Risk-Weighting – How to Fake up Resilience in a Banking System

Introduction

How resilient is the global banking system? Are banks’ capital buffers now much larger than they were going into the Global Financial Crisis of 2007/8, as authorities claim?

The buffers – called ‘Common Equity Tier 1’ (or CET1), ‘Tier 1 Capital’,¹ and ‘Total Capital’² – stand at impressive percentages of something, and show significant surpluses over their minimum values.

Yet banks claiming such surpluses run into trouble. Silicon Valley Bank issued a bullish Mid-Quarter-Update on Wednesday 8^th March 2023: slide 14 claimed a ‘Common Equity Tier 1 Ratio’ of 12.21% against a ‘regulatory minimum’ of 7%, a ‘Tier 1 Capital Ratio’ of 15.62% (minimum 8.5%), and a ‘Total Capital Ratio’ of 16.4% (minimum 10.5%). Two days later Silicon Valley Bank was history.

Risk-weighting – the chewing gum connecting low capital to high business volume

The technique that justifies a bank’s modest capital to its business volume is risk-weighting. The common denominator in the three capital ratios is the bank’s Risk-Weighted Assets, or RWAs. RWAs derive from every piece of the bank’s risk-bearing business being processed through a methodology to determine what size of loss could result from it.

• Whether the business appears on the bank’s balance sheet, like a loan;
• Whether it sits off the bank’s balance sheet, like a guarantee, a trade letter of credit, foreign exchange contracts or derivatives;
• An amount for operational risk, to account for losses, for example, from IT failures and fraud.

The result of the methodology’s calculation is in all cases a given amount, which is the Risk-Weighted Asset equivalent of the piece of business concerned or, in the case of operational risk, the Risk-Weighted Asset equivalent of the maximum possible loss in the particular operational process. All of these equivalents are then added up to determine the bank’s total of Risk-Weighted Assets.

The risk-weightings are invariably lower than 100% of the nominal amount: they are based on data from the last 15 years of easy money and asset price inflation, in which bankruptcies have been rare and the value of loan collateral has been steady or increasing, thus reducing banks’ credit losses.

HSBC UK Bank plc – ringfenced and safe as (glass)houses

We do not have to look far to find examples of banks whose Risk-Weighted Assets are far below their nominal amounts. HSBC UK Bank plc, the part that has acquired SVB’s UK subsidiary, claimed on 31/12/21 to have a ‘Common Equity Tier 1 Ratio’ of 15.5%, a ‘Tier 1 Capital Ratio’ of 18.0%, and a ‘Total Capital Ratio’ of 21.6%.³ Its Risk-Weighted Assets were £83.7bn, including £72.8bn for credit risk where the underlying nominal amount of the business was £265.9bn. That is a shrinkage of 73% thanks to risk-weighting.

Without risk-weighting its capital ratios would have been 4.8%, 5.6% and 6.8%: all well below the ‘regulatory minimum’. Indeed, the bank also had £112bn at the Bank of England, risk-weighted at 0%. If those holdings were not risk-weighted either, the bank’s ratios would sink further, to 3.4%, 4.0% and 4.8% respectively.

Monte dei Paschi di Siena – resiliently insolvent⁴

Monte dei Paschi di Siena, at 31/12/21, had total assets of €137.9bn and equity of €5.8bn, 3.6% of its assets (p. 156 and p. 162). It had €2.5bn of bad loans (p. 393), so its equity was really €3.3bn or 2.4% of its assets.

Instead the bank claimed Total Capital of €7.7bn: CET1 of €6.0bn plus Tier 2 Capital of €1.7bn.⁵ This gave it capital ratios of 12.5%, 12.5% and 14.6% (p. 9), its RWAs being €47.8bn (p. 79). €33.6bn of its RWAs were for ‘Credit and counterparty risk’ on banking assets of €129.9bn and on an unspecified nominal amount of off-balance sheet contracts: €33.6bn reflects a discount rate of 74% for the banking assets assuming the unspecified remainder converted to an RWA of absolutely nothing.

Credit Suisse – solid, reliable and trusted⁶… and on-the-tiles⁷

Credit Suisse had a CET1 Ratio of 14.1% at the end of 2022, and a Total Capital Ratio of 20.0% (p. 2), based on CET1 of CHF35.3bn, and on CHF14.7bn of ‘Additional Tier 1 Capital’ that the rescue deal with UBS proposes to erase (p. 73).⁸ Total assets were CHF531bn but RWAs were only CHF251bn including for all of their derivatives business (p. 60). Now this optically strong bank has crumbled.

Conclusion

Risk-weighting has been a convenient way for banks and their regulators to lay claim to resilience, but without banks adding to their capital. Instead all business undergoes an increasingly radical shrinkage via the risk-weighting process, using benevolent data on historical losses that is skewed by 15 years of central bank money-printing. Capital need only be 7-10.5% of this much diminished, risk-weighted amount. This hall-of-mirrors is now being shattered, as optically ‘well-capitalized’ and ‘resilient’ banks go to the wall.