The process of risk weighting assets will become even more crucial to calculating bank capital adequacy under Basel III than it is already, which is why there is growing dissent about the unexplained discrepancies between how different banks are measuring the same risks.

What is it?

Capital requirements under Basel regulations are calculated based on the risk-weighted assets (RWAs) of a bank, rather than its gross total assets. This means the process of risk weighting is vital to deciding how much capital a bank needs. Under the standardised methodology, banks use the ratings of external credit rating agencies or parameters provided by the regulator to risk weight their portfolio.

But more sophisticated banks use the foundation or advanced internal ratings-based (IRB) approaches, which allow them to build their own risk models. These calculate the probability of default (PD) and loss given default (LGD) rates for different types of assets. They are mainly based on historic data, and are validated by the local supervisor.

What is happening?

There has long been evidence that not all risk-weighting models are equal. For example, The Banker’s Top 1000 World Banks survey showed that in 2010, RWAs were almost 56% of total assets in Spain, compared with only 33% in Sweden.

In the second half of 2011, the European Banking Authority conducted stress-tests to calculate the capital needs of banks under its jurisdiction to protect them from the ongoing eurozone sovereign debt crisis. This shone a light on significant differences between risk weighting at different banks. Santander chief executive Alfredo Saenz told a press conference in October 2011 that the bank could find €4bn in extra capital by introducing new IRB models.

Even among the Swedish banks themselves, there are stark discrepancies on similar assets, with risk weights on corporate loan portfolios ranging from 5% to 15%. In fact, it is quite possible for two banks to assign different risk weights to exactly the same corporate loan.

“While that does not appear to make sense if you look purely at one loan, it is not so crazy across the portfolio as a whole – some banks will be better at managing their exposures to at-risk borrowers, so the risk of losses is different for each bank even on the same credit,” says one equity analyst.

What do regulators say?

José María Roldán, director-general of banking regulation at the Banco de Espana, says there is an element of paranoia about the responses of banks to the risk weightings and resultant capital ratios of their competitors. But equally, he acknowledges that there are discrepancies that cannot be logically explained by differences in historical loss rates alone.

“In Spain, PDs and LGDs may be higher than in other countries, but also there has been intensive regulatory supervision of the [IRB] models that the banks use,” says Mr Roldan.

He believes the bulk of capital ratio increases will still come from asset sales and equity raisings, rather than RWA adjustments. And he points out that in some cases, Spanish banks had already planned changes to their process of risk weighting – for example, switching to the advanced measurement approach for calculating operational risk – before the EBA capital requirements were announced.

“If banks were planning model changes before the EBA announcement, there is no reason why they should postpone these changes. But obviously if models are changed purely to comply with the EBA capital requirements this would not be acceptable,” he says.

What do the banks say?

The paranoia looks set to get worse because Basel III is extending the risk-weighting process for elements such as market risk and counterparty credit risk on derivative transactions. In theory, these risks will be marked to market (using credit default swap spreads in the case of counterparty risks), which limits the scope for tinkering.

Rage-ometer March

But Ioannis Akkizidis, a consultant at risk management specialist FRSGlobal, says there is still room for banks to influence risk weights by adjusting expected recoveries from any default. And banks do not disclose the content of their trading books, making it almost impossible to benchmark how risk weights are calculated.

Yet despite their mistrust of each other’s calculations, banks are not necessarily keen on regulators standardising the process either. “In almost every European jurisdiction, there are banks that will be undercapitalised under Basel III. Neither the banks nor the regulators want to trigger a further banking crisis, so any harmonisation will have to happen very slowly, to wait for the recovery cycle,” says the equity analyst.

What can be done?

The fact that risk weights in Europe have been on a downward trend in the past three years, when economic risks have clearly risen, is alarming. Mr Roldan, who sat on the standards and implementation group of the Basel Committee in 2011, is adamant that greater international supervisory co-operation is essential.

“The Basel Committee has begun an exercise to create an international benchmark credit portfolio, and test how the model outputs vary for each bank. More transparency and granularity on RWAs is needed to ensure effective Basel III implementation. Basel III raises the bar generally, so differences of interpretation on risk weightings could lead to large differences in capital requirements,” he says.


All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker

For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Top 1000 2023

Request a demonstration to The Banker Database

Join our community

The Banker on Twitter