I’ve noted several times in recent months that the Basel Committee on Banking Supervision is slowing turning its weighty turret towards the key secret in Australian banking: its use of internal risk weightings to allocate capital to mortgages.
To cut a long story short, the opaque internal risk models of the banks enable them to heavily discount the amount of capital they are required by Basel to reserve in the event that there’s a problem with defaults. This factor ultimately determines the bank’s leverage and thus the amount it can lend.
Australian banks run opaque models that nobody knows (except maybe APRA but who knows?). And the circumstantial evidence, such as fabulously over-valued housing, rather suggests that the banks are being a tad optimistic in their modelling assumptions, allowing them to lend more and create said over-valuation.
Well, that’s going to change. At least, maybe it is. Basel wants to bring such models into the light and last night it released a new study into how. Firstly, it lays blame for the problem mostly at the feet of regulators:
- A sizeable portion of the variation is due to supervisory decisions applied either to all banks in a jurisdiction, or to individual banks. An example of the former would be policy decisions to restrict modelling options (eg to disallow any diversification benefit between types of risk). An example of the latter would be the application of supervisory multipliers: around one-quarter of the total variation in the hypothetical diversified portfolio could be attributed to this single factor. These supervisory actions typically result in higher capital requirements than would otherwise be the case but can also increase the variation in mRWA between banks, particularly across jurisdictions. These supervisory actions, particularly at an individual bank level, are often not disclosed.
- Another important source of variation is due to modelling choices made by banks. The exercise found that a small number of key modelling choices are the main drivers of the remaining model-driven variability.
Next, it looks at how to make such models transparent:
Common standards for the frequency of reporting – less than half of the banks in the sample reported information on a quarterly basis;
2. Common standards for explanations of the drivers of the change in mRWAs from period to period;
3. A more granular and consistent segmentation of the components of mRWAs to facilitate a deeper recognition of a bank’s market risks;
4. Disclosure of key modelling choices, particularly those highlighted by the hypothetical test portfolio exercise as driving the greatest variation in the results of models; and
5. Disclosure of key differences in models used for internal risk management and those used for regulatory capital calculations. It was found that banks seldom directly report the 10-day 99% VaR used in regulatory capital calculations
And consistent:
Closely defining the modelling approach for the IRC model, including the assumptions used for migration and default probabilities and the correlation structure;
• Reducing the flexibility in choosing the length of historical data to calibrate VaR models; and
• Defining a single scaling approach to obtain a 10-day VaR and sVaR measure.
These areas can be considered in addition to policy options which already form part of the fundamental review of the trading book, namely:
• Strengthening the relationship between standardised approaches and internal models to be able to benchmark internal model results;
• Moving from separate VaR and sVaR based measures to a single Expected Shortfall based measure; and
• Enhancing regulatory oversight through a more granular approval process of internal models.
This is a policy discussion document and is not yet in train for actual rules. But there is every chance it will be.
Which makes me wonder why APRA does not have a representative on the panel doing the study. I don’t know why but it seems a bad idea.
A little bird told me of an asset swap between two banks to give the impression of higher capital ratio…
Lord Varys? j/k
All good stuff, but all stuff the global banking sector is working to fray at the edges and roll back.
The big ones I reckon are these
‘Disclosure of key differences in models used for internal risk management and those used for regulatory capital calculations. It was found that banks seldom directly report the 10-day 99% VaR used in regulatory capital calculations’
and
‘ Strengthening the relationship between standardised approaches and internal models to be able to benchmark internal model results;
• Moving from separate VaR and sVaR based measures to a single Expected Shortfall based measure;’
Ultimately the contemporary banking model is as much about leveraging the margin between regulatory reporting requirements and internal modeling as it is between effective use of deposits to develop returns.
It is also a system which plays heavily in favour of a few large global banks against smaller national players. I once had a large ratings agency regional chief tell me that any application of the the process he was applying to (large state owned) Russian banks would probably find half the banks in Europe insolvent..
