In the post-crisis clean-up operation, regulators have prodded banks from all directions. Lenders have had to look at the way they pay their staff, how they offer products to clients, and how they manage their funding and liquidity.
But it is capital ratios that regulators and the market have been focusing on with particular interest. The amount of common equity and total capital banks must hold against risk-weighted assets has risen sharply since the onset of the crisis.
Yet in the focus on raising ratios, concerns are mounting that the denominator of the ratio has been waylaid. Regulators and bankers have sweated over the minutiae of what counts as capital in particular, how hybrid securities should be structured and what form subordinated debt may take. Less attention has been focused on how assets are totted up.
The lack of focus has been so extreme that some fear that the risk-weighting process effectively constitutes a rug under which banks can sweep assets out of sight.
"For investors today, banks are the blackest of boxes," Andrew Haldane, executive director for financial stability at the Bank of England said in a speech at the end of August. "One area of conspicuous darkness is banks risk weights."
When the European Banking Authority pushed the continents larger lenders into hitting a 9% core capital ratio by the end of June 2012, risk-weighted asset mitigation was one strategy used by banks to comply.
Around a quarter of the aggregate recapitalisation came from banks using measures which directly targeted reductions in risk-weighted assets. Europes banks added some 9bn of capital to their ratios by moving to advanced risk-weighting models or tweaking ones already in place. That made up around 10% of the total recapitalisation effort.
"Weve been surprised by the way banks have been able to reduce RWAs by changing the parameters of their internal models," says Elie Darwish, senior fixed income research analyst at Natixis. "I guess the overall debate about RWA is going to be a key topic once the ECB is the central regulator for eurozone banks we know that national approaches blur the picture."
Analysts worries over capital ratios emerged with the introduction of Basel II. The framework allows banks to use their own models to risk-weight the assets they hold. Indeed, it incentivises banks to use the internal risk-based method, rewarding them with lower capital requirements.
But with each bank running its own risk models, the weights assigned to apparently similar risks can vary greatly. For example, European banks assign risk-weights to their mortgage portfolios that vary from 7% to 27%, according to an IMF working paper, with the average at 14%.
Those differences do not necessarily mean that some banks are playing the system. But it does make it difficult for investors to clearly understand the risks of any one institution in comparison to another.
"We will need a kind of harmonisation in Europe," says Darwish. "A similar mortgage in France would not be risk-weighted in the same way at, say, Bank A as at Bank B. Does that make sense? Probably not. With Basel III weve done a huge job of improving the quality of the numerator of the common equity ratios. Now the question is the denominator. Clearly we need to be sure that the assets are risk-weighted in the same way, with a conservative approach."
No easy solution
That is not to say that internal risk-weightings should be done away with altogether. Indeed, the standardised approach has come under attack as Europes sovereign debt crisis has unfolded. Under that approach, banks were allowed to assign a zero risk-weight to debt of their own government. In the peak of the sovereign crisis, that simply intensified fears over what was sitting on the balance sheets of banks in peripheral Europe.
"While a more standardised approach may carry the benefit of simplicity, it may not necessarily capture properly the cost of risk and a one-size-fits-all may not lead to greater financial stability," IMF economists Vanessa Le Leslé and Sofiya Avramova said in a working paper on RWAs published in March 2012.
So it could be argued with apologies to Winston Churchill that the internal ratings-based approach is the worst form of bank risk calculation, except all those other forms that have been tried from time to time.
Le Leslé and Avarmova said a solution to worries about risk-weights was more likely to be found in tweaks to the internal risk based approach.
"A better compromise could be to continue to let banks use their internal models to calculate RWAs, but regulators and supervisors would address possible deficiencies and contain excessive bank discretion," they said.
Leverage ratio returns
It is already something regulators are scrutinising. One bank capital specialist says the topic of RWA mitigation and variations between different banks IRB approaches is "very central" to European regulators.
There are several measures in the works to address worries over the usefulness of having a myriad of internal risk-weighting models.
At the most basic level, the introduction of a simple leverage ratio will give a broad indication of the ratio of capital to lending. It is effectively a backstop to risk-weighted models.
