Risk-weighted assets: ground zero for games played by regulators and bankers

The Economist ran an interesting article in which it looked at some of the problems with the risk-based capital.

Regular readers know that risk-based capital came into being in the 1980s to hide the fact that banks were taking on greater leverage and risk.  Bank regulators blessed risk based capital as it was seen as a way to attract more capital to the banks by allowing them to provide a more competitive return on equity.

One example of how risk based capital hides the greater leverage and risk is to look at sovereign debt.

To calculate risk adjusted assets, the denominator in the capital ratio calculation, the risk weighting for each asset type is multiplied by the amount of each type of asset.  Basel I assigned a zero risk weighting to sovereign debt.  A zero risk weighting implies these assets have no risk and therefore they go away for calculating capital ratios.

Clearly sovereign debt has risk.  In the 1980s, a large US bank showed there was interest rate risk when it lost over half of its book capital after buying a sizable US Treasury bond position and having interest rates move against it.  More recently we saw there is also credit risk with the restructuring of Greek sovereign debt.

What made the adoption of risk-based capital possible is the opacity surrounding bank balance sheets.  As the Bank of England's Andrew Haldane says, banks are 'black boxes'.

What made risk-based capital a danger to the financial system was that as the regulators moved from Basel I to Basel II they created more opacity surrounding the leverage of and the risks on and off the bank balance sheets.

This made it impossible for the market participants to properly assess the risk of the banks, adjust their exposures to reflect this risk and exert discipline on the banks to restrain their risk taking.  The result was the financial crisis that began in 2007.

Risk-based capital is the classic example of the combination of increasingly complex rules/regulations and regulatory oversight being substituted to the detriment of the financial system for transparency and market discipline.

If banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, market participants could independently assess the risk of the banks.  During this independent assessment, market participants could, if they chose to do so, calculate risk-based capital ratios for the banks.

As a practical matter, market participants are unlikely to calculate risk-based capital ratios.  What the market participants care about is the risk that each bank is taking.  Market participants can then adjust both the amount and pricing of their exposures to each bank to reflect this independent assessment of risk.

“Risk-weight optimisers” are those wizards of finance whose job it is to reduce the size of the balance-sheet—or at least the one that is used to calculate how much capital banks need to hold against bad times—without sacrificing returns. 

The job may soon have less scope for creativity. 

Regulators are beginning to wonder whether to keep letting banks decide the riskiness of their own assets, which in turn has an impact on the capital they set aside.... 

But the system was soon gamed. Banks realised that they could spice up their returns by holding assets that were safe enough to require little capital, but risky enough to deliver profits. The obvious pre-crisis examples were American subprime mortgages that had been bundled up and then insured. Because risk models said these would hardly ever produce losses, banks were able to load up on them without having to set aside much capital. 

Figuring out how much trickery is still going on is difficult, even for regulators, since the big banks use complex “internal models” based on the quality of their own assets. 

Some of the variation between banks is explained by genuine differences in the riskiness of their assets. German mortgages, say, tend to be less risky than American ones. 

Some differences, however, smell fishy. Britain’s Financial Services Authority has found that banks assign wildly different numbers to identical baskets of borrowers. ...

Regulators are responding. 

The correct regulatory response would be to require banks provide ultra transparency.

Unlike setting minimum capital levels or leverage ratios, ultra transparency restrains the banks from loading up on riskier assets.  This restraint occurs because unlike capital ratios, with ultra transparency the bank's cost of funds increases with the more risk the bank takes.