Europe’s great bank balance sheet fiddle

November 23, 2011

By George Hay
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

European banks are about to indulge in some sleight of hand. Though they have been told by regulators to raise 106 billion euros of capital by next summer, that doesn’t mean they will issue that amount of new equity. Lenders are also planning to fiddle with the way they calculate risk-weighted assets (RWAs). They may end up shooting themselves in the foot.

There are three straightforward ways for banks to boost their capital ratios. They can issue equity – but valuations are low and investors wary. They can decide to not renew loans when they mature – but this takes time. And they can sell assets, but this may trigger losses, which could be counter-productive.

There is another approach, however. This is where banks hang onto their assets, but change the way in which they calculate the associated risks. This process is euphemistically known as “RWA optimisation”.

When banks make loans, regulators demand that they set aside a certain amount of capital. But different classes of loans carry differing risks. That is why assets are risk-weighted before calculating capital ratios.

Calculating RWAs is far from straightforward, however. Most small and medium-sized lenders use the so-called “standardised” methodology developed by the Basel Committee and policed by national regulators. A bank’s assets are divided into separate pools and weighted according to their perceived riskiness. These pools are fairly crude: all residential mortgages, for example, carry a 35 percent risk-weighting regardless of quality.

Big banks tend to use a more sophisticated option called the “internal ratings-based” (IRB) approach. In this case, risk-weightings are based on banks’ own analysis of the past performance of their loan portfolios.

For each set of loans, banks estimate a probability of default (PD) and how much of the loan will be written off if it goes bad – the loss given default (LGD). These figures are then used to calculate risk-weighted assets. There are two varieties: “advanced” IRB, where the bank supplies both its PD and LGD, and “foundation” IRB, where the LGD is sourced from a set regulatory scale.

Switching from the standardised method to the IRB approach isn’t easy: a bank must assemble a large risk team and get the regulator’s blessing. But the move can pay off. For example, if a bank can show that its mortgage loans have a lower-than-average probability of default, switching to IRB could shrink its risk-weighted assets – thereby boosting its capital ratio. Italian lender Banco Popolare could boost its core Tier 1 ratio by as much as 100 basis points by switching from the standardised model to IRB, according to a person familiar with the situation.

Banks can also surf between the “foundation” and “advanced” IRB calculations. After it took over HBOS in 2009, Lloyds Banking Group found that its new acquisition used advanced IRB, while Lloyds used the foundation approach. Applying Lloyds’ methodology to the HBOS balance sheet reduced the new group’s RWAs by 34 billion pounds, according to Barclays Capital – boosting the combined bank’s core Tier 1 ratio by 50 basis points.

Strict regulators require lenders to jump through hoops to change their calculating method, and may not allow them to chop and change. But regulators are acutely aware that if banks can’t find new capital, it will have to come from the state. A spot of RWA gerrymandering might be preferable.

Indeed, European regulators have given banks a big leg-up when it comes to sovereign debt. Under the standardised approach, government bonds carry a zero risk-weighting. In theory, banks that switch to the IRB method should apply a more stringent analysis to their sovereign portfolios.

But the European Union’s interpretation allows banks to have their cake and eat it. Using a wheeze called “IRB permanent partial use” EU banks are able to keep a zero risk-weighting for member states’ debt, while applying their own risk calculations to everything else. Basel says this is “not in line with the spirit” of its rules.

There’s nothing intrinsically wrong with banks taking a more sophisticated approach to measuring risk. The problem is that they only have an incentive to do so if it gives them a better capital ratio.

And even if these tactics are legitimate banks may be shooting themselves in the foot. The whole point of boosting capital ratios is to restore the market’s confidence in European banks. If investors think the system is being gamed, they will remain wary.

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