Guest Post: Regulators Are Encouraging Banks To Game Risk Models

Tyler Durden's picture

Submitted by Finance Addict

Regulators Are Encouraging Banks To Game Risk Models

Two interesting articles were published yesterday discussing how banks in Europe are resorting to clever tricks that artificially raise their loss-absorbing capital to levels specified by regulators. They’re doing this especially to hit the level of 9% core capital-as-a-percentage of risk-weighted assets that the regulators require as a response to the most recent stress tests. While actually selling loans and exposures would be one way to achieve this so-called “risk-weighted asset optimization”, it looks like many banks are actually just choosing to fiddle around with the internal, self-created risk models that both the current Basel II and the not-so-new-and-improved Basel III regulatory regimes allow them to use. Yes, these regulatory regimes allow the banks to decide, for themselves, how risky their loans are. Which of course then drives how much or how little loss-absorbing capital they must hold. Don’t worry, though, because the regulators approve the models on a yearly basis.

And which banks have taken advantage of this so far?

Reuters reports in Financial Alchemy Foils Capital Rules as Banks Redefine Risk that

“Santander said it planned to increase capital by 4 billion euros by optimizing risk-weighted assets and internal models. BBVA said the total effect of revising its model was expected to be 2.1 billion euros of additional capital.”

I haven’t yet come across an instance of a bank having to increase its count of risk-weighted assets due to its model changes. Funny how it seems to move in one direction only. For example in Fears rise over lenders’ capital tinkering the Financial Times notes that Lloyds has, through a combination of selling and model-tinkering, dropped its 2010 risk-weighted assets by a whopping £16 billion. With the blessing of UK regulators.

And why might the regulators be so approving of such dubious and artificial tactics? Well, sorry to say, we’re in a little bit of a hostage situation at the moment. The banks are reluctant to raise capital on the equity markets because 1) their share prices are already in the toilet and 2) issuing shares to new investors would make current investors unhappy. (Although, probably not as unhappy as if the bank were to collapse for failing to hold enough capital to absorb its losses.) Meanwhile people are deathly afraid that the banks will cut off credit to small business sector. (That is, any more than they already have.) Have a look at what Andrew Haldane of the Bank of England said in a speech yesterday:

 ”‘There is a strong argument for making risk weights dynamic and real-economy focused. At present, they are calibrated to the risk to a bank. In future, they need to reflect returns to society,’ he was quoted as saying.”

And he’s not  a politician, but a regulator. In fact, he is the Executive Director of Financial Stability. And Haldane, in my opinion, generally has the right idea about banks and their risks. Which are risks not just “to themselves” but to all of society and the global economy. Yet here Haldane’s endorsing the sort of sleight of hand that banks are all too ready to perform with no encouragement. Not a good sign.

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GeneMarchbanks's picture

'Banks are in the business of hiding risk' paraphrasing Taleb. Too true. Starts at the top.

Hard1's picture

Boy!, these days is so much cheaper to tweak the risk model than to issue equity.   (Bank CRO that asked us to remain anonymous).


After all the models already weigh Italy, Spain, Portugal, Ireland and France as "risk free assets" and a capital cushion of 2% of face value is required for Greek bonds trading at 35 cents.

Yalperson's picture

Correction: The Financial Alchemy article mentioned is by Bloomberg News, not Reuters.

The Axe's picture

Same old story..if cental banker has your back it doesn't fucking matter.. BAC sold its China stake at a 10% discount, yet neither stock goes down....???

hambone's picture

dollar strengthening, Euro weakening...and this results in a US rally in the face of massive risk??? 

Anybody want to offer under what circumstances this would make sense?

Oil up, gold this the precursor of a total disconnect from ES and Eur/dol pair?  Simply stated, nothing matters any more but printing.  This has the wiff of the onset of hyperinflation...

alien-IQ's picture

"Have you ever stood and stared at
it? Marveled at its
beauty. Its genius. Billions of
people just living out their
lives... oblivious."

Agent Smith

Eally Ucked's picture

The only question is who are they gaming? It must be soverign interests because I don't see too much public interests in it. Is it financial war, who is smarter wins? Brain wars? 

alien-IQ's picture

Fraud is bullish. Didn't you already know that?

El Viejo's picture

Banks have no risk.

Gromit's picture

It's not productive to ask a bank to countenance its own demise.

It's just an association of individuals conspiring to use someone else's money to generate accounting profits which can be distributed in cash as bonuses.

I remember years ago as a retail stockbroker clients would bring in old worthless stock certificates and ask to speak to an official at the company before they would be convinced.

When it's gone it's gone. But no-one will acknowledge this before the fact. After the fact there is no-one to answer the phone.


ebworthen's picture

They are gaming a 9% core-capital-to-risk?


Oh sure, those European banks are just fine...

Nothing To See Here's picture

Why would banks refuse to take risks if they know they are going to be bailed out with public funds? They knew it before 2008 and they were proven right. Nothing changed so far, if only that they now know that the system is ever more dependent on governments implicitly guaranteeing debts.

--End The Fed--

catch edge ghost's picture

It's the Depends economy. Thick absorbent diapers to contain the mess, but they never take off the dirty one.

topcallingtroll's picture

I dont see how anybody, no matter how bullish, can have any faith in bank regulation anymore.

My bullish view relies on most people being so stupid that they cant comprehend this, much less get concerned with it.

The rest of us know it might be an issue someday, but we gotta make money.

willien1derland's picture

The only inference I can interpret from the recent word storms by MSM et al is that the loss profile within the banking system must be PROFOUND; a magnitude which very few have the ability to grasp...Politically it is impossible to address as there is no measure of austerity that could be implemented to offset the loss - That is why governments continue to institute cyclical Keysian solutions; they fail because the diagnosis is wrong...the issues are STRUCTURAL & their magnitude is so great that NO ONE in any position of responsibility is willing to address them materially. By virtue of the trend & choices being taken there will be another catastrophic event that will occur simply by virtue of no constraints to the banksters therefore it is a race to the bottom - negative real interest rates for the EU - an inflated Euro - Negative Real Interest Rates in the US - an inflating USD - Negative Real Interest Rates in Japan - A depreciating Yen...question is when all develop nations take the same tactic at the same time who is the contra-party?

GoldenTool's picture

Gold and oil...


Do unto others

AldoHux_IV's picture

That's bank logic for you: you're damned either way in trying to prevent us from blowing up the real economy.

Downtoolong's picture

So much Blue Smoke you can't even see the Mirrors until you run face first into one.