UK looks into how meaningless bank capital is

The Wall Street Journal reports that UK regulators are looking into just how meaningless bank capital ratios are.  Specifically, the regulators are looking at how banks assign risk weights to their assets.

This exercise is exactly as useful as rearranging the deck chairs on the Titanic.

Why?

Because since the beginning of the financial crisis, bank capital has been meaningless.  The suspension of mark-to-market accounting combined with regulatory forbearance has effectively divorced what is reported in bank financial statements from reality.

The OECD made the point that the suspension of mark-to-market accounting combined with regulatory forbearance distorts both the asset and equity accounts.  This renders any bank capital ratio meaningless.

The UK regulator's examination of how banks apply a risk adjustment to their overstated assets doesn't address the underlying problem that the assets are mis-stated.

As part of a review that began in November, U.K. bank supervisors are assessing the "risk weights" banks assign to their assets—a notoriously subjective process that many analysts and investors are convinced banks have used to understate the riskiness of their balance sheets. 

Please re-read the highlighted text as it explains the simple fact that even if the financial statement accounts were accurate, Basel capital regulations are subject to being gamed by the banks.

Because banks' capital cushions are generally calculated as a percentage of their risk-weighted assets, banks can make their capital buffers look fatter by understating the riskiness of their assets. 

Not all assets are created equal. Banks can hold smaller amounts of capital against less risky assets, such as residential mortgages or government bonds. The riskier the loan, the more a bank must put aside. 

British banks are locked in tense discussions with the Financial Services Authority to determine how and whether they need to shore up their balance sheets, according to regulators and bank executives. 

The results of these negotiations, which could see banks sell chunks of their businesses or issue debt, will be presented by the Bank of England in March.

Given the stakes, naturally the banks have an incentive to game the calculation of their risk-weighted capital ratios.

A Europe-wide rule change in 2008 gave banks more freedom over calculating their risks and resulting capital needs. In combination with pressure from investors to boost their capital levels, that led to British banks systematically cutting their risk weights over recent years. 

The Bank of England recently published data showing that average risk weights for U.K. banks are at their lowest levels since 1987. Further analysis shows British banks could be overestimating their capital levels by between £5 billion ($7.9 billion) and £35 billion by applying aggressive risk weights, according to the BoE.... 

Surprise! Given the incentive and the freedom to game their capital ratios the banks did just that.

The U.K.'s biggest banks use complex in-house models to predict how likely borrowers are to default and how much capital they should hold to cover potential losses. Although these models are ratified by the U.K. regulator, investors and analysts are worried that banks' methodologies are too opaque or simply don't add up. ... 

For instance, according to its most recent disclosure, Lloyds assigns a 2.2% risk weighting to £143.5 billion in mortgages—more than half of its total portfolio. That means it only needs to keep back £250 million to cover potential losses. Using a pre-2008 model, where mortgages had a 35% weighting, Lloyds would have to hold £4 billion in reserves.... 

Of course the bank methodologies are opaque.  If they told the market how they were modeling their assets to minimize their capital ratios, market participants would realize that the banks are far riskier than they are presenting themselves to be.

The benefits to banks of adjusting their internal models can be enormous.  

Deutsche Bank Thursday said it shaved around €55 billion from risk-weighted assets in the fourth quarter through changes to its models and other adjustments, a move that boosted its capital ratios but drew concern from some analysts on what would happen if regulators took a tougher stance.

Deutsche Bank's ability to dramatically change its capital ratios by changing its models reveals the fundamental flaw in relying on capital ratios that can be gamed by the banks.

Concern around risk weights is shared by regulators globally. 

The Basel Committee in charge of setting new international rules for banks said Thursday it found material differences on risk weightings from bank to bank in a recent study, in large part because of the choices banks made on what to include in their models and how regulators policed them. 

"Model-based approaches haven't given as accurate results as regulators had anticipated they would. Everyone is on a learning curve, so what constituted a good model back in 2006 may not constitute a good model today," said Vishal Vedi, a partner in Deloitte's financial services advisory practice. 

It is currently unclear what steps regulators will take to reappraise risk weights. 

One idea would see minimum risk weights for certain types of assets, such as home loans. Swedish regulators made such a move in November, with a plan to set a 15% floor on mortgage risk weights. 

Another approach is to go back to fully-standardized risk weights. For example last year, U.K. banks were ordered to change the way they treat commercial-property loans, a move that collectively added around £45 billion to risk-weighted assets at RBS, Lloyds and Barclays BARC.

A better idea 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 disclosure, the market would value each bank's exposures and exert discipline on the banks to ensure they are adequately capitalized.