Basel and the Illusion of Capital Strength

In the post-crisis analyses of the financial system, governments and regulators may disagree on the merits of narrow banking or a Tobin-style tax on financial transactions. But all agree that that the crisis exposed an undercapitalized banking sector. Under the reforms of the Basel framework, there will be significant increases in the capital banks are required to hold. However, one of the great ironies of the crisis is that, ahead of its impact, the banking system appeared well-capitalized. Banks were reporting capital ratios well above the minimum levels required under Basel 1. And Basel 2, due to be implemented just as the crisis hit, proposed no overall increase in the level of capital held by the banking sector.

Take, for example, Northern Rock and UBS, two of the banks worst hit by the first phase of the crisis during the second half of 2007. At the end of 2006, Northern Rock reported a Tier 1 ratio of 8.5%, more than twice the regulatory minimum and higher than the 7.7% ratio it reported at the end of 2005. Meanwhile, UBS reported a Tier 1 ratio of 11.9% at the end of 2006, one of the highest in the European banking sector.

Why did banks appear so strongly capitalized? Was there a simple flaw in the Basel approach to the risk-weighting of bank assets that contributed to this illusion of capital strength?

Under Basel, assets are effectively risk-weighted from a 100% ceiling rather than around a 100% mid-point. Few asset categories are weighted more than 100%, with major asset categories (interbank loans, mortgages) risk-weighted at significantly less than 100%. Weighting from a ceiling rather than a mid-point has a crucial effect on asset values and capital ratios. It disconnects the total value of risk-weighted assets (RWAs) from the total unweighted value of bank assets. Crucially, it pushes down the risk-weighted value of assets, so they are significantly lower than unweighted asset values. And this in turn disconnects RWA-based capital ratios (such as the benchmark Tier 1 ratio) from unweighted leverage ratios (for example, equity as a proportion of total balance sheet assets). Risk-weighted capital ratios are significantly higher than capital ratios based on unweighted assets.

In their reporting, banks tended to focus on their ‘strong’ Basel capital ratios rather than the value of their RWAs. Yet the capital ratios only looked strong because the value of RWAs was so much lower than the value of unweighted assets. As a result, investors and regulators lost sight, or failed to realize that strong Basel Tier 1 ratios were compatible with surprisingly low unweighted capital ratios.

Northern Rock and UBS were major players in asset categories – residential mortgages and trading book assets respectively – that were only lightly weighted relative to the 100% ceiling under Basel. As a result, Northern Rock’s RWAs of £30.8 billion at the end of 2006 were less than a third of its balance sheet assets of £101.0 billion. And its Tier 1 ratio of 8.5% at the end of 2006 was more than twice as high as its unweighted leverage ratio (equity-to-balance sheet assets) of 3.2%. The value of UBS’s total balance sheet assets of CHF 2.4 trillion at end 2006 was an astonishing seven times greater than its RWA of CHF 342 billion. As a result, its Tier 1 ratio of 11.9% compared with an unweighted leverage ratio of only 2.1%. UBS’s large and lightly capitalized investment bank trading book appears to be the main factor behind the disconnect. UBS’s large investment banking business accounted for over 80% of its balance sheet.

But this disconnection between the value of risk-weighted and unweighted assets was not limited to the more specialist mortgage or investment banking players. Take, for example, the big five U.K.-based universal banking groups, Barclays, HBOS, HSBC, Lloyds, and RBS. At the end of 2006, only HSBC’s RWAs were valued at more than 50% of its unweighted balance sheet assets. And even in the case of HSBC, the value of its RWAs was only 50.4% of its balance sheet assets. Overall, for the five banks combined, RWAs were valued at only 43% of unweighted balance sheet assets.

Almost everyone agrees that the Basel risk-weightings need to be recalibrated to increase banking sector capital. As part of that reform, the risk-weighting valuation framework should be reconfigured so that 100% becomes a mid-point rather than a ceiling. This would significantly improve transparency by reconnecting the total value of RWAs in the banking system with the unweighted value of those assets.

There also needs to be much better integration of Basel- and IFRS-based comprehensive GAAP. Any currently off-balance sheet assets should be recognized in full in GAAP-based reporting so that there are no opportunities for 'regulatory arbitrage' between GAAP-based reporting and regulatory accounting principles (RAP) under Basel 2.

At the very least, a schedule in the report and accounts should enable RWAs to be articulated with existing GAAP-based balance sheet assets and any off-balance sheet assets. The schedule should include a breakdown by the major risk-weighted asset categories under Basel. A schedule should be incorporated into the main financial statements (not disclosed by way of footnote) that provides a full reconciliation of GAAP-based to RAP-based balance sheets. In particular, there should be a full mapping of currently recognized assets (by class) as reported under GAAP with RAP-based major risk-weighted asset categories. This would better enable analysts, investors, and credit rating agencies to appraise the capital raising potential of banks by permitting them to compare the total value of RWAs with the total unweighted value of assets, and identify the asset categories that explain key differences. And crucially, it would also enable users to more easily compare Basel capital ratios and balance sheet leverage ratios.

Peter Welch, Founder, BankEcon.com and Paul Klumpes, Professor of Accounting, Imperial College Business School

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of Capco or any other party. Capco has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to Shahin Shojai (shahin.shojai@capco.com). Shahin Shojai is the Editor of The Capco Institute journal (www.capco.com).