Regulators Cracking Down On Banks Dubious Estimates of Risky Assets

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by David Allen, The International Forecaster:

And, now, 12 years after the Great Recession, one can reasonably argue that depositors and investors shouldn’t have to doubt whether they can trust the way banks measure their financial strength.

Our recent newsletter and blog series focused on illegal, unethical and plain bad decision making by traders and executives’ intent on getting rich quick and making names for themselves at storied – and now infamous – institutions like Deutsche Bank.

The wayward shenanigans began way back in the 1970s and 1980s but really took hold in the years leading up to the start of the financial crisis in 2007.

Besides money laundering, we wrote about two former Deutsche traders who were more recently convicted of manipulating the prices of gold and silver.

And, now, 12 years after the Great Recession, one can reasonably argue that depositors and investors shouldn’t have to doubt whether they can trust the way banks measure their financial strength.

But the reasons for skepticism and outright distrust keep growing, not just here in the U.S. but all across the globe (no, it isn’t flat, just crooked).

The Bank of England suggested last week that some lenders under its regulatory umbrella may be purposely underestimating the riskiness of some types of loans.

Banks that use their own models to make these calculations – typically the bigger, supposedly more sophisticated lenders – assign an average risk weight of 10% on mortgages they issue.

That measure is low compared with historic levels, and it’s a fraction of the 35% risk weight that lenders assign to real-estate borrowings when they use a standard model rather than a customized approach.

Call it a self-serving divergence.

Even for loans that should be of the same quality, lenders are coming up with different risk metrics. Between banks, the figures vary from a 4% to a 17% risk weight, according to the BOE.

With banks sitting on hundreds of billions of pounds of home loans, their judgment on the riskiness of mortgages has huge repercussions on their financial resilience – even more so in the midst of a prolonged pandemic.

In short, the BOE’s concern is a bright red, flashing flag.

Banks in virtually all democratic nations are required to hold a minimum amount of capital against loans, after adjusting for their comparative riskiness.

This method of calculating so-called “risk-weighted assets” is extraordinarily tedious if not outrightly complex. Outsiders, even auditors, generally don’t have the means to question the result.

One consequence of that is that banks can appear safer than they are if their calculations produce a lower risk-weighted number for their assets than a more conservative approach might produce.

But U.K. banks aren’t alone in the unwanted attention their risk models are getting.

Sweden’s Riksbank recently asked the country’s biggest bank, Svenska Handelsbanken, to start using a standard model instead of its own internal version when calculating the risk it takes at its British subsidiary.

That particular portfolio consists mainly of commercial and residential real-estate holdings and accounts for more than 10% of the group’s assets.

As a result of the switch, the 149-year-old Swedish bank’s core capital will take a hit when measured relative to risk-weighted assets:

They’ll be required to take about 1.6 percentage points off June’s 18.7% common-equity Tier 1 ratio.

Even for a bank that claims to be one of the most financially sound in the world, this erosion of its strength isn’t a mere rounding error. Yet, its capital buffers still comfortably exceed the demands of the regulators.

But Handelsbanken’s premium valuation on the stock market is largely a result of its history of conserving capital.

So was Deutsche Bank in the golden years of the last century, and look what’s happened to it.

Riksbank said simply that the time had come to use the same calculation of the U.K. assets’ riskiness at both a subsidiary and group level, and that the move wasn’t meant to be a Brexit-related retaliation.

This isn’t the only instance that methods used for risk weightings have been questioned recently.

Britain’s Metro Bank is also being probed by the BOE for scoring some assets too generously.

And regulators fined Citigroup the equivalent of $57 million in part because its beancounters underestimated risk assets at its U.K. unit.

The good news is that Europe’s banks won’t be able to rely as much in the future on their own “black-box” models for calculating risk.

Tougher rules are poised to be phased in starting in 2023. That could lead to European banks needing 135 billion euros ($159 billion) in fresh capital.

Those reforms alone won’t completely solve the problem, and they’re still two years away.

But right now, there’s a general mood of leniency toward banks because of the global pandemic.

The lenders’ so-called “leverage ratio” – a blunted metric of financial strength that doesn’t account for the riskiness of bank assets – has been temporarily eased.

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