Bank capital requirements: Risk weights you cannot trust and the implications for Basel III

Jens Hagendorff, Francesco Vallascas

Recent research shows that capital requirements are only loosely related to a market measure of bank portfolio risk. Changes introduced under Basel II meant that banks with the riskiest portfolios were particularly likely to hold insufficient capital. Banks that relied on government support during the crisis appeared to be well-capitalised beforehand, suggesting they engaged in capital arbitrage. Until the regulatory concept of risk better reflects actual risk, the proposed increases in risk-weighted capital requirements under Basel III will have little effect.

One of the primary purposes of bank capital is to absorb losses. Where bank capital holdings are insufficient to absorb losses, banks will either fail or – if bank failure is deemed too costly for the economy – be bailed out. In practice, banks frequently receive public funds where capital holdings are insufficient to cover losses in order to prevent bank failure. Whether or not bank capital holdings are sufficient and in line with the risk of bank portfolios is therefore an important question that is hotly debated among policymakers and in the press.

Capital adequacy and the financial crisis

The financial crisis that started in 2007 illustrates that capital-adequacy rules have failed to ensure that banks’ capital holdings are in line with the riskiness of their assets. This is true despite numerous refinements and revisions over the last two decades (Goldstein 2012). From the onset of the financial crisis, fears that banks hold insufficient capital have critically undermined the functioning of interbank markets. When banks are not subject to regulatory capital requirements commensurate with their portfolio risk, bank solvency is likely to be threatened by adverse shocks to the value of bank asset portfolios.

The Basel Accord of 1988 introduced minimum capital standards as a fixed proportion of the risk exposure of a bank, as measured by risk-weighted assets. In most countries, the minimum capital requirement is 8% of risk-weighted assets. Underlying Basel is the notion that the risk weights assigned to each asset class reflect the associated economic risks. Thus, a key question is whether this regulatory measure of bank portfolio risk is reflective of the true portfolio risk of a bank. If not, banks will try to game the system by investing in risky assets which maximise returns while reducing capital requirements. Some commentators have long argued that this is in fact the case.

The problem with the Basel risk-weighting system

Banks’ ability to game the system is nicely illustrated by Figure 1. The graph shows the value of total assets, risk-weighted assets, and the proportion of risk-weighted assets to total assets of the world’s largest 124 banks. The proportion of risk-weighted assets to total assets has been falling steadily since 2000. One way of interpreting this is that banks have become progressively less risky over time. A different interpretation is that banks have increasingly gamed the Basel rules, resulting in lower risk-weighted assets – and thus lower capital requirements – but probably no less risk.

Figure 1. The decline of risk-weighted assets to total assets

How risk sensitive are Basel capital requirements?

In a recent study (Vallascas and Hagendorff 2013), we analyse just how risk sensitive the Basel capital requirements for banks really are. We examine the risk sensitivity of capital requirements for an international sample of large banks between 2000 and 2010. We demonstrate that capital requirements are only loosely related to a market measure of the portfolio risk of banks. Owing to this weak risk calibration, even pronounced increases in portfolio risk generate almost negligible increases in capital requirements. To illustrate this, we show that when the market measure of portfolio risk increases nearly threefold (from 2.1% to 6.2%), the average bank in our sample faces additional capital requirements of 0.78 percentage points (assuming capital requirements of 8% of risk-weighted assets).

Modifications to the original Basel Accord (Basel II) were designed to enhance the sensitivity of capital requirements to bank portfolio risk via the introduction of more granular risk weights. Our study shows that, in many ways, Basel II has made things worse in terms of the risk-sensitivity of capital requirements. Under Basel II, banks display only a marginal improvement in the risk sensitivity of their capital requirements. Most importantly, however, the internal ratings-based approach under Basel II has introduced asymmetric risk elasticities for low- and high-risk bank portfolios. While banks with low-risk portfolios reduce their capital requirements when adopting the internal ratings-based approach, banks with high-risk portfolios are not required to hold significantly more capital. This implies that banks with the riskiest asset portfolios are particularly at risk of holding insufficient capital under Basel II.

Overall, our results clearly show that the risk sensitivity of capital requirements is very weak and that this has undesirable consequences. First, we show the capital buffers that banks typically hold above regulatory requirements partly result from capital arbitrage. This means that banks with higher capital buffers report lower amounts of risk-weighted assets per unit of assets for a given level of portfolio risk. As a result, banks may be undercapitalised in spite of holding capital well above the minimum regulatory requirements. Second, we show that capital arbitrage diminishes banks’ ability to withstand adverse shocks. We show that banks that increased their capital buffers markedly during 2008 and 2009 and did so relying at least in part on government support displayed a particularly low risk sensitivity of their capital requirements between 2000 and 2007.

The implications for Basel III

Our results raise doubts over whether the revisions to capital requirements which are in the processes of being implemented will be sufficient to ensure that banks hold capital in line with their portfolio risk. The Basel III revisions are designed to increase both the quantity and quality of minimum capital holdings by further enhancing the risk sensitivity of capital requirements. As regards increases in risk-weighted assets relative to Basel II, the Basel Committee (2011: 31) reports that “a 1.23 factor is a rough approximation based on the average increase in [risk-weighted assets] associated with the enhancements to risk coverage in Basel 3 relative to Basel 2”. However, as long as the regulatory concept of risk exposure underlying the computation of risk-weighted assets remains only weakly related to risk, the proposed increases in capital requirements are unlikely to align capital holdings with the effective riskiness of bank asset portfolios. The risk sensitivity of capital requirements we report is of such a low magnitude that we question whether Basel III will improve the relationship between capital requirements and risk in an economically meaningful way. The projected increase in risk-weighted assets under Basel III suggests that – even under a minimum capital ratio of 13% – banks in our sample will only be required to hold, on average, 1.94% of additional capital per unit of assets. Such an increase is unlikely to make minimum capital requirements more reflective of bank portfolio risk in an economically meaningful way.

Our findings support a much more profound overhaul of capital adequacy rules than currently proposed. In line with our findings, Admati and Hellwig (2013) call for an increase in capital requirements (based on unweighted assets) well into double-digit territory to improve the safety of the financial system. Naturally, concerns over bank lending means that the phasing-in of higher capital requirements will have to be carefully managed by policymakers (Calamoris 2013) and complemented by tight and efficient supervision that minimises banks’ ability to game the system. However, it is equally clear that the risk-sensitivity of the Basel capital adequacy framework is inadequate, and attempts by Basel III to moderately improve the risk sensitivity of capital requirements will not be able to address this issue.

References

Admati, Anat and Martin Hellwig (2013), The Bankers’ New Clothes: What’s Wrong With Banking and What to Do about it?, Princeton University Press.

Basel Committee on Banking Supervision (2011), “Basel III: a global regulatory framework for more resilient banks and banking systems”, Bank for International Settlements.

Calomiris, Charles (2013), “Is a 25% bank equity requirement really a no-brainer?”, VoxEU.org, 28 Nov.

Goldstein, Morris (2012), “The EU’s implementation of Basel III: A deeply flawed compromise”, VoxEU.org, 27 May.

Vallascas, F and J Hagendorff (2013), “The Risk Sensitivity of Capital Requirements: Evidence from an International Sample of Large Banks”, Review of Finance, 17: 1947–1988.