In case anybody still doubted that RWAs affect banks’ lending allocation…

Just a very very quick post tonight.

Our business is constrained by the capital we have available to cover risk-weighted assets (RWA) resulting from the risks in our business, by the size of our on- and off-balance sheet assets through their contribution to leverage ratio requirements and regulatory liquidity ratios, and by our risk appetite. Together, these constraints create a close link between our strategy, the risks that our businesses take and the balance sheet and capital resources that we have available to absorb those risks. As described in “Equity attribution framework” in the “Capital management” section of this report, our equity attribution framework reflects our objectives of maintaining a strong capital base and guiding businesses towards activities that appropriately balance profit potential, risk, balance sheet and capital usage.

Where does this come from? The 2013 annual report of UBS, the largest Swiss bank (page 150).

How banks are incentivised by Basel’s risk-weighted assets is clear. What provides has a low capital treatment (= low RWA), has relatively low default risk, is highly collateralised, even though it doesn’t bring in much interest income? Yep, mortgages (as well as some tranches of securitised products such as RMBSs, and sovereign debt).

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3 responses to “In case anybody still doubted that RWAs affect banks’ lending allocation…”

  1. Justin Merrill says :

    Julien, don’t forget that (if memory serves me correctly) RMBS had a more favorable risk weighting than residential loans. This clearly incentivized securitization; which means originators selling off their loans to buy back rMBS. This creates less “skin in the game” and information asymmetry because they will keep the best mortgages and sell the junk.

    • Julien Noizet says :

      Justin, I agree. I actually mentioned that fact in previous posts.
      Banks can either keep the loans or securitize and sell them, often to… other banks. So banks were incentivised to purchase RMBSs rather than originate and maintain a mortgage book because of the better capital treatment, that’s for sure. And Basel 3 pretty much changes nothing about that.

      However, in practice, even pre-crisis, RMBSs remained a small share of banks’ balance sheet. Most of banks’ assets remained actual mortgages they had originated. Operationally it’s hard to securitize all the loans you originated, sell them on, then replace them entirely by purchasing RMBSs structured from loans originated by competitors!

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