Editor's Note: A version of this post originally appeared in Moody's Investors Service's July 11 Credit Outlook.
Last Friday, the Basel Committee on Banking Supervision reported material inconsistencies in credit risk measurement practices among banks, marring comparability of capital ratios, a credit negative for investors.
The results of the Basel Committee's analysis of risk-weighted assets for credit risk in the banking book makes it clear that investors should not reach conclusions about risk and capital quality based solely on banks' comparative reported risk-based ratios, but instead must consider other quantitative and qualitative factors.
RWAs are a key regulatory measure of the risk of a bank's assets and the measure is used to determine the minimum amount of capital each bank must hold. The RWA calculation involves a host of relatively complex inputs that are not publicly disclosed in detail. Investors have been aware of significant comparability issues underlying banks' reported RWAs for some time. However, owing to the lack of disclosure and complexity of the underlying calculations, it is usually impossible to reliably estimate the magnitude of such differences. The Basel Committee's report provides investors with a benchmark that would not be available from analyzing banks' public disclosures.
The report indicates that underlying differences in the assets' risk composition are responsible for up to three quarters of the variation in average RWAs for credit risk, which the metric is designed to show. This indicates that the metric is functioning reasonably well, but there is room for improvement, since the remaining variation is driven by differences in both supervisory and bank practices. At the supervisory level, these differences result from discretion permitted under the Basel framework or deviation in the national implementation of the Basel standards. At the bank level, the diversity is caused by factors such as differences in credit risk modeling techniques and differing interpretations of the Basel framework.
The diversity in supervisory and bank practices impairs the comparison of banks' RWAs and related capital metrics. In the Basel Committee's study, a hypothetical portfolio of assets was risk-weighted for 32 major international banks according to their respective RWA models. The Basel Committee found that the capital ratios of 22 banks would lie within one percentage point of a 10% risk-based capital ratio benchmark. This is a reasonable level of distortion for what is a complex and subjective metric, and contrasts favorably with the original Basel framework. However the remaining banks were as much as two percentage points above or below the benchmark. Accordingly, in extreme cases, for the same portfolio of assets and the same capital, one bank might report a capital/RWA ratio of 8%, while a peer might report a capital/RWA ratio of 12%. In this example, the first bank would appear to be significantly weaker than the second a false conclusion.
The sovereign asset class showed the greatest variation in treatment among the banks the Basel Committee reviewed. The report indicated that there were generally no significant notable or distinctive regional patterns in the results, with the exception that North American banks generally had above-average risk weights.
The divergence in results caused solely by different credit risk measurement practices could in some cases create a material difference in perceived risk. Unfortunately, the opacity of the underlying calculations and disclosures usually make it impossible for investors to distinguish differences in credit risk from differences in measurement practices.
The preliminary short-term policy options to deal with the diversity in practices outlined in the report include enhanced disclosure, additional guidance and possible clarification of the rules. The report also noted that national supervisors would undertake supervisory follow-up with certain banks. Longer term, the committee may examine the potential for further international harmonization of the rules and may limit the flexibility of banks' credit risk modeling techniques.
Donald Robertson is a vice president and senior credit officer with Moody's Investors Service.