TIME TO WORK OUT REAL ODDS IN THE WEIGHTING GAME / THE FINANCIAL TIMES ( RECOMMENDED READING )

Time to work out real odds in the weighting game

By Patrick Jenkins

Published: May 2 2011 22:39

You don’t get branded a geek any more if you utter the words Basel III capital ratio. Ever since the financial crisis turned the global banking system upside down, the world’s regulators – gathered under the auspices of the Basel Committee on Banking Regulation – have stood centre stage. Just as bankers were considered godlike in the financial boom years, bank regulators are the rock stars of today, and Basel III is their anthem.


The aim of the new rules, due to be introduced gradually by 2019, is laudable enough – to make banks more resistant to future shocks. At their centre is a requirement that banks should hold equity equivalent to 7 per cent of their risk-weighted assets.
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There are some doubters. Their principal worry is that clamping down on the banks will simply push a lot of the riskiest assets that are made uneconomic for banks to hold, into a lightly supervised “shadow” banking system of money market funds and hedge funds.


But what if Basel III doesn’t even resolve the core issues of the banks? On paper, it should. The old rules, Basel II, were far weaker. They forced a bank to hold only $2 of capital for every $100 of risk-weighted assets they held on their books, compared with $7 under Basel III.


Regulators rightly point out, too, that the $7 must normally be unadulterated equity, whereas under the old rules some banks might actually have had as little as $1 of equity, with the rest made up of lower-quality capital.


Regulators also like to stress – again, with some justification – that the denominator of the capital-to-risk weighted asset ratio is tougher under Basel III, too. In other words, the risk weights applied to different assets are heavier.


But RWA changes have only really hit trading assets – particularly the kind of derivatives, such as collateralised debt obligations that allowed the financial crisis to take a grip. Many assets, including the kind of mortgage lending that underpinned many of those CDOs, remain largely unaffected by Basel III.


The justification is that the existing Basel II rules already provided very detailed mechanisms by which to judge the riskiness, and therefore the capital requirements, of individual assets, such as mortgages. While Basel I, the original incarnation of the global capital rule book, prescribed that mortgages, no matter where or what kind, should carry a 50 per cent risk weighting, Basel II allowed banks and their regulators to reflect the fact that a large subprime loan to a road sweeper in Hackney was probably more risky than a small mortgage to a highly paid civil servant living in Hampstead. By using complex formulas to judge the borrower’s “probability of default” and the lender’s “loss given default”, you end up with a far more sophisticated risk weighting.


But judgment can be a shortcoming, too. A test conducted by the UK’s Financial Services Authority on an anonymised sample of 13 banks showed a huge disparity in the key “probability of default” data. On one typical corporate loan, with an A minus credit rating, the most cautious estimate of the risk was 100 times greater than the most bullish. That translated into risk weightings ranging from 30 per cent of the value of the loan to 189 per cent.


Multiply that kind of differential across the loan book and suddenly all the fine efforts of global regulators to set a unified capital standard of 7 per cent look rather hollow. As Andrew Haldane at the Bank of England has said, some reported capital ratios could be “several percentage points” higher than they should be.
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US banks, which have never moved from the Basel I to Basel II, tend to agree. Jamie Dimon, the outspoken chief executive of JPMorgan, says European banks have exploited the subjectivity of the risk weighting system with “aggressive” risk calculations.
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That argument ignores the underlying differences in business models – US banks don’t keep mortgages on their books but offload them to the central agencies, Fannie Mae and Freddie Mac; US banks have vast credit card loan volumes.
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But Simon Samuels and his analyst team at Barclays Capital concluded, nevertheless, in a recent report that from an investor viewpoint the Dimon argument is likely to prevail. Investors distrust European banks’ RWA numbers – a key factor holding back share prices.
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News that regulators, such as FSA chairman Lord Turner, are keen to overhaul the risk weighting system and its subjective judgments is welcome. Tough headline capital ratios are nonsensical otherwise. This isn’t just about fairness or logic. It’s about making regulation worthwhile. Mortgages and corporate loans have been at the root of most financial crises in history. It is about time they were regulated in an objective way that reflected their real risks.

Patrick Jenkins is the FT’s banking
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Copyright The Financial Times Limited 2011.