Bank analysts spooked by huge gulfs in Basel RWA review
Some banks calculating measures that are 3% of the median in Basel Committee study, while others are more than 2,500%
A Basel Committee on Banking Supervision review has found huge variation in risk-weighted assets (RWAs) calculated by 15 participating banks for trading book exposures – triggering calls for the system to be fixed and warnings from bank analysts that valuations may be affected.
The review, under way for much of last year, required banks to calculate a series of measures that feed into risk-weighted asset (RWA) calculations – such as value-at-risk – for 24 asset class-specific test portfolios, and two diversified portfolios. For one of the focused portfolios, the review found banks' numbers ranged from less than 3% of the group's median to more than 2,500%. Last week, Risk reported the review would find gaps of "many multiples" in bank RWAs.
Under the incoming Basel III rules, banks will be required to hold more equity capital against RWAs, but if the industry is generating such a wide spread of RWAs, analysts warn it will undermine the new regime.
"It's incredibly important for the market to have confidence the calculation of risks that a bank has taken is correctly calibrated," says Huw van Steenis, a bank analyst at Morgan Stanley in London. "Given the degree of complexity in the RWA calculation process, it is inevitable that judgement is very hard for investors to make. Confidence has to come from transparency and an appropriate process between bank and regulator. Right now, it is very difficult to see whether that process is appropriate or not."
The result could be greater uncertainty about bank earnings forecasts. "If investors have doubts about how a bank calculates RWA, and the amount of capital that those calculations produce, then that means confidence in how the bank makes money is eroded as well," says one analyst at a large European bank. "It is enormously difficult for outsiders to understand what is going on in banks. How can I forecast earnings if I don't understand the balance sheet?"
It's incredibly important for the market to have confidence that the calculation of risks that a bank has taken is correctly calibrated
The past two years have seen growing complaints from banks and analysts that the ratio of RWAs to assets is very different from one institution to the next. It has never been clear how much of this variation is due to portfolio differences and national accounting rules, but the accusation from some quarters was that banks are gaming the system. In fact, while internal modelling choices are a significant factor behind the difference in RWA numbers, the review carefully avoids suggesting those choices were an attempt to reduce capital requirements – instead, the committee finds that differing supervisory guidance was a big factor, with multipliers applied by national regulators responsible for roughly a quarter of the total variation seen in the diversified portfolio.
The specific portfolios were the source of the most alarming variations, however. The review breaks these down to some of the component risk measures used to calculate trading book capital – VAR, stressed VAR and the incremental risk charge (IRC). For one portfolio, containing foreign exchange forwards and options, VAR numbers ranged from around 75% of the median to more than 1,000%. In credit, a portfolio containing bought credit default swaps on 10 financial names had IRC numbers that were anywhere from 5% to 1,000% of the median.
The review states that the supervisory decisions behind some of this variance are made on either an industry-wide or bank-by-bank basis. As one example of an industry-wide policy, the UK's Financial Services Authority (FSA) last year removed the freedom for its banks to model loss given default for sovereign exposures in the banking book.
Another example can be found in the US. Under its version of the Basel 2.5 trading book capital rules – which came into force this month – banks have to run correlation positions hit by the comprehensive risk measure (CRM) through the more simplistic standardised approach and add 8% of the resulting charge onto their internally modelled CRM capital requirement. That is different from the approach used elsewhere, in which a floor is applied.
An example of the bank-by-bank treatment can be found in Germany, where the Bundesanstalt für Finanzdienstleistungsaufsicht applies a multiplier to VAR and stressed VAR calculations to address modelling weakness at individual institutions. The base multiplier is set at three times the bank's internally modelled figures, and can be increased by qualitative and quantitative add-ons.
The report also discussed the sheer range of modelling choices available to banks – which can be numbered in the hundreds of thousands, say some observers – as a contributor to the variance. For instance, banks are free to choose their own historical look-back periods for VAR and stressed VAR. To have allowed such divergent approaches to take hold is, according to one industry source that spoke to Risk last week, "a complete failure of supervision".
And things could get worse. The RWA review is being carried out in two parts – the trading book results will be followed by a banking book review – and analysts are already worried what it will reveal.
"For most banks, trading book RWAs are no more than 15% of their RWA total. A vanishingly small number of banks have ever been knocked over by trading book risk. It is always banking book risk that causes the serious problems. If the banking book review reveals a similar level of variance as its trading book counterpart, then we'll know the RWA system will definitely have to be fixed for people to show faith in Basel III again," says Dan Davies, bank analyst at Exane BNP Paribas in London.
The trading book RWA review considers a number of solutions to the problem – regulators could be more vigorous in removing modelling approval, and could force banks to use the less risk-sensitive standardised approach on portfolios where model construction is faulty, for example. The Basel Committee has also suggested that banks calculate and publish their standardised model RWA number alongside their internally modelled number to enable a fair comparison across firms. A crude flooring system has also been put forward that would prevent internally modelled RWAs falling below a certain percentage of their standardised equivalent, or even the full standardised number.
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