Checking how banks measure riskiness of their assets requires disclosure of asset-level data

A Bloomberg article reports that now that the battle over risk-adjusted capital requirements is over, regulators are turning to examine how banks' measure the riskiness of their assets.

The best way to ensure 1) that the risk adjustments are not manipulated and 2) that banks converge on the same risk adjustments for the same assets is disclosure of the asset-level data.  The market will force a common risk-adjustment across all financial institutions.

Global banking regulators are moving their attention to disparities in the way firms measure the riskiness of their assets on concern lenders may be using their internal models to mitigate rules aimed at making them boost capital. 

... Now regulators are preparing to assess how banks set risk weightings amid criticism firms’ calculations are inconsistent, said a person with direct knowledge of the matter who declined to be identified because the talks are private. 

“There is no question that the weightings can be manipulated,” said Charles Goodhart, a former Bank of England policy maker and professor at the London School of Economics. “They are light years away from being scientific. The idea that risk can be captured and then not adjusted to reflect dynamic markets is absolutely flawed.” 

The internal ratings rules determine how much capital banks should set aside to cover assets such as mortgages, derivatives as well as consumer and corporate loans. The riskier the asset, the higher weighting it attracts and the more capital a bank is required to allocate. That affects the profitability of trading and investing in those assets for the lender. 

Firms use their own internal models to decide how much capital to assign based on their own view of those assets defaulting. The models aren’t disclosed and banks can reach different risk weightings for the same assets, regulators and analysts say. 

“The basic problem with all this data is can you trust the banks to tell you the bad news?” said Prem Sikka, an accounting professor at the University of Essex. “Regulators won’t have the resources to scrutinize things in detail, but if things are publicly available, ordinary people, academics, lenders, depositors -- anyone who’s interested -- can look and help with the regulation of these banks by pointing out anomalies.” 

A clear statement of the benefits of asset-level disclosure as it applies to risk-weighting assets.

... Regulators are considering a peer-review process, setting up a sub-committee of the Basel Committee to ask a sample of banks to calculate risk weightings on a group of comparable assets to assess whether they are being calculated consistently, the person with knowledge of the plans said. A spokesman for the committee declined to comment. 

However, in a world where regulators are protecting their information monopoly, regulators would rather consider a one-off solution like a peer-review assessment of comparable assets.  The problem with a peer-review is that neither the regulators nor the market knows if the responses a bank gives to the peer-review are consistent with how it actually risk-weights the assets.

“The definition of risk weights is incredibly important,” Adair Turner, chairman of Britain’s Financial Services Authority and a member of the Basel Committee, said in a June 24 speech. “There is a major project for the Basel Committee and the international authorities to really focus on the commonality of risk weights,” he said. “The integrity of this whole system depends on us really being confident” that banks are using the same risk-ratings. 

Given that the numerator in the capital ratio, namely capital, is an accounting construct that at best is a lagging indicator and at worst is subject to substantial manipulation, the integrity of the whole system is already compromised.

... Lloyds Banking Group Plc (LLOY), the U.K.’s biggest mortgage lender, reduced the estimated risk of default on its mortgages to 12 percent in 2010 from 17 percent in 2009, according to a May filing. By contrast, Royal Bank of Scotland Group Plc, owner of NatWest, raised its estimate for defaults to 13 percent over the same period from 12 percent, according to Morgan Stanley analysts. Officials at the two banks declined to comment on their calculations. 

HSBC Holdings Plc (HSBA)’s Finance Director, Iain Mackay, said last month at an investor meeting that Europe’s biggest bank had been able to make “significant risk weight asset savings” in the past years through a process of “data cleansing.” 

“It’s not transparent to anybody outside whether the model is as good as it could be and, therefore, the capital weighting is right,” Chairman Douglas Flint told the meeting on May 11.