A boring story of critical Basel risk-weight differentials

After years of negotiations, international banking regulators have finally come up with an apparent finalisation of Basel 3 standards. Warning: this post is going to be quite technical, and clearly not as exciting as topics such as monetary policy. But in order to understand the fundamental weaknesses of the banking system, it is critical to understand the details of its inner mechanical structure. This is where the Devil is, as they say.

The main, and potentially worrying, evolution of the standards is the

aggregate output floor, which will ensure that banks’ risk-weighted assets (RWAs) generated by internal models are no lower than 72.5% of RWAs as calculated by the Basel III framework’s standardised approaches. Banks will also be required to disclose their RWAs based on these standardised approaches.

What does this imply in practice? A while ago, I described the various methods under which banks were allowed to calculate their ‘risk-weighted assets’, which represent the denominator in their regulatory capitalisation formula:

Banks can calculate the risk-weighs they apply to their assets based on a few different methodologies since the introduction of Basel 2 in the years prior to the crisis. Under the ‘Standardised Method’ (which is similar to Basel 1), risk-weights are defined by regulation. Under the ‘Internal Rating Based’ method, banks can calculate their risk-weights based on internal model calculations. Under IRB, models estimate probability of default (PD), loss given default (LGD), and exposure at default (EAD). IRB is subdivided between Foundation IRB (banks only estimate PD while the two other parameters are provided by regulators) and Advanced IRB (banks use their own estimate of those three parameters). Typically, small banks use the Standardised Method, medium-sized banks F-IRB and large banks A-IRB. Basel 2 wasn’t implemented in the US before the crisis and was only progressively implemented in Europe in the few years preceding the crisis.

While Basel 3 did not make any significant change to those methods, at least in the case of credit risk, regulators have argued for years about the possibility of tightening the flexibility given to banks under IRB.

As followers of this blog already know, I view Basel’s RWA concept as one of the most critical factors which triggered the build-up of financial imbalances that led to the financial crisis. In particular Basel 1 – in place until the mid-2000s in the US – only provided fixed risk-weights – and therefore incentives for bankers to optimise their return per unit of equity by investing in asset classes benefiting from low risk-weights (i.e. real estate, securitised products, OECD sovereign exposures…). This in turn distorted the allocation of capital in the economy out of line with the long-term plan of economic actors.

Since the introduction of IRB and internal models by Basel 2, it has been uncertain whether banks using their own models to calculate risk-weights made it more or less likely for misallocations to develop in a systemic manner. There are two opposing views.

On the one hand, more calculations flexibility can give banks the opportunity to reduce the previously artificially-large risk-weight differential between mortgage and business lending for example, thereby reducing the potential for regulatory-induced misallocation and representing a state of affairs closer to what a free market would look like.

On the other hand, there are also instances of banks mostly ‘gaming’ the system with regulators’ support. Those banks usually understand that regulators see real estate/mortgage lending as safer than other types of activities and consequently attempt to push risk-weights on such lending as low as possible. This often succeeds and gains regulatory approval, and it is not a rare sight to see mortgages being risk-weighted around 10% of their balance sheet value (vs. 50% in Basel 1 and 35% in Basel 2’s standardised method). If they do not succeed in lowering risk-weights on business lending by the same margin, this exacerbates the differential between the two types of activities and adds further incentives for banks to grow their real estate lending business at the expense of more productive lending to private corporations.

Now Basel 3 is finally introducing floor to banks’ internal models. The era of the 10% risk-weighted mortgage has come to an end. Once fully applied, asset classes’ risk weights will not be allowed to be lower than 72.5% of the standardised approach value. Unless I am mistaken, this seems to imply a minimum of about 25% for residential mortgages.

Now whether this is good or bad depends on our starting point. If banks, on aggregate, tended to game the system, amplifying the differential vs. the free market, then this floor is likely to reduce the difference between low and high risk-weight asset classes. However, if on aggregate internal models’ flexibility represented an improvement vs. Basel’s rigid calculation methods, then this new approach will tend to deteriorate the capital allocation capabilities of the banking system.

Indeed, the critical concept here is the differential between Basel and the free market. A free market would also take a view as to how much capital a free banking system should maintain against certain types of exposures. While there would be no risk-weight, market actors would have an average view as to the safe level of leverage that free banks should have according to the structure of their balance sheet. In order to simplify this concept of capital requirements in a free market for this post, we can translate this view into a ‘free market risk-weight-equivalent’. Perhaps I’ll write a more elaborate demonstration another time.

So let’s assume a free market in which, on average, mortgages are risk-weighted at 40%, lending to large international firms at 50% and to SMEs at 70%. As this represents a free market ‘equilibrium’, there is no distortion in the allocation of loanable funds. Both corporate and mortgage banks are able to cover their cost of capital at the margin.

