Basel risk weights can’t be trusted

Capital adequacy and the financial meltdown

The financial meltdown that were only available in 2007 illustrates that capital-adequacy rules have didn’t make sure that banks’ capital holdings are based on the riskiness of their assets. That is true despite numerous refinements and revisions during the last 2 decades (Goldstein 2012). From the onset of the financial meltdown, fears that banks hold insufficient capital have critically undermined the functioning of interbank markets. When banks aren’t at the mercy of regulatory capital requirements commensurate with their portfolio risk, bank solvency may very well be threatened by adverse shocks to the worthiness of bank asset portfolios.

The Basel Accord of 1988 introduced minimum capital standards as a set proportion of the chance exposure of a bank, as measured by risk-weighted assets. Generally in most countries, the minimum capital requirement is 8% of risk-weighted assets. Underlying Basel may be the notion that the chance weights assigned to each asset class reflect the associated economic risks. Thus, an integral question is whether this regulatory way of measuring bank portfolio risk is reflective of the real portfolio threat of a bank. If not, banks will attempt to game the machine by buying risky assets which maximise returns while reducing capital requirements. Some commentators have long argued that is actually the case.

The problem with the Basel risk-weighting system

Banks’ capability to game the machine is nicely illustrated by Figure 1. The graph shows the worthiness of total assets, risk-weighted assets, and the proportion of risk-weighted assets to total assets of the world’s largest 124 banks. The proportion of risk-weighted assets to total assets has been falling steadily since 2000. One method of interpreting that is that banks have grown to be progressively less risky as time passes. A different interpretation is that banks have increasingly gamed the Basel rules, leading to lower risk-weighted assets – and therefore lower capital requirements – but probably believe it or not risk.

Figure 1 . The decline of risk-weighted assets to total assets

How risk sensitive are Basel capital requirements?

In a recently available study (Vallascas and Hagendorff 2013), we analyse precisely how risk sensitive the Basel capital requirements for banks are really. We examine the chance sensitivity of capital requirements for a global sample of large banks between 2000 and 2010. We demonstrate that capital requirements are just loosely related to market way of measuring the portfolio threat of banks. Due to this weak risk calibration, even pronounced increases in portfolio risk generate almost negligible increases in capital requirements. To illustrate this, we show that whenever the market way of measuring portfolio risk increases nearly threefold (from 2.1% to 6.2%), the common bank inside our sample faces additional capital requirements of 0.78 percentage points (assuming capital requirements of 8% of risk-weighted assets).

Modifications to the initial Basel Accord (Basel II) were made to improve the sensitivity of capital requirements to bank portfolio risk via the introduction of more granular risk weights. Our study implies that, in lots of ways, Basel II has made things worse regarding the risk-sensitivity of capital requirements. Under Basel II, banks display only a marginal improvement in the chance sensitivity of their capital requirements. Most of all, however, the inner ratings-based approach under Basel II has introduced asymmetric risk elasticities for low- and high-risk bank portfolios. While banks with low-risk portfolios reduce their capital requirements when adopting the inner ratings-based approach, banks with high-risk portfolios aren’t required to hold a lot more capital. Therefore that banks with the riskiest asset portfolios are particularly vulnerable to holding insufficient capital under Basel II.

Overall, our results clearly show that the chance sensitivity of capital requirements is quite weak and that has undesirable consequences. First, we show the administrative centre buffers that banks typically hold above regulatory requirements partly derive from capital arbitrage. Which means that banks with higher capital buffers report small amounts of risk-weighted assets per unit of assets for confirmed degree of portfolio risk. Consequently, banks could be undercapitalised regardless of holding capital well above the minimum regulatory requirements. Second, we show that capital arbitrage diminishes banks’ capability to withstand adverse shocks. We show that banks that increased their capital buffers markedly during 2008 and 2009 and did so relying at least partly on government support displayed an especially low risk sensitivity of their capital requirements between 2000 and 2007.

The implications for Basel III

Our results raise doubts over if the revisions to capital requirements which are in the processes to be implemented will be sufficient to make sure that banks hold capital consistent with their portfolio risk. The Basel III revisions are made to increase both quantity and quality of minimum capital holdings by further enhancing the chance sensitivity of capital requirements. In regards to increases in risk-weighted assets in accordance with Basel II, the Basel Committee (2011: 31) reports that “a 1.23 factor is a rough approximation predicated on the average upsurge in [risk-weighted assets] linked to the enhancements to risk coverage in Basel 3 in accordance with Basel 2”. However, so long as the regulatory idea of risk exposure underlying the computation of risk-weighted assets remains only weakly linked to risk, the proposed increases in capital requirements are unlikely to align capital holdings with the effective riskiness of bank asset portfolios. The chance sensitivity of capital requirements we report is of such a minimal magnitude that people question whether Basel III will enhance the relationship between capital requirements and risk within an economically meaningful way. The projected upsurge in risk-weighted assets under Basel III shows that – even under the very least capital ratio of 13% – banks inside our sample will only be asked to hold, normally, 1.94% of additional capital per unit of assets. This increase is unlikely to create minimum capital requirements more reflective of bank portfolio risk within an economically meaningful way.

Our findings support a more profound overhaul of capital adequacy rules than currently proposed. Consistent with our findings, Admati and Hellwig (2013) demand a rise in capital requirements (predicated on unweighted assets) well into double-digit territory to boost the safety of the economic climate. Naturally, concerns over bank lending implies that the phasing-in of higher capital requirements should be carefully managed by policymakers (Calamoris 2013) and complemented by tight and efficient supervision that minimises banks’ capability to game the machine. However, it really is equally clear that the risk-sensitivity of the Basel capital adequacy framework is inadequate, and attempts by Basel III to moderately enhance the risk sensitivity of capital requirements will never be able to address this problem.

References

Admati, Anat and Martin Hellwig (2013), The Bankers’ New Clothes: What’s Wrong With Banking and How to proceed about any of it?, Princeton University Press.

Basel Committee on Banking Supervision (2011), “Basel III: a worldwide regulatory framework for more resilient banks and banking systems”, Bank for International Settlements.

Vallascas, F and J Hagendorff (2013), “THE CHANCE Sensitivity of Capital Requirements: Evidence from a global Sample of Large Banks”, Overview of Finance, 17: 1947-1988.

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