It’s become fashionable to make fun of the Basel risk-based capital rules for being overly complicated and subject to gamesmanship. “Why should we risk-weight assets at all?” people ask, for some reason. “Just look at simple leverage and assume that all assets are equally risky!” Sure okay. The problems with treating all risks the same seem too self-evident to be worth discussing (though we have!) but on the other hand I challenge you to read Friday’s Basel Regulatory Consistency Assessment Programme report on the “Analysis of risk-weighted assets for credit risk in the banking book” without feeling a bit of sympathy for the simple-leverage crowd.
Not because the report is complicated, particularly? It’s actually pretty straightforward in concept. Basel II and III allow big banks to use the internal ratings-based approach to credit risk, in which the risk-weighting of a bank’s loans,1 and thus the bank’s capital requirements, are determined by the bank applying its own internal models to determine the credit risk of its borrowers. So to calibrate that system, the Baselisks went out and asked a bunch of banks to give them the probability of default that they assigned to a bunch of sovereign, financial, and corporate borrowers. Lo and behold some banks assigned different probabilities of default to some borrowers than others did and so you get somewhat head-scratching charts like this one: Read more »