Capital Arbitrage and BIS Risk Weightings

A recent article on VOX looked at some of the issues with risk weightings for bank regulatory capital under the revised BIS rules.

These rules require that assets with different perceived credit risk are valued differently for the purposes of determining a bank's minimum capital requirement.  Originally, the rules were very basic with assets falling into a small number of categories, with a different weighting assigned to each.  The system has now become much more complex, allowing detailed criteria against which each asset can be assessed.

One issue which has attracted much comment is the fact that banks are allowed to design their own criteria for determining risk weightings, known as the internal ratings based (IRB) approach.  Although the criteria have to be approved by the regulators, it is argued that they are not well placed to second guess the banks.  This is therefore likely to result in weaker criteria than would be designed by an outside party.

Another issue, more relevant to the VOX article, is capital arbitrage.  The problem here is that the actions of banks are not independent of the risk weighting criteria.  To some extent that's fine.  If banks choose to invest in safer assets on the basis that it has a lower capital requirement, then things are operating as intended.  The difficulty is that however detailed the criteria, they are merely a rough approximation of true risk.  There will always be an imperfect match with elements that don't fit well and it's those elements towards which business tends to gyrate.

A good way to illustrate this process is by looking at the world of asset-backed securities and ratings criteria.  When the ratings agents rate corporate borrowers, they assess the different companies as they are and decide the ratings.  Within any particular rating, there will therefore naturally be better and worse borrowers - some who are nearly at the next rating up and some who are barely above the rating below.

In rating asset-backed transactions, the rating agents use a set of criteria to determine what rating to give.  But now the game is different, because the structurer has the ability to design his transaction.  Improving credit risk costs money, so of the structurer's objective is to get away with as little credit enhancement as possible, whilst still achieving the desired rating.  In other words, he is always aiming for the very bottom of the range of credit risk for that rating.  And because the criteria are only really rules of thumb, that can mean a risk that is below what would normally be expected for that rating.

So, a similar issue can arise in banks that are subject to capital requirements based on a set of rules.  One aspect of this that was highly relevant to the financial crisis was the banking book / trading book distinction.  But the problem arises, albeit it in smaller way, even within the normal loan portfolio.  And making the rules more and more granular is unlikely to solve the problem in a practical way.  This is one of the main reasons why alternative capital requirements, such as the Leverage Ratio, are so important.