DIMON CALLS FOUL ON RISK MODELS / THE WALL STREET JOURNAL ( RECOMMENDED READING )

• HEARD ON THE STREET
• MARCH 11, 2011

Dimon Calls Foul on Risk Models

By DAVID REILLY

Bank strength still is very much in the eye of the beholder.

In Europe, some bankers and regulators have fretted in recent days over potential problems with bank "stress tests," namely that firms can rely on differing definitions of Tier 1 capital, a key measure of bank strength.

That debate comes as worries rise in the U.S. that varying approaches in the calculation of Tier 1 ratios will put big American institutions at a competitive disadvantage to European rivals.

J.P. Morgan Chase CEO James Dimon recently fired a broadside over that issue. He questioned differences in models other banks use to calculate risk-weighted assets that help determine Tier 1 ratios. A comparison of J.P. Morgan's risk-weighted assets to peers suggests their approach "can't be accurate," Mr. Dimon said at his bank's investor-day conference last month. "I mean, obviously, someone's using far more aggressive models." Although Mr. Dimon didn't single out particular institutions, it appears he was pointing a finger at Europe.

Risk weightings of assets measure the threat of loss posed by different holdings. So, a government bond will receive a lower risk weighting than a "junk" bond. A lower risk weighting for a bank's total assets may allow it to hold less capital. That can help boost returns and profit.

Determining risk weightings relies on complex calculations and judgments. In the U.S., banks calculate them based on an older, restrictive version of international capital standards. European banks use an updated version allowing wider discretion through management's use of internally devised risk models.

The result: Major European banks' risk-weighted assets at the end of the third quarter were about 27% of total assets; at U.S. banks, they were 54%, according to a December report by Goldman Sachs. Some of this may be due to differences in holdings, such as big European banks holding far fewer mortgages. But the difference still is striking, especially given similarities in investment-banking operations.

Risk-weighted assets are likely to rise at both U.S. and European firms in coming years under new standards. But even then, the trans-Atlantic difference may not change much. Goldman's analysts forecast that under new rules, European risk-weighted assets would rise to about 39%, while they would increase to 71% for U.S. banks.

Such figures, along with Mr. Dimon's comments, underscore competitive pressures facing banks as new capital rules take shape. U.S. banks also feel the Dodd-Frank Act requires them to hold more capital than some European rivals.

But the danger mightn't be so much that U.S. banks face competitive constraints as it is that European banks, by using higher leverage, or borrowed money, are courting greater risk.

For investors, the answer is to cast a skeptical eye on regulatory measures of bank strength and weigh them against unadjusted values of assets and equity. As the crisis showed, no matter how fine-tuned, models often can mislead.

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