How Risky Are Banks’ Risk Weighted Assets? Evidence from the Financial Crisis

How Risky Are Banks’ Risk Weighted Assets? Evidence from the Financial Crisis. By Sonali Das & Amadou N. R. Sy
IMF Working Paper No. 12/36
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25687.0

Summary: We study how investors account for the riskiness of banks’ risk-weighted assets (RWA) by examining the determinants of stock returns and market measures of risk. We find that banks with higher RWA had lower stock returns over the US and European crises. This relationship is weaker in Europe where banks can use Basel II internal risk models. For large banks, investors paid less attention to RWA and rewarded instead lower wholesale funding and better asset quality. RWA do not, in general, predict market measures of risk although there is evidence of a positive relationship before the US crisis which becomes negative afterwards.

Introduction:

“The leverage ratio - a simple ratio of capital to balance sheet assets - and the more complex riskbased requirements work well together. The leverage requirement provides a baseline level of capital to protect the safety net, while the risk-based requirement can capture additional risks that are not covered by the leverage framework. The more advanced and complex the models become, the greater the need for such a baseline. The leverage ratio ensures that a capital backstop remains even if model errors or other miscalculations impair the reliability of risk-based capital. This is a crucial consideration - particularly as we work through the implementation of Basel II standard. By restraining balance sheet growth, the leverage ratio promotes stability and resilience during difficult economic periods.”– Remarks by Sheila Bair, Chairman, Federal Deposit Insurance Corporation before the Basel Committee on Banking Supervision, Merida, Mexico, October 4, 2006.

The financial crisis that began in 2007 has exposed a number of important weaknesses in banking regulation. A key challenge is how to appropriately determine the riskiness of banks’ assets. The principle that regulatory capital requirements should be tied to the risks taken by banks was accepted internationally and formalized with the Basel I accord in 1988, and the definition of capital and measurement of risks have undergone several revisions since that time.  The second Basel accord, published in 2004, recommended banks hold total regulatory capital equal to at least 8 percent of their risk-weighted assets (RWA). The recently updated Basel III guidelines emphasize higher quality forms of capital, but makes limited strides in the measurement of risks. Instead, Basel III proposes as a complementary measure, a non-riskweighted leverage ratio.

Risk weighted assets are an important element of risk-based capital ratios. Indeed, banks can increase their capital adequacy ratios in two ways: (i) by increasing the amount of regulatory capital held, which boosts the numerator of the ratio, or (ii) by decreasing risk-weighted assets, which is the denominator of the regulatory ratio. A key concern about current methods of determining risk-weighted assets is that they leave room for individual banks to “optimize” capital requirements by underestimating their risks and thus being permitted to hold lower capital. Jones (2000) discusses techniques banks can use to engage in regulatory capital arbitrage and provides evidence on the magnitude of these activities in the Unites States. Even under the Basel I system, in which particular classes of assets are assigned fixed risk-weights, the capital ratio denominator can be circumvented. Merton (1995) provides an example in which, in place of a portfolio of mortgages, a bank can hold the economic equivalent of that portfolio at a riskweight one-eighth as large. Innovations in financial products since the first Basel accord have also likely made it easier for financial institutions to manipulate their regulatory risk measure.  Acharya, Schnabl, and Suarez (2010) analyze asset-backed commercial paper and find results suggesting that banks used this form of securitization to concentrate, rather than disperse, financial risks in the banking sector while reducing bank capital requirements.

In addition to concerns about underestimating the riskiness of assets, there are differences in calculation of risk weighted assets across countries that may have unintended effects on financial stability. Lord Adair Turner, chairman of the UK Financial Services Authority, warned in June that international differences in the calculation of risk-weighted assets could undermine Basel III3 and Sheila Bair, former chairman of the US Federal Deposit Insurance Corporation, added her concern that Europe and the US may be diverging in their calculation of RWA: “The risk weightings are highly variable in Europe and have led to continuing declines in capital levels, even in the recession. There's pretty strong evidence that the RWA calculation isn't working as it's supposed to.”

