Eurozone banks manipulation of Tier 1 capital ratio confirms it is meaningless

In an article, the Financial Times highlighted how easily banks can manipulated their Tier 1 capital ratio.

What makes this article significant is it highlights how monetary policy and the regulatory policy of forbearance directly contributed to manipulation of the capital ratio.

Concern is growing that banks in Europe and elsewhere are moving to meet new tougher capital requirements by tinkering with their internal models to make their holdings appear less risky.... 

All of these requirements are aimed at making banks more resilient by forcing them to have more capital to absorb unexpected losses. But banks, faced with volatile markets and low share prices, are reluctant to issue equity right now. 

So many of them are instead trying to reach the required ratios by reducing the denominator, through what they call “risk-weighted asset optimisation”. In some cases, that means selling or running down risky assets, but in others, it means changing the way risk weights are calculated to cut the amount of capital that will be required. 

Regulators, who must approve bank models, are alive to the problem and the European Banking Authority’s board has essentially set a floor on how low the risk weights can go when it comes to calculating the EU’s 9 per cent target. 

“The language of RWA optimisation is basically regulatory arbitrage,” said one senior EU regulator. 

But that hasn’t stopped many banks from doing their best to boost their ratios....

Some of the optimisation is encouraged by the regulators. Banks effectively get an risk-weighted asset break when they switch from the old Basel I rules – which apply standardised risk weights to loans based on their category – to the “internal ratings based” system that is the basis for Basel II and III. 

Under the internal ratings system, banks come up with models that predict the probability a particular loan will default and the likely loss if that occurs. The numbers are then plugged into a formula that assigns a risk weight. 

In general, using internal ratings produces somewhat lower risk weights – and therefore requires less capital – than the standardised approach because regulators want banks to build good models and improve risk management.... 

Of course, the best way to "model" these loans would be to disclose them to market participants.  The market would then assess the risk of the loans.

But there is a second kind of optimisation that regulators are more concerned about. When banks create models, regulators then back-test them and will only approve those that produce probabilities of default and predicted losses that are higher than real-life experience. 

But the current recession has produced lower loan default rates than past downturns – partly because interest rates are low – so many bank models are currently producing results that are significantly more conservative than real life. 

And partly because of regulatory forbearance...

That creates room for banks to tweak their models, and some are doing so in a deliberate effort to cut their capital needs, industry participants say.... 

Supervisors in the UK and elsewhere also said they will be looking carefully at bank plans to reach their new capital requirements and intend to come down hard to anything they see as cheating.

No market participant believes this.

If regulators were really going to come down hard, they would require that banks disclose their current asset, liability and off-balance sheet exposure detail.  This would allow the market participants to monitor if regulators come down hard on how banks reach the meaningless capital requirements.