Some Banks Think Some Borrowers Are Riskier Than Other Banks Think They Are

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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 wehave!) 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:

The point is that some - mainly European, surprise! - banks would have 5-22% lower capital ratios (much higher RWAs) if they used the median credit risk weighting that everyone else did, while other banks would have 10-18% higher capital ratios if they did so. (If you don't see how the chart says that, that's okay. Kate Mackenzie has a good discussion at Alphaville that, among other things, explains that.) So perhaps everyone should be smushed to the median, I guess, I don't know. The report doesn't say that; it just vagues around about harmonization for a while.2

But the report answers none of the interesting questions, which to my mind start with:

  • What is the correlation between (1) a bank's assessed probability of default of Obligor X and (2) that bank's exposure to Obligor X?
  • If it's negative (higher exposure goes with lower PD), what is the causality? Like: Do banks lend more to credits that they think are safer, or do they look at where they lend the most money and say "well I sure hope that's a safe credit"?
  • If it's positive: why are banks lending more to riskier credits than safer ones?3
  • Either way: why is letting banks set their capital requirements based on their own assessment of credit risk a good idea again?

There's a fatal circularity to this project: your lending is constrained by (1) your assessment of credit risk and (2) capital requirements, but if the rules collapse (2) back into (1) what do you have? You have relying on bankers to be good bankers, basically, plus a lot of complicated apparatus.4

The other fun set of unanswered questions in the report is, like:

  • Can you publish a list of all the sovereigns, banks, and corporates who were in this project, and what their mean/median internal-bank-ratings were?
  • And also list their Moody's and S&P ratings alongside, so we can compare?
  • Or at least tell us the companies/countries whose Moody's/S&P ratings differ most dramatically from their lenders' ratings?

I mean, you can see why they didn't do that, this is all very confidential and serious and so forth and everyone would be pissed at everyone else if that list was released. But wouldn't it be fun to know? One reason that internal ratings based risk weighting is a thing is that the alternative is to rely on ratings agencies, and who wants that? Even the ratings agencies don't think you should take their ratings seriously. The banks' internal ratings, on the other hand, represent actual commercial judgments of people with actual money at risk on their credit judgments. I mean, that plus gamesmanship. The individual banks' ratings are obviously divergent, perhaps in part due to gamesmanship. The average ratings, though, may have some meaning to them. Perhaps they could be used for something?5

Regulatory Consistency Assessment Programme (RCAP): Analysis of risk-weighted assets for credit risk in the banking book [BIS]
RWAs, straight outta Basel [FTAV]
Basel Report Finds Diverging Bank Views on Risk [DealBook]

1.This report is about the banking book, i.e. loans, as opposed to the trading book, which produced an earlier and even more amusingBasel report. The loans are less amusing but more important; per Friday's report:

This report presents the results of initial analysis by the Committee of variation in risk weights for credit risk in the banking book across major international banks. The focus on credit risk is important, as it constitutes the largest component of risk-weighted assets (RWAs), and a dominant source of overall variations in RWA at the bank level, accounting for 77% of the observed dispersion. In contrast, market risk (at 11%) and operational risk (at 9%) are less important sources of RWA variability.

2.Too boring for the main text:

The short-term policy options that the Committee will consider include enhanced disclosure, additional guidance, and possible clarifications of the Basel framework. These options could be built on in the on-going work on enhanced disclosure by the Committee’s Working Group on Disclosure, and the RCAP assessment process. The RCAP is dealing with country-specific consistency vis-à-vis the Basel framework, and helping identify potential areas of different interpretation that need clarification or refinement in the regulatory framework. In addition, national supervisors will undertake supervisory follow-up with specific banks.

Over the medium term, the Committee will examine the potential to further harmonise national implementation requirements and to put constraints on IRB parameter estimates. This policy work would also benefit from additional top-down analyses based on better data, such as more granular information on the types of exposures within bank portfolios and information on credit risk mitigation. It may also be valuable to examine how cross-bank differences in RWAs vary over time as banks transition from Basel I to Basel II and then to Basel III.

3.One sensible answer there would be "because the riskier ones pay more" but that raises its own set of interesting but unanswered questions, like, how do the banks' internal credit risk assessments correlate with the actual pricing of their loans? I will guess "not perfectly" is some part of the answer.

4.Kate Mackenzie reminds me that I was fond of this circularity in the trading book. Somehow it feels less troubling there? A lot goes on in the trading book and building some sort of VaR-based risk weighting seems like a sensible addition to what traders already do: banks really have both traders and risk managers. The whole point of the lending book - maybe I oversimplify a bit? - is to maximize the ratio of contractual cash flows to assessed credit risk. Having the double-check on that be, like, assessed credit risk feels weird.

5.An obvious something is the aforementioned "smush every bank's internal ratings down to the average" but then you have the problem that the bank's internal assessment no longer matters for anything except gaming the average, and then you get Libor, basically.