Model behaviour

How regulators can restore trust in bank capital

The Basel Committee just dealt another blow to the self-assessment of banking risk. This powerful group of global supervisors published new evidence on July 5, unmasking shortcomings in the models that tell lenders how much capital they need. For fans of the status quo, it makes gory reading.

Regulators currently allow banks to weight their assets by how risky they are. This then determines how much capital they need. But investors increasingly believe that lenders massage their sums to cut their capital requirements. From the outside, it can be difficult to see where justified diversity of risk ends and where fiddling begins.
 
The committee has made a stab at cutting through this. It looked at 40 per cent of the banking book assets of 32 banks, assumed they each held core Tier-1 ratios of 10 per cent on their risk-weighted assets (RWAs), and tested how they would fare if each had to assess their assets using the average risk-weightings of all the banks in the study. One unnamed European bank winds up with a 7.8 per cent core Tier-1 capital ratio, while an American peer rises to 11.8 per cent. Apply the same assumptions to the whole banking book and the worst bank falls to 5.9 per cent, with the best at 15.7 per cent.

Not all of these differences reflect foul play. The appropriate risk weight for a Spanish mortgage will differ from a similar asset in Germany. What investors are rightly worried about is that the "own model" system allows banks to assign different risk weights to exactly the same loan - and that their own national regulators are complicit.

Basel's study is timid on policy prescription, but it strengthens the case for standardisation. The question is how to get there. Global regulators could force banks to work out risk weights by means of standardised inputs dictated by them, instead of selected by banks themselves. This could be quite painful: some of the RWAs yielded by banks' own models in Basel's study are only 25 per cent of their standardised equivalents, which means capital needs would soar.

The committee knows this. The latest thinking is to force banks to disclose both their own model RWAs, but also their standardised figures, according to a person familiar with the situation. That stops short of holding banks to a higher capital standard overnight. But at least investors could then exercise proper scrutiny - and be better placed to ask if its management is pulling a fast one.