Risk-Based Capital: The Good, the Bad and Mostly the Ugly

The Basel capital framework categorizes assets by risk level. Safer assets receive lower risk weights than higher risk assets. The sum of the weighted or adjusted assets is then compared to existing capital to determine capital adequacy. Supporters believe risk based capital is a superior measure of bank strength compared to non-risk-adjusted accounting based measures like the leverage ratio. Unfortunately, the facts do not support this belief.

The flaws plaguing risk-based capital are well known: The weights are far from scientific; they are heavily influenced by politics and tradition. The more serious problem, however, is their mechanical attachment to history based on the use of flawed value-at-risk methodology, which confuses history with science. If the future deviates from history, then the resulting risk weights are incorrect. For example, using 25 years of pre-crisis data from the Great Moderation presents a misleadingly low level of mortgage risk. It is like meteorologists without knowledge of storms trying to forecast long-term weather.

Next, risk-based capital fails to recognize that banks do not passively accept regulation – they react to it by adapting their behavior. They will engage in regulatory arbitrage to shrink their capital requirements without trimming actual risk by inappropriately risk-weighting assets. This is made easy by risk-based capital's reliance on bank internal risk models to set lower risk weights. This flexibility allows banks to have vastly different risk weights for the same assets. The gaming of results leads to risk-weighted assets to total asset ratios of less than 60% at many large banks. Furthermore, the ratio is falling as total assets continue to grow faster than RWA. This opacity underlies investor mistrust of big bank balance sheets. No wonder many of them trade at discounts to their breakup values.

The problem will worsen under Basel III's new higher nominal capital requirements for RWA. The higher capital standards increase the incentive to manipulate models to reduce RWA. The lower RWA only appear to make risk disappear while actually creating stealth leverage. The London Whale situation in which the models and inputs were changed to fit the desired low risk weights may be just the start of this development.

Risk standards should be objective, forward looking and do no harm. Risk-based capital fails on all accounts. Worse than ineffectual, risk-based capital serves to increase systemic risk. It causes herding into portfolio concentrations of incorrectly classified low-weighted assets. Next, it breeds overconfidence and a false sense of security by substituting models for judgment. The biggest risks faced are those believed to be mistakenly under control. Finally, risk-based capital is procyclical. Thus, banks appear well capitalized in calm periods. Consequently, they are encouraged to return capital via dividends and share repurchases just as they did in 2007 and 2008, leaving them undercapitalized during the crisis.

The conceit of risk-based capital is it assumes regulators relying on bank models and inputs can predict risk. In reality, the future is uncertain. Substituting a probability distribution for uncertainty does not make us safer. Instead, it can cause a risk misdiagnosis leading to the acceptance of low probability, high-impact adverse events – black swans – which become evident during a crisis.

Probabilities are of limited use when dealing with black swans. A 1% chance of failure does not mean that 99% of the bank survives if it occurs. Prudence trumps prediction when dealing with black swans. Risk-based capital models capture only particular risks. Consequently, they are inferior to less elegant, but more practical simple measures like the leverage test that can serve as an early warning indicator. Thus, the preferred approach is to abandon an overreliance on risk-based capital. Instead, use risk-based capital only as a supplement to a meaningful leverage test, not the inadequate 3% leverage ratio proposed by Basel III. These actions combined with traditional judgment-based safety and soundness supervision would present a more accurate measure of capital adequacy.

Risk-based capital has a weak empirical foundation, which was exposed by the financial crisis. Its supporters need to keep an open mind and address this ugly fact, recognizing that no map is better than a wrong map. Only then can we prevent RWA from standing for Really Wrong Answers.

J.V.Rizzi is a banking industry consultant and investor. He is also an instructor at Loyola University Chicago.