Nice King Tiger II
Very interesting.
Do you have a quick table for the current risk weightings vs the proposed?
Nobody knows them, that’s the point.
I’ve seen some tables on the current weightings although I don’t have it to hand.
Yes very interesting indeed – thanks.
The tables you have seen are not the internal risk models…
Ah no – you are right, I was talking about the APRA tables.
My error – sorry.
I would still like to see the current APRA risk weighting tables compared with the proposed Basel III if anyone has it.
Cheers.
Nice one Peter,
Other commenters here take note, when shown that you have made a mistake, acknowledge what the other person has said, clarify your position and continue with the discussion.
If only it was like this all the time …
Pete. A few months back I estimated the big four banks’ risk weightings and capital charges on mortgage lending. Here are the charts:
Average Risk Weights
Average Capital Charge
Bare in mind that the Basel standard is 35% risk-weight (2.8% capital charge) on mortgage lending with an LVR under 80%.
Many thanks Leith.
To answer the final question: because we’re special.
A backgrounder, for those who aren’t fuy across the issue.
http://www.macrobusiness.com.au/2010/11/deep-t-the-capital-rort/
Insolvet
Now there’s a word.
If you’re a big company doing just fine but 25% or more of your customers are trading insolvent/close to 90 days behind in payments and a protion defaults over the amount you can cover as a loss. Does that make you vicariously insolvent, or insolvent by proxy?
Again I feel its the house of cards, you only need for one to slip and you’re screwed and like this credit game the lower in the stack that weak card is the more damage it can do.
Well done on covering this. I see very little on this key topic in the MSM, perhaps understandably, given the MSM’s intimate ties to the RE industry.
Didn’t Basel II allow banks globally the choice between the IRB (internal ratings based approach) and the stanbdardised approach?
Most banks globally went with IRB, just as the 4 majors did.
This sounds very similar to how Banks report “underlying profit” which is profits after ‘adjustments they see fit’…
i.e. Just make up what-ever numbers you want mate!
And what is happening between reporting dates could even more significant.
Markets don’t crash on reporting dates so the question is what are the maximum exposures during any quarter/month and where are the random audits to check them.
I believe there have been instances in banking of balance sheet management at reporting dates and more aggressive positioning between them.
I am glad someone else is catching on to this.
This is from my piece on NAB (but holds true for the Big 4)
RWA density:
RWA density decreased from 61.8% in 2007 to 45.3% in 2011 due to the introduction of Basel II as it deemed residential real estate less risky – risk weight moved from 50% to 35% or IRB approach (the risk weighting used depends on the lender’s historical loss experience). This gives a low number in a country such as Australia where the housing market has been in a boom for decades. Since the largest business for NAB is residential mortgages, this had a big impact on their RWA .
Increase in Riskier Business Activities:
One could argue that a lower RWA density implies a shift to less risky assets but a review of NAB’s business growth contradicts that argument:
- The Current Loan to Value Ratio (CLVR) has increased by 5.6% in the last year alone from 50.2% in March 2011 to 55.8% in March 2012, implying a decrease in quality of new loans.
- Low Document Loans increased to 2.4% in March 2012 from 2.0% in March 2011. “Low Doc” is just another word for sub-prime.
Concentration of Risk:
Rather than diversifying their risk, NAB has continuously shifted their asset mix towards more residential mortgage lending, increasing the weighting of residential mortgages in its loan portfolio from 57.0% in 2007 to 65.1% in 2011 . The second and the third pillar of Basel II clearly fail here as this increase has not raised any concerns.
Total Capital Leverage:
The ratio of NAB’s Total Capital to Total Assets decreased from 6.2% in 2007 to 5.1% in 2011, not a result envisaged by Basel II.
My calculations vary slightly from Leith’s and I arrive at 25% RWA for residential mortgages but I guess that’s “peanuts” and is way beyond the 50% of Basel I or 35% of Basel II (and may I mention that the US has upped their RWA to 100-150% depending on LVR)
Good post, cheers