Aurora Borealis
1 August 2013 CFA Institute Journal Review

Why Markets Do Not Trust Basel II Internal Ratings-Based Approach: What Can Be Done about It? (Digest Summary)

  1. Butt Man-Kit, CFA

The Basel capital adequacy standard is in crisis. Many of the world’s most important banks have not adopted it, whereas those that have are facing rebellion from capital markets that no longer trust risk-weighted assets. A simpler and more transparent approach is supported to regain the trust.

What’s Inside?

Most of the global banking system has grown up under various versions of the Basel capital adequacy regime over the past quarter of a century. Despite its longevity, there is a growing question over Basel’s role as a global framework. Almost eight years after Basel II came into effect, the importance-weighted adoption rates fell to just over 50%. The author first illustrates the extent to which confidence in the Basel framework has collapsed. Second, he examines whether that collapse is fair. Lastly, he considers the options available to the Basel Committee to deal with the problem and regain trust.

How Is This Research Useful to Practitioners?

Basel II offers the internal ratings–based (IRB) approach to banks to weight their assets’ risk exposure with a certain level of discretion. The weighted exposure is called a “risk-weighted asset” (RWA). But a comprehensive survey revealed that investor trust in RWAs is extraordinarily low and that confidence has fallen sharply over the past year.

The author has several explanations for the decrease in confidence. One explanation is that external observers are unable to do their own audit trails on how RWAs are calculated at a bank because the calculations for deriving RWAs are extraordinarily complicated. In addition, although European banks usually have lower RWAs compared with those of U.S. banks, the author argues that such comparisons are actually useless. U.S. banks tend to focus on managing the nominal balance sheet; they thus often prefer subprime loans over prime loans. Therefore, U.S. banks tend to report higher levels of impairment losses than European banks.

Moreover, the size of RWA variations among banks is considered too big by many observers. Investors become skeptical about such results; banks with lower average risk weightings are seen as cheating.

The author discusses the meaningfulness of comparing specific granular portfolios among banks—for example, comparing the risk weighting within AAA loan books between two banks. He shows that the result can be very different depending on differences in collateral or the loans being at different ends of the credit rating spectrum. But the underlying reasons are not observable by investors. The author concludes that the risk weightings appear to be neither comparable between banks nor stable over time.

Finally, when the U.K. Financial Services Authority gave the same hypothetical loan book to 13 European banks and asked them to estimate the probability of default, their estimates had extreme variations. The author concludes that the market is right to doubt RWAs.

To win back investors’ trust, the author suggests that the Basel Committee abandon the IRB regime and replace it with a less complicated, simpler, more transparent RWA regime.

To simplify the calculation, two problems have to be solved. First, investors and regulators may not be comfortable with heavier reliance on credit rating agencies. Second, moving back to a simpler approach might be seen as a loss of credibility for the Basel Committee, so the committee may be reluctant to do so.

Dumbing down the RWA calculation approach is preferred by both investors and regulators. The Basel Committee should create a level playing field for the world’s banking system by simplifying the RWA calculation approach.

How Did the Author Conduct This Research?

The author is a managing director and equity analyst at Barclays. He heads up the equity research team covering the European bank sector and has responsibility for sectorwide thematic research. The raw data of this research are mostly drawn from Barclays research. The data on investors’ thoughts on RWAs are from a survey conducted by Barclays in 2012. The results demonstrate that investors have lost confidence in RWAs.

To investigate whether European banks calculate their RWAs consistently, he uses the banks’ 2011 annual reports; the RWAs varied from more than 30% to more than 70%. The author is thus skeptical regarding the consistency of their RWA calculations.

The author recommends that the Basel Committee dumb down the RWA calculation approach. The solution is supported by both investors and regulators. A survey found that the majority of investors want model discretion removed from banks entirely, with a simpler and more transparent RWA regime used instead. Besides, regulators around the world, such as those in Australia, Sweden, and Switzerland, are beginning to dumb down the complex RWA calculations under the IRB approach by themselves.

Abstractor’s Viewpoint

Investors lose trust in RWAs because the internal ratings are inconsistent, biased, and lack transparency. The author suggests that the Basel Committee replace the IRB approach with the standardized approach, which requires banks to categorize their exposures depending on the equivalent external credit rating.

The external credit rating agencies, however, are also being blamed on similar grounds. Investors have lost confidence in the credibility of the external credit rating. The ultimate solution for regaining investors’ trust is to restore integrity and transparency in the financial industry.

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