Basel study shows banks game their reported capital ratios by up to 20%

Bloomberg reports that the Basel Committee has confirmed just how easy it is to manipulate and overstate bank capital ratios.

Specifically, the Committee looked at the variations in the risk-weights banks assign to their assets, particularly corporate and household debt, and found that this variation results in banks reporting capital ratios that are up to 20% higher than a more conservative peer bank's risk-weighting would suggest.

Please note, we are only talking about manipulating and overstating bank capital ratios by the assignment of risk-weights.  The study excludes manipulating and overstating bank capital ratio by suspension of mark-to-market accounting or regulatory forbearance.

Naturally, the Basel Committee is looking for how to address this problem of gaming the capital ratios.

“The short-term policy options that the committee will consider include enhanced disclosure, additional guidance and possible clarifications of the Basel framework,” the group said.

Regular readers know and the Basel Committee confirms that the number one way for ending gaming of bank capital ratios is to require the banks to provide enhanced disclosure.

Specifically, banks must disclose their current global asset, liability and off-balance sheet exposure details.

With this information, any market participant who is interested can independently calculate a bank's capital ratio and compare this independent calculation with what the bank reports.

With market participants having an ability to independently calculate a bank's capital ratio, banks have an incentive to be as conservative as possible in the capital ratio they report.  This minimizes the chances of the bank being portrayed as even riskier than it is.