At the heart of global bank regulatory capital standards, known as The Basel Accord, is the idea that since assets represent a diversity of risk, each should be risk weighted differently. Numerous bank regulators and bank reform advocates in the last few years have become increasingly vocal in their displeasure about this framework. Every time that the Basel Committee for Banking Supervision comments on risk weighted assets (RWAs), market participants try to read the tea leaves to see if the Basel Committee will issue guidelines that would restrict the existing flexibility that exists in how market participants come up with many of the inputs for the regulatory capital calculation.
Until the Basel Committee finds a compromise between proscriptive risk measurement methodologies and those that are flexible, banks are currently extremely focused on optimizing their RWAs in the hopes of some regulatory capital relief. In almost fifteen years of working with banks and regulators on Basel I – III, I have observed a variety of ways that banks optimize their RWAs with varying degrees of success.
Irrespective of a bank’s size a good place to start is the banking book. Since those assets will carry a full RWA, this is an area where banks should focus on having high quality and reliable data to calculate probabilities of default and loss severities. If the data are questionable, this should be a red flag for risk managers, auditors, and bank regulators about the validity of regulatory capital calculations. Also imperative is documenting whatever high quality and liquid collateral is being used for loans or derivatives, since this will help banks reduce regulatory capital.
More aggressive in optimizing regulatory capital is to reduce the maturities of portfolios and to reduce positions in illiquid assets that result in higher RWAs. This action may impact a bank’s earning adversely, but in the longer run will be advantageous in complying with regulatory capital rules. Also, illiquid assets do not help banks meet new liquidity standards which demand high quality liquid assets.
The next place to look for capital savings is in the trading book. Products such as structured credit, project finance, and securities and derivatives trading can have significant credit risk. The Basel Committee is focusing on making sure that banks properly calculate RWAs for the trading book, since it traditionally has had lighter capital treatment than the banking book. During the crisis, banks found themselves undercapitalized when numerous assets booked in the trading book were simultaneously declining in credit quality or becoming illiquid.
A category where it is definitely worthwhile for large banks to spend time exploring is in the area of derivatives. By requiring collateral from counterparties in OTC derivatives or having trades clear through derivatives clearing organizations, banks can reduce their credit risk, which can provide capital relief. Netting derivatives transactions and compression are also ways for banks to reduce their RWAs.
To the chagrin of financial reformers, Basel guidance leave significant room for banks to optimize the credit conversion factors (CCF) computation for multi-product, multi-counterparty facilities relying on mathematical models and accurate description of the facilities and sub-facilities structures. As long as banks can document the quality and reliability of data going into CCF calculations, this can help their optimization strategies.
Challenges to RWA Optimization
While numerous banks in the US and Europe have programs in place to optimize RWAs, they are from being fully implemented. Hence, there is more scope for regulatory capital relief. According to McKinsey and Company’s report ‘Capital Management Banking’s New Imperative, 85% of banks say they have programs to optimize RWAs and have seen savings 5-15% through optimization. Yet, most optimization programs are often falling behind schedule, not managed across the entire bank uniformly, and are not well integrated with liquidity and leverage ratios.
Challenges in implementing RWA optimization programs are usually about data collection and making changes in systems to collect the data to the level of granularity desired by regulators. There can be very significant RWAs across sovereign, bank, corporate, retail, and equity portfolios. Analysis performed by the Basel Committee has demonstrated that retail and corporate exposures are the main component of credit RWAs for banking portfolios due to their higher risk weights versus other asset classes such as sovereign bonds.
If a bank does not have internal data than it will struggle to be allowed to use advanced models and to justify to bank regulators that it should have lighter capital requirements. As Moody’s Analytics points out in its, ‘Capital Ratio Optimization for Basel III,’ report, the calculation of exposure at default (EAD) for undrawn facilities may represent a substantial challenge for those institutions without relevant credit history or appropriate behavioral models in retail credit facilities such as credit cards.
Although Basel III represents is a uniform global capital framework, there are significant changes when it is adopted into law by each member country. For examples, rules to risk weight residential mortgages in the standardized approach are usually specific per local country regulation. Another important difference is that non-US banks in their countries can use of external ratings to assess collateral eligibilities and haircuts or to derive risk weights. In the US, due to Dodd-Frank Act, regulators have introduced an an alternative Simplified Supervisory Formula Approach (SSFA) to the Internal Ratings Based approach to risk weight securitization products. Having to implement this new approach will be challenging since banks were used to relying on credit rating for securitization. Special attention will have to be given to the data inputs and calculations for the SSFA.
Optimization can Improve Risk Management
Before creating RWA optimization strategies or reassessing existing ones, banks should assess very carefully whether they have the right staff and technology to implement programs successfully. Boards of Directors and senior management have to be ready to dedicate high level human resources throughout risk management, audit, and compliance to make optimization work.
Optimization does not mean manipulating data or refusing to comply with bank regulations. If banks’ senior executives take optimization programs seriously, they can do a lot to dramatically improve risk management and be adequately capitalized to survive unexpected losses.