The Basel Committee on Banking Supervision has found that banks around the world are inconsistent in the way that they assess credit risk in their banking books.
It is an important study because so much rests on the risk weights produced by banks’ internal models. Most important, they determine how much capital banks need to raise, so the suggestion that lenders (and national regulators) are applying different standards is worrying.
The research draws on supervisory data from more than 100 large banks that have adopted the internal ratings-based model for credit risk in the banking book, according to the committee, “as well as additional data on sovereign, bank and corporate exposures collected from 32 major international banks”, as part of a wider assessment of regulatory consistency around the world.
As part of the process, the committee asked banks to evaluate the risks in a hypothetical portfolio of sovereign, bank and corporate borrowers and exposures (which account on average for about 40% of participating banks’ total credit risk-weighted assets), and used the results to make assumptions about how this diversity of opinion would affect capital ratios.
Assuming a benchmark capital ratio of 10%, the study suggests that banks’ internal models could produce actual ratios that range from 7.8% to 11.8%.
Some of this variation reflects real differences in risk preferences, “as intended under the risk-based capital framework”, says the committee. But the results suggest that a standardised approach to risk is still some way off.
“While some variation in risk weightings should be expected with internal model-based approaches, the considerable variation observed warrants further attention,” says Stefan Ingves, chairman of the Basel Committee and governor of the Swedish central bank.
The problem is that a more standardised approach would mean that many banks, inevitably, would need to raise more capital, which they are reluctant to do as long as they have access to cheap debt funding (and free equity courtesy of taxpayers).
However, the committee is not proposing any radical action to address the divergence in risk weights.
“In the near term, information from this study on the relative positions of banks is being used by national supervisors and banks to take action to improve consistency,” says Ingves. “In addition, the committee is using the results as part of its ongoing work to improve the comparability of the regulatory capital ratios and to enhance bank disclosures. The committee will be considering similar exercises to monitor consistency in capital outcomes and assess improvement over time.”
Banks often argue in public that the complexity of regulation is a burden on them, but in the case of bank capital it is the very complexity of the system that gives them such latitude in deciding risk weights. And, as they know, a simpler system would be one in which banks had to raise much more capital. None of them want that.
