(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)
By Martin Hutchinson
NEW YORK, June 22 (Reuters Breakingviews) - It’s time for bank regulators to get heavy on risk weighting. The financial and euro zone crises have shown the drawbacks of using banks’ home-grown models to weigh different risks. These encourage unhealthy arbitrage by favoring assets that enjoy favorable treatment. A tougher cap on the ratio of equity to total assets would limit abuse. So would banning risk measures that ignore extreme events.
New Basel III rules have lifted the amount of capital that banks must hold. However, like their predecessors, they still use risk weightings to calculate the asset total used when calculating capital ratios. This has led to problems in the past: in particular, the decision by European regulators to attach a zero risk-weighting to sovereign debt allowed banks to hold almost unlimited quantities of government bonds. As the euro zone crisis has shown, government debt is far from risk-free. Though Basel III attempts to address some of these shortcomings, it may still underestimate sovereign risk, thereby making corporate and consumer loans less attractive.
To combat this problem, global regulators have also introduced a leverage ratio, which caps the total amount of un-weighted assets that banks can hold as a proportion of equity. But this ratio has been set at a mere 3 percent, adjusted for derivatives, allowing banks to lever themselves 33 times. That ratio proved excessive for Bear Stearns and Lehman Brothers in 2008. U.S. commercial bank regulators have long imposed a ratio. Setting it at 5 percent of total assets would make it harder for banks to load up on seemingly risk-free loans.
But risk-weightings have another flaw: their dependence on discredited Value-at-Risk measures, which assume that risks have a normal distribution and little mutual correlation. The market crash of 2007 and 2008 showed that VaR underestimates the risk of “tail” events, encouraging traders to load up on products that can blow up. JPMorgan’s (JPM.N) recent trading losses again demonstrated VaR’s shortcomings.
Again, regulators are aware of the problem. In a consultation document issued in May 2012, the Basel Committee said banks should switch to risk management methods that properly recognize tail risks. But for now, bank capital measures are still too dependent on risk weightings. They should be modified.
SIGN UP FOR BREAKINGVIEWS EMAIL ALERTS: www.breakingviews.com/TOPNewsSubscription
- The Basel III regulations’ main capital requirements involve a complex system of risk weightings for different types of bank assets.
- From Jan. 1, 2013 to 2017, bank regulators will also test a leverage ratio, with minimum average Tier 1 capital in each quarter being set at 3 percent of total exposure, which is calculated as the balance sheet total plus an additional allowance for derivatives.
- The Basel III regulations also contemplate that banks will calculate their risk exposure using a Value at Risk model, which the regulators will approve.
- The Swiss National Bank has recommended that Swiss banks should report each quarter on the risk-weighted assets calculation performed according to the standardized risk models used by regulators, as well as their own internal models.
- Bank for International Settlements (BIS) – Basel III, revised version June 2011: link.reuters.com/wyr77r
- BIS consultative document – Fundamental review of the trading book: link.reuters.com/myq78s
- Treasury/Fed/FDIC: Regulatory Capital Rules - Regulatory Capital – Implementation of Basel III: link.reuters.com/bek78s
A farewell to VaRms [ID:nL4E8GE74I]
- For previous columns by the author, Reuters customers can click on [HUTCH/]
(Editing by Peter Thal Larsen and Martin Langfield)
((email@example.com)) Keywords: BREAKINGVIEWS BANKS/CAPITAL
C Reuters 2012. All rights reserved. Republication or redistribution of Reuters content, including by caching, framing, or similar means, is expressly prohibited without the prior written consent of Reuters. Reuters and the Reuters sphere logo are registered trademarks and trademarks of the Reuters group of companies around the world.