Basel Committee Tries to Address Discrepancies in Bank Capital Ratios

By Francesco Ninfole

Which banks are best-capitalized? The answer is not that easy, if Basel III risk-based capital ratios are the only thing looked at. It depends a lot on what is observed. The European asset quality review and stress tests performed by the European Central Bank have been another proof in this sense. The final results could be misleading for some banks, especially those with a credit-oriented business model.

The ECB has adopted the capital definition in the European directive CRD IV, which says the reference ratio to identify banks with capital shortfalls is the so-called CET 1 (common equity tier 1). This risk-based ratio means that capital (in absolute terms) is compared to risk-weighted assets (RWA). The problem is that weightings differ a lot from bank to bank and from country to country, as there is no one standard model. For German and French banks, RWAs are 25% of total assets, while for Italian and Spanish ones RWAs are about 45%.

Risk-weighted assets are the denominator in the CET 1 ratio. The lower the RWAs, the higher the ratio. The principle here is that each asset has a different risk, and the capital required to cover that risk is also different. It sounds reasonable. But in practice banks used weightings in their internal models for evaluating risks to look better-capitalized without strengthening their balance sheets. This favors investment banks instead of commercial banks.

On November 12 the Basel Committee on Banking Supervision confirmed that “there are material variances in banks’ regulatory capital ratios that arise from factors other than differences in the riskiness of banks’ portfolios.” These variances “undermine confidence in capital ratios.” In response, the committee initiated a number of policy and supervisory actions to address the excessive variability in risk-weighted assets that is the result of the banks’ internal models. The modifications under consideration will narrow the modeling choices available and will increase consistency.

But for now banking regulation continues to rely on the risk-based ratio. That is one of the reasons German and French banks (more investment-oriented) looked so solid in the ECB assessment relative to some of their European peers. How would results have differed if the ECB had used an unweighted ratio, like the leverage ratio, which compares capital to total assets? The differences could have been huge. Nine Italian banks failed the test based on risk-weighted ratios at end of 2013—they came out the weakest in Europe. But Italian banks have better leverage ratios than average: Intesa Sanpaolo above 6%, Mediobanca, Banca Popolare di Milano, Banca popolare dell’Emiglia Romagno and UBI Banca above 5%, UniCredit at 4.6%. On the opposite end, a lot of big European banks (Crédit Agricole, BNP Paribas, SocGen, KBC Bank, ING and Deutsche Bank) were below 4%.

For a complete understanding of the ECB assessment, it is not enough to look only at leverage ratios. It is also necessary to consider the capital measures launched this year, national conditions of the stress test and transitional adjustments (which differ for every country). But capital ratios will continue to be risk-based until at least 2018. This leads to potential misunderstanding of banks’ robustness and also to disincentives to credit-oriented business models.

* Francesco Ninfole is a banking reporter for MF – Milano Finanza