Bill Coen, secretary general of the Basel Committee on Banking Supervision, has backed calls for banks’ risk-weighted assets to be audited following the loan classification blunder at a fast-growing U.K. high street challenger bank.
Metro Bank PLC is being investigated by both the Bank of England's Prudential Regulation Authority and the Financial Conduct Authority after it disclosed in January that about 10% of its £14.5 billion loan book had been assigned incorrect risk-weightings.
After correcting its errors, Metro said its risk-weighted assets had risen by £900 million to £8.9 billion and the bank found it was suddenly undercapitalized. In the third quarter of 2018, its core capital ratio stood at 19.1% but after correcting for its mistakes over its assets, it stood at 13.1%. The bank undertook a £375 million equity raising on May 16 as a result.
Coen told S&P Global Market Intelligence: "Although this is not an issue that has yet been discussed at the Basel Committee, I can certainly see the added value of having external auditors provide an additional input into how a bank risk-weights its assets. This builds on existing controls in place, like the bank’s three lines of defense as well as bank supervisory oversight. External audits of risk weights could provide another sensible line of defense."
The Institute for Chartered Accountants in England and Wales said risk-weighting calculations are complex and should be internally audited, and perhaps also by independent examiners.
"Banks and their stakeholders need more confidence in the controls, processes and governance surrounding the calculation. For challenger banks seeking to offer alternatives in the retail banking sector, investor confidence is critical. Demonstrating their key metrics are reliable is vital," said Philippa Kelly, head of financial services at the ICAEW.
The ICAEW came to the same conclusion after it was commissioned by the Prudential Regulation Authority to look at the issue in 2014. However, the Bank of England still does not require banks to audit their risk-weighted assets.
Banks and regulators calculate how risky particular sets of assets are, based on an assessment of the bank’s potential losses. Riskier assets have higher risk weights while low-risk assets, such as central bank deposits or, more controversially, sovereign bonds, can have risk weights as low as zero so a bank does not have to hold any capital against them. Various banking regulators have examined discrepancies in risk-weighting including the Basel committee itself and the European Banking Authority.
Data from the European Banking Authority showed there is considerable variation in the degree of risk assigned to a similar kind of loans under internal models created by the banks themselves, as well as within the standardized models that smaller banks like Metro are often required to use.
Banks using an internal ratings-based model to assess risk reported the maximum risk-weighting attached to corporate loans was 97%, for instance, while the minimum was 22%. Lending in these portfolios to SMEs ranged from 95.4% to 13%. For banks' retail operations, the risk-weighting on loans secured on property ranged from 4% to 41%, including loans to both individuals and to SMEs.
Banks using the standardized model also showed wide variations in risk-weighting for similar types of loans. They ranged from 103% to 6.4% for corporate lending, and 102% to 0% specifically for the SME segment. Retail lending by banks using this model reported risk-weightings of between 77% and 47% overall, and between 76.5% and 5.9% for loans to SMEs specifically.
The Basel Committee has published reforms designed to reduce the variability in risk-weighted assets and to improve comparability of capital ratios among banks. A key component of its measures is the output floor, which sets a floor in capital requirements calculated under internal models at 72.5% of those required by banks using the standardized model. Its aim is to reduce inconsistency in risk-weighted assets that are not justified by risk fundamentals.
The zero risk-weighting assigned to sovereign bonds has long been controversial since it encourages banks to increase their stock of sovereign debt — increasing the risk of a so-called "doom loop." This occurs when weak banks can destabilize their home nation’s government, while governments in trouble can push their banks over the edge.
However, it is politically sensitive within the European Union for regulators to admit that some countries are riskier than others, said analysts.
"There was a realization that formally embedding into bank regulation the notion that some countries in the EU are riskier than others was too political to be addressed solely by regulators," said Sam Theodore, managing director at Scope Ratings.
Indeed, the European Systemic Risk Board has said that "policymakers have not reached consensus on whether and how to reform the regulatory treatment of banks’ sovereign exposures."
A paper from the Center for Economic Policy Research suggested there were large discrepancies in banks’ risk-weighting partly as a result of where the bank was headquartered.
"We find that a large share of risk weight variability can be explained by differences in the underlying risk, but there are statistically significant and economically important differences relating to the country in which the bank is headquartered. This provides evidence that standards are implemented differently from jurisdiction to jurisdiction," Zsofia Doeme and Stefan Kerbl, economists at Oesterreichische Nationalbank, wrote in the paper for the Center.
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