In this paper, we study whether equity investors find banks’ reported risk-weighted assets to be a credible measure of risk. First, did banks with lower risk-weighted assets have higher stock returns during the recent financial crisis? And second, do measures of risk based on equity market information correspond to risk-weighted assets? Demirgüç-Kunt, Detragiache, and Merrouche (2010) and Beltratti and Stulz (2010) study banks’ stock return performance during the financial crisis as well, focusing primarily on the effect of different measures of capital and bank governance, respectively. Our paper studies whether markets price bank risk as measured by RWA, to inform the debate on how best to measure the risks embedded in banks’ portfolios.  Addressing the first question, we find that banks with higher RWA performed worse during the severe phase of the crisis, from July 2007 to September 2008, suggesting that equity investors did look at RWA as a determinant of banks’ stock returns in this period. This relationship is weaker in Europe where banks can use Basel II internal risk models. For large banks, investors paid less attention to RWA and rewarded instead lower wholesale funding and better asset quality.

We find as in Demirguc-Kunt, Detragiache, and Merrouche (2010) that markets do not respond to all measures of capital, but respond positively to higher quality measures – that is, capital with greater loss-absorbing potential. We also investigate the possibility of a capital-liquidity trade-off in the market assessment of banks. Our results indicate that there is indeed a capital-liquidity trade-off: (i) banks with more stable sources of short-term funding are not rewarded as highly for having higher capital, and (ii) banks with liquid assets are not rewarded as highly for having higher capital.

Regarding the relationship between RWA and stock market measures of bank risk, we find that RWA do not, in general, predict market measures of banks’ riskiness. There is evidence, however, of a positive relationship between RWA and market risk in the three years prior to the crisis, from 2004 to 2006, and this relationship becomes negative after the crisis. This could result from the large increase in market measures of risk, which reflect the volatility of a bank’s stock price, since the crisis, while banks have not adjusted their RWA to account for increased risk.

Conclusions

There has been a steady decline in the measure of asset-risk that banks report to regulators—riskweighted assets (RWA)—over the last decade. In light of this trend and other indications that banks can “optimize” their capital by under-reporting RWA in an attempt to minimize regulatory burdens, we study how equity market investors account for the riskiness of RWA by examining the determinants of stock returns and stock-market measures of risk of an international panel of banks.

Regarding banking stock returns, we find a negative relationship between RWA and stock returns over periods of financial crisis, suggesting that investors use RWA as an indicator of bank portfolio risk. Indeed, banks with higher risk-weighted assets performed worse during the severe phase of the crisis, from July 2007 to September 2008. We find a similar result when we focus on the ongoing crisis in the Europe.

Comparing regions with different regulatory structures, we find, however, that the relationship between stock returns and RWA is weaker in countries where banks have more discretion in the calculation of RWA. Specifically, in countries that had implemented Basel II before the onset of the recent financial crisis, allowing banks to use their own internal models to assess credit risks, investors look to other balance-sheet measures of risk exposure but not RWA. Our results also suggest that for large banks, investors paid less attention to the quality of capital and RWAs during the crisis and rewarded instead lower reliance on wholesale funding and better asset quality as measured by the relative size of customer deposit and non-performing loans, respectively.

We confirm results from previous studies that only capital with the greatest loss-absorbing potential matters for stock returns. In addition, we find a trade-off between capital and liquidity in terms of their positive effects on bank stock returns. The more stable a bank’s funding, the less positive the effect of higher capital on its stock return; the more liquid a bank’s assets, the less an increase in capital will increase its stock return.

When it comes to stock-market measures of risk, we find that RWA do not, in general, predict market measures of bank risk. There is evidence, however, of a break in the relationship between stock market measures of risk and RWA since the start of the crisis. Indeed, we find a positive relationship between RWA and market risk in the three years prior to the crisis, from 2004 to 2006, and this relationship becomes negative after the crisis. This could result from the large increase in market measures of risk, which reflect the volatility of a bank’s stock price, since the crisis, while banks have not adjusted their RWA to reflect increased risk.

In light of increasing risk-aversion in markets during times of crisis, the question of how market assessments of risk should be incorporated into banking regulation and supervision remains. Indeed, the asymmetry of information between banks, supervisors, and market participants regarding how risky RWA are can lead to increased uncertainty about the adequacy of bank capital, which during a financial crisis, can have damaging effects for financial stability.