Now some newly-designed regulatory framework called, well… Bern (let’s stick to Swiss cities), comes to the conclusion that mortgages should be risk-weighted 50%, and lending to any corporation 100%. While this represents an increase in the case of all types of exposure, the differential between mortgages and corporations is now 50%, whereas it used to be just 10% and 30% under the free market. As a result, bankers whose specialty was corporate lending will have to adjust the structure of their balance sheet if they wish to maintain the same level of profitability. Corporate lending volume is likely to decline as the least profitable lending opportunities at the margin are not renewed as they now do not cover their cost of capital anymore. The outcome of this alteration in risk-weight hierarchy is a reduction in the supply of loanable funds towards the most capital-intensive asset classes. This reduction potentially leads to unused (or ‘excess’) bank reserves released on the interbank market, lowering funding costs and making it possible to profitably extend credit to marginal borrowers within the ‘cheapest’ (from a capital perspective) asset classes.

So this latest Basel reform, good or bad? Existing research is unclear. As I reported in a previous post, researchers found a set of results that seemed to confirm that German banks on aggregate tended to ‘game’ the system using regulatory-validated internal models. However, Germany is a very peculiar and unique banking market and this result may not apply everywhere, and this research doesn’t tell much about the differential described above.

Another research piece published by the BIS showed some confusing results. Among a portfolio of large banks surveyed by the BIS, median risk-weights on mortgages were down to a mere 17%, whereas median SME corporate lending stood at 60% and large corporate lending 47%. Clearly mortgage lending represented the easiest way for banks on aggregate to optimise their RoE, and it does look like the banks surveyed tried to push risk-weights as low as possible in a number of cases.

We could argue that those risk-weights are too low for all those lending categories and therefore endanger the resilience of the banking system. This is indeed possible, but not my point today.

Today, I am not interested in looking at the absolute required amounts of capital that should be held against exposures, but at the relative amounts of capital across types of exposures. I am exclusively focusing on loanable fund allocation within the economic system as a whole. From a systemic point of view, risk-weight differentials matter considerably as explained above.

Basel 1’s risk weight for all corporate exposures stood at 100%, while Basel 2’s were more granular, with 50% for corporations rated between A- and A+, 100% between BBB- and BBB+ and 150% between B- and BB+. This rating spectrum covers the vast majority of small to large companies.

Basel Risk Weight Comparison

Now look at the differentials. The differentials in risk-weight between the Standardised Method and IRB for an average large industrial company rated in the BBB-range and an average SME rated in the BB-range are respectively 53% and 90%. Between mortgages and the same average corporates under IRB? 30% and 43%, whereas it used to be 65% and 115% under the rigid Basel framework. No wonder business lending growth started slowing down to the benefit of real estate lending since the introduction of Basel.

Historical aggregate lending

How will Basel’s ‘output floors’ affect those differentials? Here again it is hard to say. If the asset class differentials seen under IRB represented those that would be prevalent in a free market, then Basel’s new output floor is a big step backwards. My intuition indeed tells me that IRB was an improvement: banks’ balance sheet mostly comprised commercial loans in the past (see chart above and the table below on US banks from C.A. Phillips ‘Banking and the Business Cycle), and it looks highly unlikely that bankers would held two, three or four times more capital against those loans as against mortgages or sovereign exposures. Seen this way, this latest Basel twist is bad news.

CA Phillips_US Banks Balance Sheet 1928-32

PS: while most economists and virtually all politicians are unaware of the potentially devastating effects of their bank capital requirements alchemy, they do understand that lowering risk-weights/capital requirements on some types of exposures has the effect of boosting them.

Politicians’ latest brilliant idea? Lower requirements for ‘climate financing’ “in a bid to boost the green economy and counter climate change.” Perhaps time they looked at the overall picture and start wondering how on Earth real estate markets, securitised products and sovereign debt are so attractive to the financial sector?

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2 responses to “A boring story of critical Basel risk-weight differentials”

  1. intajake says :

    Great post.so it looks like the basel regulatory risk weighted bias towards real estate is exacerbated by these latest regs.which will ultimately set us up for similar sceneario as ’08(gosh a decade now) at some point in the future.It’s a strange regulation-self propelling cycle.A future mortage/real estate bank crisis will no doubt prompt more calls for more regulation to enforce ‘safer bank lending’ which would again inadvertedly bias real estate-further concentating credit allocation.

    Note;Central bank credit control which stipulated directing credit towards SME’s had objectively good and stable outcomes in south east asia.Other more liberal examples would be Germany where local community banks lended towards sme’s(customarily).This promoted local stable growth.I think the direction of bank lending has particular outcomes that we should pay attention to.lending for productive firms which create goods and services is more sustainable than lending for pre-existing real estate lending(mortage).As the latter type of lending can raise asset price which eventually incease debt servicing obligations.Where as the former raises output,creating consumer prices deflation as well as boosting employment.

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