was little flexibility to use internal models, inevitably show higher risk-weighted assets. This may mean that they are better prepared and capitalised if those risks play out.

That impression is reinforced by the fact that western Europe records the lowest level of risk-weighted

asset quality 2

assets as a proportion of total assets. Yet this region has by far the highest level of impairments as a proportion of total operating income, almost 10 percentage points clear of the Middle East.

The lack of correlation between risk weights and actual impairment in Europe – indeed, the inverse correlation of risk weights falling even while asset quality is deteriorating – should cause serious concern among Europe’s regulators. A number of senior banking executives in the US have criticised the apparent willingness of western European banks to game the Basel system. It is noticeable that impairments correlate closely to risk weights in all other regions (although the conservatism of central and eastern Europe is apparent).

Basel III regulations are intended to close some of the loopholes, and there is an expectation that market risk in particular will receive a tougher treatment. Of course, it is easier for banks to wind down their positions in traded securities than to dispose of long-term mortgage or corporate loans, so many banks may simply choose to cut their exposure to financial markets. But for western European banks with substantial markets businesses that have not used the traditional US-style originate-to-distribute model, the adjustment will be more difficult. Market risk weightings in Europe have increased as a proportion of total risks, and are now the highest for any region. But they are still the smallest component of the risk bucket for European banks.

rwa

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