The ratio shows the amount of tier one capital which banks hold, as a proportion of their total assets. That will put a brake on risk-weight mitigation getting out of hand, says Romain Brive, from the global structured credit and solutions desk at Natixis.
As well as the leverage ratio, European regulators are considering requiring banks to hold long term wholesale debt and equity equivalent to 10% of total assets. Proposed in the draft of the Crisis Management Directive, it would make banks hold a chunk of bail-inable securities. Similarly to the leverage ratio, this metric would be calculated against total assets, again stripping out any wonky valuations that might arise from the risk weighting process.
"When you look at the leverage ratio and bail-in, both of those regulations are not based on RWA but on the total balance sheet," says Brive. "Its a way to balance RWA for total capital ratios. Even if as a bank youre efficient in managing your RWAs, you still need higher capital for your leverage ratio."
Another approach is to increase transparency over the risk-weights that banks are applying to their assets.
One way to do this is to have lenders apply their risk-weighting models to a single portfolio of assets. The UKs Financial Services Authority ran such an exercise in 2009, asking banks to apply their risk-weights to a hypothetical common portfolio. Difficulties arose because the number of assets that all the banks calculated risk-weights on was minimal.
But revealingly, on the assets that were jointly analysed, the probabilities of default that banks assigned to the same assets varied significantly.
Nevertheless, the FSA concluded that it was satisfied with the risk models used. It said the banks internal ratings-based models were broadly consistent with external data, such as that from rating agencies.
"We do not intend that the IRB process generate identical probabilities of default for the same obligors across firms," the FSA wrote in its summary of the exercise in 2010. "Were this to occur, it might cause systemic risk."
The idea of using a common portfolio from which to compare banks risk-weighting models has since been revived as the world moves towards Basel III. Citis chief executive Vikram Pandit has been one proponent.
Another solution is that banks simply disclose more information about their own risk models.
Basel IIIs three pillar approach allows for this. While pillar one concerns minimum capital ratios, and pillar two allows for closer supervision, pillar three focuses on market discipline. The idea is that, the more investors understand about the risks banks are carrying, the better they can price their investment risks.
"Theyre hoping, rightly, that forcing banks to provide maximum disclosure that allows every analyst to back-solve will improve market discipline and will incentivise banks not to get too aggressive," says a capital specialist.In the wake of the financial crash, those black boxes may soon be opened up.
|Bank strategies: chicken versus egg|
|As Basel III hoves into view, banks have been forced into a bout of soul-searching. The frameworks much higher capital requirements mean that banks have to be sure they are focusing their attention on the right business areas.
It may seem straightforward, then, to focus on the capital-light areas of operation. But not everyone would agree.
In a paper released in mid-2012, PwC said it was "perverse" that banks should begin optimising their portfolio by asking what was the best way of using their stock of capital."Perhaps a more strategically coherent question would be: We see a profitable opportunity to service the needs of abc customers, with xyz products and services, in αβγ ways ... what resources do we need for that?," the consultancy said.
It argued that banks products and services have all evolved out of a customer need, so banks should continue to direct their strategies according to what customers will pay for.
The consultancy also pointed out that margins might be higher in more capital-intense areas of banking operations, simply because more competitors might be leaving those businesses.
An interesting case study could be ahead in the form of the Swedish banks. While most lenders across Europe are focusing on how to reach Basel III capital ratios with minimum disruption to their business models, the Swedish banks could have an opposite problem.
They could be set to see their capital ratios jump if Basel II floors on risk-weighted assets are stripped out."CRD IV says that under certain conditions the floor would disappear if there is a quick implementation of Basel III, which is the case in Sweden," says Elie Darwish, senior fixed income research analyst at Natixis. "This means in theory that Swedish banks for instance would have much higher Basel III common equity tier one ratios than their floored Basel II ratios. The question mark is what will they do with this sudden excess capital some banks will have 16% CET1 ratios by 2015. It will be interesting to see what these Swedish banks do to manage excess capital there will either be a huge increase in lending, or dividend paybacks."