12 February 2011

Risk Weighted Assets -- Tricky Part of Minimum Capital Standards

In the context of higher global minimum capital standards and Basel III there has been lots of talk about the capital quality and required capital levels. In result, on 12 September 2010 the Group of Governors and Heads of Supervision announced the following:
* Introduction of a minimum common equity capital ratio (Core Tier 1 Capital Ratio) and setting it to 4.5% of Risk-Weighted Assets (RWA) by 1 January 2015
* Gradually increasing Tier 1 Capital Ratio from the current 4% to 6% of RWA by 1 January 2015
* Gradually introducing a Capital Conservation Buffer of 2.5% of RWA by 1 January 2019; the Capital Conservation Buffer should consist of equity capital, and thus effectively brings the total Core Tier 1 Capital Ratio up to 7% and Tier 1 Capital Ratio up to 8.5%
* In addition, for countries that experience excessive credit growth, there will be a Countercyclical Buffer of up to 2.5% of RWA (however, normally this buffer is zero)
* Besides, parallel run of non-risk-based Tier 1 Leverage Ratio (Tier 1 Capital divided by total exposure) of 3% was agreed; Leverage Ratio is being considered to be migrated to Pillar 1 in 2018
What has got far too little attention is the calculation of Risk-Weighted Assets, especially in case of credit exposures. This may well be where the devil lies.

Consider the example of Danske Bank Group, which recently released its annual report and risk management report for 2010. The bank has attracted my attention because at 31 December 2010 its Risk-Weighted Assets formed only 26.3% of total assets, and Core Tier 1 Capital divided by total assets was as low as 2.6% (and this despite of the solid reported Core Tier 1 Capital Ratio of 10.1%). For simplicity reason, let’s forget about other risks, and focus to credit risk and major exposure classes (corporate customers, retail exposures secured by real property and other retail exposures) under IRB approach only. In that way we have covered nearly 70% of Danske’s total credit exposure (expressed as EAD).

The table below shows Danske’s credit exposure (EAD) and its calculation of Risk-Weighted Assets for each of the selected exposure classes. From this data we have derived a simple quotient of RWA and EAD (column “RWA/EAD”), which shall answer the question: how many percentages form Risk-Weighted Assets from the total credit exposure in a given exposure class? The quotient is also known as Risk Weight (RW). We see that for regulatory capital purposes the bank needs to take into account 33.8% of its exposure to corporate customers; in case of retail exposures secured by real property this number is 13.0% and in case of other retail exposures 19.7%.

The next table illustrates regulatory capital as a percentage of total credit exposure (EAD) for each of the selected exposure classes (derived as capital requirement times Risk Weight). The respective calculation is done for the different required minimum capital ratios set out in Basel III framework:
1) 4.5% which is the minimum Core Tier 1 Capital requirement,
2) 7% which is the minimum Core Tier 1 Capital requirement plus conservation buffer, and
3) 8.5% which is the minimum Tier 1 Capital requirement plus conservation buffer.
What we see, is that the minimum capital requirement is still very low in Basel III when compared to the total credit exposure – and it’s obvious that this comes from the bank’s calculation of Risk Weighted Assets. I don’t want to rush to conclude that Danske calculates RWA intentionally wrongly, far from it; in fact, everything can well be in line with all the relevant regulations. The root cause may be the Basel formula for deriving Risk Weight from the internally estimated risk parameters such as PD and LGD.  

There is one more thing in the above example that urges to question if Basel III is a sufficiently well considered regulatory reform. Namely: even in case of the Tier 1 Capital Ratio of 8.5%, capital requirement as a percentage of credit exposure is still lower than the proposed Tier 1 Leverage Ratio of 3%. This is not only the case for low risk residential mortgages, but as shown, may also be true for corporate customers. Honestly, it seems a bit strange even for banks with low risk profile. Leverage Ratio and risk-based minimum capital standards appear not to be consistent with each other.

P.S. If you like this post, you may want to read also the related posts:


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