Peston on Banking (2) Risk Weighting

Robert Peston highlights the problems caused by the Basel Accords. Their aim was to standardise capital requirements, so that banks would not be put at a disadvantage, if their local regulations required more capital than their competitors in other countries.

With banks going international, they would be put at a disadvantage if they were compelled to hold more capital than their competitors. So the Americans decided to push for worldwide minimum standards for the amount of capital banks have to hold, relative to their assets, to create a level playing field.

The Basel rules on the capital requirements for banks were formalised in 1988. The outcome was that capital held by banks turned out to be totally inadequate. There were a number of reasons.

• The rules undermined banks sense of institutional responsibility for their lending and for the way they managed their balance sheets. Banking shifted away from being almost exclusively based on an assessment of the credit worthiness of individual customers and moved towards the development of strategies to maximise gross lending subject to the Basel Rules.

• The Basel Rules specified the risk in inherent in different types of loans to different borrowers, eg mortgage versus loans to businesses or loans to government. The regulators distorted the flows of credit to those borrowers in ways that were unexpected and dangerous.

• The Basel Rules introduced two concepts, risk weightings for loans and relative loss absorbency for capital, which proved to be flawed.

• Risk weightings grouped types of loans according to their riskiness, as determined by the Basel Committee. All business loans had a risk weighting of one. Residential mortgages were deemed less risky so they were given a risk weighting of a half. Loans to other banks were given a risk weighting of a fifth, and loans to governments a risk weighting of nil.

• Capital requirements were tied to risk weightings. Banks had to hold capital equal to at least 8 percent of risk-weighted loans. This meant that Banks had to hold $8 for every $100 loaned to a business, but only $4 dollars for every $100 lent on housing mortgages. Only tiny amounts of capital had to be held against loans to other banks. No capital at all had to be held for loans to governments. AAA-rated collateralised debt obligations faced very small capital requirements.

• These weightings gave banks incentives to make loans to the groups that had the lowest capital requirements and the highest returns. These often turned out to be high risk.

• Loans to business were all treated the same, regardless of the size of the business. Big companies did not want to pay high interest rates need to cover the large capital charge, so they tended to bypass the banking system, and sell bonds to investors directly. This made big business dependent on short-term money markets.

• Banks had very strong incentives to channel disproportionate volumes of loans to house buyers.

• The credit rating agencies were given excessive power, because they could determine the capital requirements for many loans.

• Banks were encouraged to use flawed Value at Risk models to determine how much capital they needed to cover the risk of trading losses and their holdings of securities.