risk weighted assets
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 »
There’s a surprisingly large and vocal group of people who think that capital ratio requirements for large banks should be much higher than they are now (like, 15+%), and that those ratios should be based on total assets rather than any sort of regulatory risk-weighting. It’s surprising not because those are especially bad or counterintuitive ideas, but because who would have guessed a year ago that that would be a thing that people talked about? Good work, Admati & Hellwig.1
- Every U.S. bank would have to have a minimum 10% capital ratio,
- The biggest banks – those with over $400 billion in assets – would have to have up to 15%,
- The ratio is just (Tangible Common Equity) ÷ (Total Assets plus some off-balance-sheet things including lending commitments); i.e. it’s not risk-weighted at all, and
- “the [Federal Deposit Insurance] Corporation, the [Federal Reserve] Board, and the Comptroller [of the Currency] shall be prohibited from any further implementation of [Basel III].”
This feels like it may not be intended all that seriously, but whatever, let’s do the math and see what it gets us. Roughly speaking, it gets us the following:
Bloomberg this week had an article about how bespoke synthetic CDOs are coming back in vogue, and various people have fretted about that, because synthetic CDOs are scary, financial crisis, etc. And, sure, it’s certainly possible that the next financial crisis will be exactly like the last, only with more Cyprus.1 But today let’s talk about something tangentially related.
If you require banks to have capital based on risk-weighted assets, and if capital is expensive (at least for bankers), then you’ll have banks who want to lower the risk weights of their assets. There are many ways to do this, including buying safer assets, selling riskier assets, monkeying with models, etc., but one popular way is to buy credit protection against risky assets. The reason that this is popular is because of regulatory discontinuities: if you have $100 worth of stuff with a 200% risk weight, then you have $200 of risk-weighted assets, but if you buy protection against the riskiest $10 of it then you might go from $200 of risk-weighted assets all the way to $6.30, because the safest $90 of it might have only a 7% risk weight.
That’s a big jump. If your aim is to have capital equal to 12% of your risk-weighted assets, then your capital requirements go from $24 to like 75 cents. If your cost of capital is 10%, then that jump saves you $2.32 a year. So you could pay, say, $2 a year to the protection provider and still be up a few cents, versus not buying credit protection – plus, of course, you’ve got credit protection (meaning that you get more money back if there are defaults). And if you pay $2 a year for five years to protect $10 worth of risk, then the protection provider should do that trade all day long: he’s getting paid $10 to take $10 of risk. At worst – if 10% of your stuff, or for that matter all of your stuff, defaults – he breaks even. It’s free money.
That’s oversimplified (time value, counterparty risk, whatever), but it’s kind of a thing. To some extent that thinking underlies things like the glorious Credit Suisse PAF2 trade, where Credit Suisse basically wrote credit protection to itself because doing so saved it so much on risk-weighted assets. But the folks on the Basel Committee on Banking Supervision don’t particularly like it, and so they released a document today yelling at banks about it. Read more »
Aaahhh I love the Bank of England’s latest Financial Stability Report. I mean: I haven’t read it, per se. But it follows the wonderful official-sector-report layout of blandly apocalyptic text running down the right side and lovely charts running down the left, so you can close one eye and it’s a delight. The charts are a nice mix of (1) visually displaying quantitative information and (2) not:
The gist of the report is, as the Journal puts it:
U.K. banks may be misleading investors over the true state of their financial health, the Bank of England said Thursday, in its starkest warning yet to banks to restore investor confidence and get credit flowing.
“One factor which may make stated levels of capital misleading is under-recognition of expected future losses on loans,” the committee said in the BOE’s twice-yearly Financial Stability Report.Banks may be further overstating their health by making “aggressive” use of risk weights used to determine how much capital different categories of loan require, officials added.
And here’s the bottom-line recommendation: Read more »
A thing you might want is for investors to be able to understand the financial situation of the companies they invest in. Traditionally, that is a thing that many people want, anyway.* Much of our system of corporate finance is dedicated to that and it mostly works okay.
A place where it breaks down a bit is in financial institutions. Because big financial institutions more or less take shareholder money, leverage it 10 or 30 times, and invest it all in a large and ever-changing mix of mark-to-market assets, some of which they mark themselves. Then they tell you things like “our assets have a current expected value of around X, with a daily variance of around Y” and since they’re sporting they also give you some sort of rough breakdown of what classes those assets fall into and stuff. This does not give you precise confidence about what those assets are worth today or what they’ll be worth in a week. And you can’t really find out much granular detail about the assets, because disclosing them all would be a competitive problem and/or just take too long / make your eyes glaze over. If you’re lucky maybe the banks disclose in some useful form actionable information about whatever you’re currently worried about, but you’re probably worried about the wrong things anyway.
So you do the best you can, and rely on external sources, like ratings agencies, who might know more than you, maybe, sometimes, or like Warren Buffett. Or you rely on government oversight to keep your financial institutions more or less solvent. But regulators, too, need some sort of heuristic for figuring out what assets are risky and how risky they are. After all, a big part of their job is regulating those risks, by doing things like setting capital requirements. It turns out that this is hard. So they sometimes outsource that job to ratings agencies. That doesn’t always work. Then they get all “we’re going to stop outsourcing risk regulation to ratings agencies.” That doesn’t always work either.