Banks’ Capital Estimates Seen Overstated; Regulators’ Report Is Liable to Support Push Toward Tighter Rules for Lenders

July 5, 2013, 12:50 p.m. ET

Banks’ Capital Estimates Seen Overstated

Regulators’ Report Is Liable to Support Push Toward Tighter Rules for Lenders

GEOFFREY T. SMITH

The discretion banks use in judging the riskiness of their long-term assets can overstate their capital ratios by up to 20%, global regulators said in a final report on the subject Friday. The long-awaited report, by the Basel Committee on Banking Supervision, appeared to confirm what many outside the banking industry had long suspected: that banks have a structural bias to understate the risk embedded in the vast majority of their investments, so as to make them look better-capitalized and protected against possible shocks than they actually are.As such, the report may provide the regulators with the empirical ammunition to impose new and tighter rules on the banks, which may in turn put pressure on them to raise their capital levels yet again. Any such discussions would only formally begin in September when the BCBS next meets.

“While some variation in risk weightings should be expected with internal model-based approaches, the considerable variation observed warrants further attention,” said Stefan Ingves, governor of Sveriges Riksbank in Sweden and the chairman of the Basel Committee.

Banks in Europe and the U.S. have spent much of the past five years trying to meet new and tougher capital standards imposed by their regulators to try and prevent a repeat of the crisis that erupted in 2008.

The report, based on data from over 100 banks world-wide, focused on the degree to which banks use the freedom allowed under existing rules to determine for themselves the riskiness of their business.

The principle of such “risk-weighting” is the cornerstone of both pre- and postcrisis rules for determining capital needs, and Mr. Ingves has already made clear that it will remain so.

However, the committee, which comprises the national regulators for all the world’s major banking jurisdictions, have fretted for a long time that banks have been using loopholes in the rules to make themselves look stronger than they are.

The report found that differences in risk-weighting approaches from bank to bank could cause a bank’s capital ratios to deviate by up to 20%. That means a bank that, under standardized measure, had a risk-adjusted capital ratio of 10%, could report one of either 8% or 12%, depending on how conservatively it worked.

However, the BCBS noted that most of the banks involved in the survey showed a deviation of no more than 1% from the standardized norm.

Under the new “Basel III” accords, banks must keep an absolute minimum of 4.5% in top-drawer capital relative to their risk-weighted assets, but they face restrictions on the payments of dividends and staff bonuses if the ratio is less than 7%.

The report suggested that banks, especially in Europe, tended to assign much lower risk-weights to their exposures to companies and to other banks under internal models than they would do under the standardized Basel methodology.

At the same time, European banks mainly choose to adopt the standardized approach to valuing their sovereign exposures, as this most often generates a zero risk-weighting—despite the well-publicized problems of many euro-zone sovereigns.

The report didn’t offer any simple solutions to reduce the scope for such deviations in future. Although it suggested that additional disclosure requirements may help, officials are conscious that banks already publish more information than most people can easily assess, and that further requirements might hinder rather than help.

Some countries, such as Germany, want to expand the use of minimum risk-weights to ensure that at least some of the risks—particularly in sovereign exposures—are captured in the Basel ratios. However, even the Deutsche Bundesbank accepts that insisting on such a step now would only intensify the squeeze on the region’s banks, making the continuing credit crunch worse in many countries. As such, any agreement on blanket ‘floors’ for risk weights on certain asset classes also seems still to be far off.