A SIMPLE way to judge the solidity of a bank is to compare the amount of money it can afford to lose without keeling over to the size and riskiness of its business. After the financial crisis, regulators sensibly worked to boost the first figure: banks now fund their lending less with money they borrow themselves, often from depositors, and more with capital belonging to their shareholders. That was the easy bit. Trying to get to the bottom of how risky banks are, and so how much capital each requires, is now top of regulators’ minds. Beyond further denting the sector’s profits, the outcome of their review threatens to introduce risks of its own.

Although seemingly arcane, the level of capital banks need is central to their profitability—and, they argue, to their ability to finance the real economy. With interest rates close to zero in much of the rich world, borrowed money is cheap for banks, if not virtually free. Shareholder funds, on the other hand, cost them around 10% a year—the return typically demanded by investors for agreeing to bear the first losses in a sector with a tendency to blow up. So the debate between bankers and their watchdogs about how much capital banks need is naturally fiery.

Regulators are fine with safer types of lending being funded by borrowed money. Government bonds are sometimes assumed to be completely safe, and so require no capital to be held against them. For every $1m of residential mortgages, current global benchmarks suggest backing of just $30,000 of capital; the rest can be funded by debt. At the other end of the scale, credit extended to a Kazakh coal mine with a patchy record of repaying its debts, say, will need to be funded with far more shareholder capital. The extra buffer of equity crimps the bank’s margins but reduces the likelihood of a failure or bail-out.

Weigh, blend and shrink

Regulatory models work by looking at all of a bank’s assets (the money a bank expects to recoup from outstanding loans is usually the biggest) and establishing whether they are more akin to safe mortgages or speculative loans. The resulting blended figure, risk-weighted assets, or RWA, has become one of banking’s most important yardsticks. Lowering banks’ RWAs means less equity is required, which usually means higher returns. It is therefore an obsession for bank bosses.

Big banks’ RWAs as a percentage of their assets, known in the jargon as RWA density, has been drifting down. That may be because banks are making safer loans. But regulators have long suspected something fishy may be afoot: that banks are assessing their ropy loans to Kazakh mines as little riskier than residential mortgages.

If that is indeed happening, regulators must partly blame themselves. The models used to gauge the riskiness of a loan book were once provided by regulators, with fixed weightings for categories such as business credit or loans to other banks. But an update to the global regulatory guidelines, known as Basel II and adopted just before the financial crisis, encouraged banks to come up with their own risk models. After all, bankers should know better than bureaucrats how risky any given loan might be. These home-made models have since been used to determine how much capital a bank needs.

The models are often fiendishly complicated, as well as being numerous: the average bank will have dozens, if not hundreds, each dealing with a different type of asset. Though regulators theoretically vet them, it is often hard to detect subtle biases. The ever-declining RWA density suggests bankers are getting savvier about “optimising” their models. Repeated studies have found that putting the same pool of loans and securities through different banks’ formulae lead to wildly different outcomes.

In response, regulators are beginning to reverse themselves, and limit banks’ discretion. The Federal Reserve, for one, has long been sceptical of banks’ in-house risk-weighting efforts. Though American lenders have to meet RWA-based capital requirements just as others do, Fed officials seem to set more store by the fearsome “stress tests” they carry out each year, to assess how banks would be affected by a range of hypothetical setbacks. These tests, beefed up in the aftermath of the crisis, also use risk models, but ones that are devised and run by regulators, not the banks themselves. To prevent gaming, banks are left in the dark as to how the models work.

Few other regulators have the staff for this labour-intensive approach, however. That has left Europe’s, among others, more reliant on banks’ own risk-weightings. So the European Central Bank recently launched an “intrusive review” of the 7,000 RWA models at the 123 banks it oversees, in an attempt to instil more consistency and conservatism. The Basel Committee, a global club of regulators, is also pondering changes to its guidelines.

The idea, in Europe and beyond, is to limit how far banks can adapt their spreadsheets to make their assets look less risky. The benchmark will be a model put together by the Basel Committee, known as the “standardised approach”, which big banks dislike because it usually requires them to hold more capital than internal models. The lenders may still use their own risk-weighting models, but any outcome that makes their assets look far less risky than the standardised approach, which is itself being overhauled, will be rejected.

That may seem like belatedly seizing the keys of the asylum back from the inmates. But shunting banks back onto standardised models is itself fraught with risk. Regulators are just as fallible as bankers: who is to say their industry-wide model is any less flawed than banks’ individual ones? European regulators worry about a “monoculture” in which watchdogs in effect steer lending to favoured types of borrower. The standardised models can themselves be gamed: banks naturally seek to lend to the riskiest borrowers within each weighting category, since they can earn higher profits (by charging higher interest) without incurring extra capital charges.

Analysts at JPMorgan Chase think RWAs at Europe’s 35 biggest banks may swell by nearly €1 trillion ($1.1 trillion), a 10% jump, as a result of the new rules likely to be imposed by the Basel Committee. That will require an extra €137 billion of capital. Many banks will need to cut dividends or scale back lending as a result. “Safe” lending such as mortgages will be particularly badly hit, the bankers claim. Investment banks, accomplished model-fiddlers, are also worried.

Financial lobbyists decry this as the advent of “Basel IV”—a big and intemperate change in the rules of banking and an underhanded way of forcing them to raise yet more capital. It comes on top of other measures which have a similar effect, such as requiring banks to gauge the risk of rising interest rates on their franchise.

Regulators’ attempts to reduce complexity and weed out wilfully distorted risk weightings is welcome. Arguably, however, supplementing risk-weighted capital ratios with a blunt and ungameable “leverage ratio”, which eschews risk-weighting altogether, has already done much of the job. Imposing multiple safeguards may help regulators sleep, but they should remember that no rules are foolproof, and all of them warp incentives.