Bloomberg News

Basel Regulators Said to Scrutinize Banks’ ‘Flawed’ Risk Models

June 28, 2011

June 29 (Bloomberg) -- Global banking regulators are moving their attention to disparities in the way firms measure the riskiness of their assets on concern lenders may be using their internal models to mitigate rules aimed at making them boost capital.

The Basel Committee on Banking Supervision agreed on June 25 to make systemically important financial institutions hold core Tier 1 capital of as much as 9.5 percent of total risk- weighted assets. Now regulators are preparing to assess how banks set risk weightings amid criticism firms’ calculations are inconsistent, said a person with direct knowledge of the matter who declined to be identified because the talks are private.

“There is no question that the weightings can be manipulated,” said Charles Goodhart, a former Bank of England policy maker and professor at the London School of Economics. “They are light years away from being scientific. The idea that risk can be captured and then not adjusted to reflect dynamic markets is absolutely flawed.”

The internal ratings rules determine how much capital banks should set aside to cover assets such as mortgages, derivatives as well as consumer and corporate loans. The riskier the asset, the higher weighting it attracts and the more capital a bank is required to allocate. That affects the profitability of trading and investing in those assets for the lender.

Firms use their own internal models to decide how much capital to assign based on their own view of those assets defaulting. The models aren’t disclosed and banks can reach different risk weightings for the same assets, regulators and analysts say.

‘Basic Problem’

“The basic problem with all this data is can you trust the banks to tell you the bad news?” said Prem Sikka, an accounting professor at the University of Essex. “Regulators won’t have the resources to scrutinize things in detail, but if things are publicly available, ordinary people, academics, lenders, depositors -- anyone who’s interested -- can look and help with the regulation of these banks by pointing out anomalies.”

U.S. bankers and regulators have criticized their European counterparts for underestimating risks on their balance sheets. By reducing the weightings so they can hold less capital, banks can also stymie regulators’ moves to prevent a repeat of the financial crisis that followed the collapse of Lehman Brothers Holdings Inc. in September 2008. Regulators agreed last year to require lenders to more than triple the highest-quality capital they hold to cushion against losses by 2019 under the so-called Basel III rules.

Peer-Review Process

European banks “effectively set their own capital requirements using internal risk estimates, unconstrained by any objective hard limits,” Sheila Bair, chairman of the U.S. Federal Deposit Insurance Corp, told a House Financial Services Committee hearing on 16 June.

Regulators are considering a peer-review process, setting up a sub-committee of the Basel Committee to ask a sample of banks to calculate risk weightings on a group of comparable assets to assess whether they are being calculated consistently, the person with knowledge of the plans said. A spokesman for the committee declined to comment.

“The definition of risk weights is incredibly important,” Adair Turner, chairman of Britain’s Financial Services Authority and a member of the Basel Committee, said in a June 24 speech. “There is a major project for the Basel Committee and the international authorities to really focus on the commonality of risk weights,” he said. “The integrity of this whole system depends on us really being confident” that banks are using the same risk-ratings. He declined to be interviewed for this story.

‘Data Cleansing’

Lloyds Banking Group Plc, the U.K.’s biggest mortgage lender, reduced the estimated risk of default on its mortgages to 12 percent in 2010 from 17 percent in 2009, according to a May filing. By contrast, Royal Bank of Scotland Group Plc, owner of NatWest, raised its estimate for defaults to 13 percent over the same period from 12 percent, according to Morgan Stanley analysts. Officials at the two banks declined to comment on their calculations.

HSBC Holdings Plc’s Finance Director, Iain Mackay, said last month at an investor meeting that Europe’s biggest bank had been able to make “significant risk weight asset savings” in the past years through a process of “data cleansing.”

“It’s not transparent to anybody outside whether the model is as good as it could be and, therefore, the capital weighting is right,” Chairman Douglas Flint told the meeting on May 11.

U.S. Banks

U.S. banks still use standardized risk weightings set by regulators after the country opted out of Basel II bank rules introduced in 2004. Under the standardized system, asset types are assigned specific weightings, giving banks less flexibility. Banks attribute a risk weighting to all the assets on their balance sheets, ranging from zero for lending to the U.S. government to 100 for derivative products.

U.S. banks applied an average risk-weighting of 69 percent of their assets compared with 41 percent for Europe, Citigroup Inc. analysts led by Kinner Lakhani said in June 20 report. The higher figure suggests U.S. banks’ balance sheets are riskier.

Analysts at Citigroup and Morgan Stanley say the difference in risk weightings may be justified.

“The key driver of differentiated risk-weights is retail banking, in our view,” Lakhani said in the report. “Empirical analysis suggests this is largely justified by the risk experience over the last downturn.” U.S. mortgage default rates are considerably higher than those in France, for example, and this is reflected in Europe’s lower weightings, Lakhani said.

Morgan Stanley

Differing U.S. and European accounting rules may also exaggerate the gap, analysts said. Adjusted for U.S. Generally Accepted Accounting Principles, the difference between European and U.S. averages shrinks from more than 30 percent to 11 percent, analysts at Morgan Stanley said in a June 19 report, citing a basket of securities firms.

Morgan Stanley estimates the average risk weighting as a proportion of total assets in the fourth quarter of 2010 was 47 percent at HSBC, 43 percent at Societe Generale SA, 45 percent at Bank of America Corp. and 44 percent at JPMorgan Chase & Co.

“Despite U.S. criticisms, our research suggests that there is actually a lot of commonality between banks,” Morgan Stanley banking analyst Huw van Steenis said.

--With assistance from Jim Brunsden in Brussels. Editors: Edward Evans, Peter Chapman.

To contact the reporters on this story: Liam Vaughan in London at lvaughan6@bloomberg.net Howard Mustoe in London at hmustoe@bloomberg.net.

To contact the editors responsible for this story: Edward Evans at eevans3@bloomberg.net


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