European banks resort to manipulation to make their capital ratios look better

In yet another article on the manipulation of capital ratios by the banks, the Wall Street Journal looks at how European banks are attempting to look better and disguise their true financial condition.

Regular readers know that the Basel capital requirements are an open invitation to the banks to manipulate their reported capital ratios.

By design, Basel capital requirements hide the true leverage and risk of the banks (I say this as an individual who helped to create Basel I and the reason for hiding the true leverage and risk was to allow the banks to earn a higher ROE - the regulators believed this was necessary to attract capital).

The Bank of England's Andrew Haldane notes what a good job the Basel capital requirements do at hiding leverage and risk when he observed that there are literally millions of assumptions that go into calculating Basel III.

Big European banks are boosting a key gauge of their financial health through largely cosmetic maneuvering, even as regulators in some countries try to crack down on the practice. 

The only way to crackdown on the practice is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can calculate capital ratios for each bank themselves.

Banks are recalculating the risks in their loan portfolios and trading books in flattering ways, a move that has the effect of raising their ratio of capital to "risk-weighted" assets—a metric that investors and regulators use to assess banks' abilities to absorb unexpected losses. 

While such maneuvering has been going on for years, analysts say it appears to be accelerating at some major European banks, which are under pressure to raise their capital ratios as new regulations known as Basel III start phasing in this year.