The Arcane World of Risk Weightings

Recently there has been a lot of discussion about the need to decrease the onerous capital requirements on securitisations as proscribed by Basel 2.5.  Of course it must be said that the voices clamouring for the loosening of the restrictions are the banks and their lobbyists.  That banks and their minions would be working behind the scenes, and in front of them, to try and push through changes which would decrease capital requirements is not in and of itself worrisome.  Lower requirements mean increased leverage means, theoretically, increased profits.

Until something goes wrong.

But that is a topic for another day. 

What I am interested in is why the Swedish central banker, Stefan Ingves, who is head of the Basel Committee on Banking Supervision, is speaking up on the topic in such august forums as the Financial Times, and even more importantly why is he suggesting softening the rules. 

A bank is required to hold a capital reserve of 8% against its "standard risk-weighted" assets. This means, essentially that a bank by definition is

The Basel committee  of which Mr Ingves is head has requested that the world's largest banks actually hold 9.5% capital versus their risk assets which gets the leverage down to 10%. 

This is because Basel is already a bit disturbed by the fact that banks, as is their wont, are constantly redesigning their risk models to achieve the lowest possible capital requirement for their assets, regardless of their riskiness.  Thus, depending on the bank, its national regulators, and the aggressiveness of its management the same portfolio of assets can have quite different capital requirements.

There is even a movement, championed in the editorial pages of the FT on July 10, 2013 suggesting that the somewhat blunt instrument of leverage ratios be instituted regardless of the risk weighting of the assets.  The number being bandied about is 3% which equates to a leverage bordering on 35 times. 

Given that banks, through their use of clever models, and pressure on their regulators have been able to carve out a niche where at the extreme they can avoid all capital requirements a minimum of 3% looks promising from a regulatory and bank solvency point of view relatively speaking.

The editorial goes on to suggest that leverage ratios are not perfect because they encourage lenders to focus on the riskiest assets available thus achieving the highest returns for a set amount of capital.  Hmmm.  Isn't that what banks always do?  It's certainly what they are doing, and, more importantly, what they are being allowed to do, perhaps even encouraged to do, by the Basel Committee in that they are allowed to use their "approved" models.

So, back to my original question, given that the Basel committee is responsible for the security/solvency of the global banking system, why is Mr Ingves opening the door even wider for increased leverage rather than being the bulwark of the system I would hope the Head of the Basel Committee on Banking Supervision.

I don't know.




.